The good news is that, because of limited resources, the Internal Revenue Service audits only about 1% of the tax returns filed each year. The bad news is that they use a very sophisticated computer system to ‘red flag’ returns that have the best odds of containing errors. Here is a list of the top targets of their search engine:
- Home office deduction. Most of us don’t get a deduction for our homes but if you run a business out of your home you are entitled to deduct that portion of your home and expenses (utilities, maintenance, insurance) that is dedicated to your business. The key to this deduction is that the home office must be used ‘exclusively and regularly’ for the business. If it’s also used as the family TV room or only used occasionally, it will likely not qualify.
- Business auto expense. Lots of people use their vehicle for their business and the IRS allows you a deduction for business use provided you follow strict guidelines and maintain accurate records. You can elect to use either the standard mileage (0.50 cents) or actual expenses. The key to this deduction is detailed recordkeeping. There are any number of tracking systems available including the basic logbook to sophisticated GPS mapping and recording systems. Try taking a 100% auto expense deduction and plan on a personal visit from an IRS agent!
- Charitable deductions. If our itemized deductions are out of line with the norm, you may get red flagged. One way this often happens is through large charitable deductions. For example, if you’re deducting $25,000 and your income is $100,000 you’re likely to get flagged…no matter that the deduction is perfectly legitimate. Another area the IRS closely monitors is non-cash charitable deductions. Why? They’ve found that people often think their used clothing, furniture and personal items are worth much more than the law will allow and people tend to have poor recordkeeping to substantiate values.
- Math errors. Making a mathematical error is one of the surest ways to trigger an IRS inquiry. There’s an old carpenter’s saying, “Measure twice, cut once!” In IRS speak it’s, “Check your math twice, file once!” Included under this category would be unreported income…a careless mistake tax filers often make.
- Large deductions for business travel, meals and entertainment. Whether you own your own business or are a W2 employee, this is a category that the IRS loves to audit. They love it because there is so much abuse and often recordkeeping is very poor. Your best defense is excellent records including who you met with, the business purpose, basic content of your discussions, where the meeting took place as well as receipts for all expenses.
- First-time homebuyers tax credit. The IRS is concerned that people may play a little loose with the rules which are quite specific in order to qualify for the first-time homebuyer’s tax credit program that was part of the Obama economic stimulus program rolled out in 2009 and 2010. A special form 5405 is required plus lots of documentation. If you participated in this program, you’ve got your homework cut out for you.
Your overall best strategy: Don’t be afraid to take legitimate deductions but for any deductions that are out of the ordinary, maintain excellent records and documentation.