You’re not alone if your heart pounds when you see a letter from the Internal Revenue Service (IRS) in your mailbox. While some lucky filers get sent a letter because they’re due a larger refund, most of us fear the worst — an audit.
Those fears may be largely unfounded for the average household. Only about one percent of taxpayers get audited, and high-income taxpayers are disproportionately targeted.
If you are audited, it might not be like you imagine. IRS agents aren’t going to burst into your home; rather they’ll send you a letter requesting more information or a meeting. The audit-by-mail method is called a correspondence audit. Office and field audits, when you meet with IRS agents at their office or your home, respectively, are less common.
An audit could focus on a particular line entry, credit or figure, and you might only need to mail or fax a copy of the relevant paperwork, such as an insurance report or receipt.
Even so, getting audited isn’t fun. In the best case, you have to take the time to dig through your records and send copies of the requested material. In the worst case, you have to do all that as well as pay penalties and interest.
What can you do to help reduce your risk of audit? Audits, or examinations as they’re also referred to, could be the result of a random selection, mismatched documents, deviation from the expected “norms” for similar returns or connection to someone who’s being audited. But there are a few things you can do to help minimize your chances of being audited.
- Enter all your information correctly. Take an extra few minutes to double-check the information you entered when preparing your tax return. A misspelled name or wrong number could lead to an examination.
- Include information from every form with your return. When an employer sends you a W-2 or 1099, it also sends a copy to the IRS. Same goes for the tax forms you receive from other organizations, such as banks and brokers. The IRS has an automated system that can flag a return when you don’t include information from one of the forms you received.
- Report alimony you receive as income. You need to include alimony you receive as income on your tax return. Alimony payments are deductible, and to claim the deduction the person must include the recipient’s tax identification number (such as a Social Security number). In other words, the IRS can trace the income to you.
- Don’t treat a hobby as a business. You might enjoy your hobby and occasionally make some money from it, but that doesn’t make it a business. It’s an important distinction because business and hobby expenses are treated differently. For example, you can’t claim a loss from your hobby and if you try, that could be a red flag.
- Know the home-office rules. Many small business owners and contractors work from home, but that doesn’t automatically mean you can claim the home-office deduction. You can’t claim a guest bedroom where you occasionally work, the room (or part of a room) must be used exclusively and regularly for business.
- Only claim the EIC if you have earned income. The Earned Income Credit (EIC) can be worth thousands of dollars for low- and middle-income households. To qualify for the credit, you need to have earned income for the year. However, only some types of income, such as wages, salaries and self-employment earnings, are considered earned income. Other types of income, including alimony, child support, unemployment benefits and Social Security won’t qualify you for the EIC.
- Be able to support your claims. The IRS knows the average charitable contributions households give in proportion to their income. If you stray too far outside the norm, that could be a red flag. Don’t let that stop your giving, but only claim a deduction for donations you can verify. The same goes for small business owners who try to underreport their income. The IRS can compare your claims to the average earnings and cost of running similar businesses in your area.
Working with a professional tax preparer, such as a certified public accountant (CPA) or enrolled agent (EA) could help you avoid making errors on your return, but it doesn’t guarantee you won’t be audited. However, if you’re audited, your preparer might help you through the process or represent you. Similar types of support are sometimes offered with online tax preparation software for a fee. In either case, if you’re required to pay more tax, the bill may get passed on to you.
Don’t let fear cost you. Some taxpayers shy away from claiming legitimate credits and deductions because they fear an audit. That could be a costly choice. There’s only a small chance you’ll get a notice letter (i.e. an audit), and it could be quick and relatively painless — especially if you keep good records.
The letter you receive should explain why it was sent and instruct you how to respond. Sometimes the letter might notify you of a change to your return that doesn’t affect your refund. If you agree with the notice, don’t owe any additional tax and aren’t instructed to reply, you don’t necessarily need to do anything.
Follow the instructions closely when the notice requires you to respond or make a payment. Generally, the notice will list the specific documents they want to review. There’ll also be a phone number on the top right corner of the notice you can call if you have questions.
If you disagree with the notice, you should write a letter explaining your position and include supporting documents to back up your claim. Mail your response and the stub that’s on the bottom of your notice and keep copies of everything for your records.
While some taxpayers are happy to deal with notices on their own, an accountant or tax attorney can help review your case and help you prepare your response if you’re feeling lost. A tax attorney can also represent you in court or take over corresponding with the IRS on your behalf.
As a quick aside, fear also leads thousands of people to fall victim to tax-related scams. Thieves may impersonate an IRS agent and demand you make a payment or face severe consequences. Don’t get caught up in a scam. Remember, the IRS will never call or email you requesting a specific type of payment, such as a money transfer. The IRS only initiates contact with taxpayers by mail, and you can choose among several methods of payment when you owe money.
Bottom line: While there’s no way to guarantee the IRS won’t ask questions about your tax return, don’t let fear of an audit keep you from using the credits or deductions you can rightfully claim. Filing a complete and accurate return could help minimize your chances of an audit, and if you do receive a notice, you may be able to quickly resolve the issue by following the instructions.
Nathaniel Sillin directs Visa’s financial education programs. To follow Practical Money Skills on Twitter: www.twitter.com/PracticalMoney
This article is intended to provide general information and should not be considered legal, tax or financial advice. It's always a good idea to consult a legal, tax or financial advisor for specific information on how certain laws apply to you and about your individual financial situation.