Red Flags to Avoid
An IRS audit. It’s what taxpayers most dread as they prepare their returns and what 1.3 million of them faced last year — up 5% from the year before.
As the White House and Congress look for more ways to shrink the federal budget deficit, your chances of being audited are likely to grow, especially if your income tops $100,000.
Although there are no foolproof methods to avoid an audit — and many returns are chosen randomly — there are certain red flags that draw the attention of IRS computers and auditors.
Here are mistakes that could cause your return to stand out and suggestions on how to avoid an audit…
Omitting or underreporting income. Employers and financial institutions sometimes report income incorrectly to taxpayers and the IRS on W-2 forms (for employees) and 1099 forms (for independent contractors).
Safest: If you receive an incorrect W-2 or 1099, don’t just substitute a different figure on your tax return. Get the mistake corrected by the source, and ask for a new W-2 or 1099.
Failing to fill out an Alternative Minimum Tax (AMT) schedule. This year, more than 3.5 million individuals are expected to owe this tricky tax, which kicks in when deductions push the regular tax below a certain minimum amount. Taxpayers who live in “high tax” states, such as New York and New Jersey, are particularly vulnerable, because state and local income tax and sales tax are not deductible for AMT purposes
Safest: Use the IRS 2006 AMT assistant, an online calculator at www.irs.gov (put “AMT Assistant” in the search window), to determine whether the AMT applies to you.
Messing up the math or leaving blanks. IRS computers easily detect math errors and omissions.
Safest: Print out your calculations so that you can double-check them. Review all lines, as well as blanks, to make sure that you didn’t leave out required information or put it in the wrong place. That includes the signature lines — remember that both spouses must sign a joint return.
Better yet: File electronically. It cuts down on math errors — E-filed returns have an accuracy rate of more than 99%, compared with 80% for paper returns, because the program checks the math.
Claiming too many deductions and/or credits. The IRS is on the lookout for excessive deductions and credits.
Example: In January, the IRS said that some taxpayers are asking for too much in refunds for certain taxes they paid in the past on long-distance phone bills. Those taxes have been ruled illegal, and the government is offering to refund to each taxpayer a “standard” phone tax amount of $30 to $60, depending on the number of exemptions claimed on the tax return, without requiring any proof. For higher amounts, proof of what was paid in phone taxes is required. IRS commissioner Mark W. Everson said that “people requesting an inflated amount will likely see their refund frozen, may have their entire tax return audited and even face criminal prosecution where warranted.”
If you request more than the standard phone tax refund, be sure to have on hand the phone bills that prove what you claim.
Safest: In general, don’t claim deductions that far exceed what tax preparers say is reasonable for your income bracket, or if you do, attach an explanation. Attach copies of bills for unusually high medical expenses. Have proper documentation for donations to charity. For used clothing and household items, take pictures of the items to show that they were in good used condition or better.
Guidelines: There are no “standard” deduction amounts. Based on IRS statistics for 2004, taxpayers with adjusted gross incomes (AGIs) of $50,000 to $100,000 itemized an average of $2,663 in charitable contributions and $6,125 in medical costs. Those with AGIs of $100,000 to $200,000 itemized an average of $4,130 for charity and $9,811 for medical costs.
Claiming losses on hobbies. Deductions for a fun activity, such as coin collecting, may be rejected if the activity results in losses that don’t make commercial sense year after year.
Safest: Don’t claim deductions for hobby expenses unless you are prepared to show that you are engaged in the activity for profit.