Well, it’s that time of the year again. If you’ve already filed your income tax, congratulations. If you’re typical you should be getting more than $3000 refunded. You might think that’s great but remember it’s your money and you let the government use it interest-free. Many people choose to claim fewer or even no dependents so that they can take home more money every paycheck. Others and maybe you’re one view withholding as a sort of savings account that can be cashed in the following year.
Our government has made it clear that fewer people will be audited this your because of funding cuts to the IRS. Of course, that doesn’t mean that you won’t be audited. A tax audit can have a severe effect on your life. You could end up learning that you owed thousands of dollars more than you had thought. However, there are things you can do to reduce the risk that you might be audited.
#1. Prove that you run a small business
If you have a small business, the IRS will forgive you if you show a loss for the first few years. However, if you report that your business has lost money for three years or more the IRS will begin to suspect that it’s more of a hobby than a business aimed at turning a profit. This can trigger a field audit, which is done in person and is a lot more nerve racking than an audit by correspondence. You need to keep records of all of your business expenses and be prepared to document how much time you spend on the business and what you did with it.
#2. Make sure you report all and we mean all of your income
The income you earn from your job is reported to the on an IRS W-2 form. If you have income from dividends, interest or capital gains this is reported to the IRS on form 1099s, as is any income that you earned as a freelancer or independent contractor. You are sent these forms and so is the IRS. So make sure that you include all of the information from them on your tax return. The reason for this is because the IRS uses a program that matches these forms to your return and flags any differences between what you reported and what was reported to the IRS. If the program finds any discrepancies, this will trigger what’s called a correspondence audit. What this amounts to is a letter from the IRS on how much more money you owe because of what you didn’t report. You can either just pay whatever amount the IRS has said you owe or challenge it if you believe that the IRS has made a mistake.
#3. Explain anything that seems “weird”
The IRS is a shark when it comes to unreported income. If you have any income that seems weird, you need to explain it as this may stop the agency from auditing you. As an example of this, if you the net income you report is too little to live on given the size of your family size and where you live, you need to include a statement revealing how you supported your family including any credit cards, loans or savings you used to pay for your cost of living.
#4. Watch those deductions for you home-office
It’s typical to have your office in one place, which would be either in your home or a rental space. Be careful to not report a deduction for both. Of course, you might legitimately have an office at home and in a rental space. If so you will need to explain this in a disclosure statement. You might also have an expense for equipment or a business storage unit. If so label this as a “storage rental cost” or an “equipment rental cost.”
#5. Be honest if you have any money overseas
If you have investment accounts or a bank account overseas you must report any income you earned from it to the IRS. While you’ve always been required to do this, there is the new Foreign Account Tax Compliance Act so that the foreign institution where you have money may start to report the information to the IRS just as would any brokerage or bank in the US. Here’s the scary thing. If you’ve had that account for years but never reported it and the IRS discovers it from your foreign investment firm or bank, you could owe some really serious penalties in addition to back taxes.
#6. Report the sale of mutual funds correctly
Let’s suppose you sold a mutual fund that you bought prior to 2011 and it was not part of your tax-advantaged retirement account and then reinvested in another mutual fund. This must be reported on your income tax return. If you fail to do this the IRS will treat everything you made from the sale of the mutual fund as a taxable gain and will recompute how much you owe. When this is the case, you need to be able to prove that only part of the proceeds you received were actually capital gains and the remaining portion was he amount you had originally invested in the fund. Of course, if you lost money on the fund, you owe nothing on the sale.
The title company sends the IRS a 1099-S form when you sell your house showing how much you sold it for. This is true even if all the capital gains you made on the sale are tax exempt because they weren’t more than $500,000 if you’re married or $250,000 if you’re single. It is recommended that you still report the information on your income tax return anyway. Why is this? It’s because that 1099-S will be part of the IRS’s automated form-matching program. If you don’t report it, this can lead to a correspondence audit.
#8. Be wise about your mortgage interest
When you and your spouse own a home, your mortgage holder will send both you and the IRS a form 1098 showing the amount of interest you paid the past year. This is an area where you need to be careful because there are cases where the 1098 has only the Social Security number and name of one of you. If that person were to die and the surviving partner tries to take the deduction, a correspondence audit may be triggered. When this is case you need to have the mortgage holder change the name and Social Security number on the 1098 to yours before it’s filed.