Avoiding an IRS audit (part 2 of 2)

Beating the computer and avoiding an IRS audit:

(Read Part 1 Here)

  1. List a Conservative Occupation

Right next to your signature you are requested to list your occupation. Some occupations attract conservative and law-abiding individuals, who help keep the DIF score low for everyone who lists that occupation on their 1040. From accountants, auditors, bank tellers, pre-school teachers, journalists, peace officers, and politicians (presumably low DIF), to real estate salespeople, entertainers, artists, marketing consultants, and horse trainers (presumably high DIF), each occupation has its own unique fingerprint indicative of either a conservative or liberal approach to filing taxes. I’m guessing (but I’m not sure) that the IRS even has statistics for persons listing no occupation or certain vague descriptions like “self-employed,” “business” and “manager.” NOTE: the author recommends that you do not use the occupation “Administrative Assistant” which changes meaning when the second word is truncated to only 3 letters by the IRS computer.

How can this work for you? That’s easy – put a spin on your occupation or job title to point out the more conservative and tax-law-respectful version of yourself. Or leave out the occupation if you believe there is no way to describe what you do without alarming the FBI. It is important that your occupation bears a close relationship with the types and amounts of your income and deductions; your DIF score will be lower if the relationships are within normal limits for your occupation. Common sense suggests that the occupation “accountant” would be the least frequently audited, not only because accountants tend to be more conservative and knowledgeable about the tax law, but they have the skills to read tax form instructions and produce proper supporting documentation in the event of an audit. I have reported myself as an accountant for 35 years, and even in years when my income and expenses were way outside normal figures for my occupation, I have never been audited, at least up to this date. Perhaps the writing of this book will change my luck. Bring it on, I have the records!

2.  Match 3rd Party Reporting

Match all 3rd Party Reports and then some. Never miss a 1099 or W-2. Be sure to include interest income on all bank accounts, and be especially careful to check that you received a 1099 from all accounts, even the one from that savings account you closed last March and might have gone to the wrong address. If you had a savings account with a small balance you may not have received a 1099 (not required if the interest is under $10). Be sure to report some interest for that account. Reporting income that you are not forced to report may lower your DIF score.

If you received a 1099 that is in error – it doesn’t belong to you or reports more income than you received, try to get the issuer to correct the 1099. If you cannot make this happen, report all the income on the 1099 in the correct place as if you had received it, and take a deduction on the same form to reduce the net income on your return to the amount that you actually received. An example of this is found in the sample return in Appendix

3.  Moderate Certain Targeted Deductions

Certain items on tax returns are frequently targeted by the IRS because they are frequently abused and auditing them produces results. Here is a list of these items and the reason the IRS looks at them:

Automobile Expenses. There are specific record-keeping requirements of which many taxpayers are unaware and often fail to follow. The records must be “contemporaneous” so the taxpayer must be able to produce them at the first audit meeting. If you go into an audit not knowing this and you make the mistake of saying “no, I don’t have a log of my business miles,” you have been blind-sided into losing the deduction, even if you really deserve it. The ability to claim a standard mileage allowance tempts many (the majority of) taxpayers to pull a number of out thin air rather than keep clipboards in their cars and meticulously track changes in their odometer reading. When given the opportunity to “estimate” business miles, who wouldn’t be tempted to overestimate to some degree? The prevalence of inadequate record-keeping and overestimation makes this category ripe with low-hanging fruit.

Meals and Entertainment. Once again the record-keeping requirements promote overestimation and inadequate record-keeping. In addition, the IRS reserves the right to disallow some meals as “lavish and extravagant,” although this term is not objectively defined.

Mortgage Interest. Amounts in excess of $50,000, even when they match the electronic reporting of the lender, raise the possibility that the mortgage balances may exceed the maximum amount ($1.1Million) on which interest may be deducted. If your mortgage interest is higher than $50,000 you may wish to deduct some amount slightly than that to give the impression that you have calculated the non-deductible portion.

Non-cash Charitable Contributions. Be sure to attach Form 8283 if your noncash contributions exceed $500. Provide an elegant description of each item donated, along with the words “exc cond”. “11 silk blouses” is more elegant than “clothing.” List an original cost that is at least 4 times the fair market value.

Travel Expenses. The temptation exists to deduct travel for vacations, weddings, and other non-deductible purposes. In addition, many travelers erroneously include their meals as travel expenses, which is incorrect, since the deduction for meals is only 50% of the amount spent, even if the meals are incurred while travelling. And again, there are specific record-keeping requirements.

Office Expenses. Many taxpayers erroneously include the cost of office equipment in this category. Equipment is an asset and must
be depreciated to be deductible. While it is acceptable to have a minimum dollar-amount “cut-off” for assets (say, anything under $100 goes in office expenses, anything over is treated as an asset), your DIF score may be lower if you reduce your office expense to an amount that flies “under the radar” by depreciating all assets, even those costing under $100.   In fact, depreciating a long list of inexpensive assets may also reduce your DIF score, because it is indicative of a more conservative taxpayer.

Miscellaneous Expenses. This catch-all category tends to accumulate significant dollar amounts, appears on both individual and business returns, and provides the taxpayer with an opportunity to include a supporting statement. But because of the variability in the supporting statements, the IRS computer does not evaluate the detail statement, just scores the return based on the total in “miscellaneous.”

What can you do to protect yourself? First of all, avoid overusing these categories. If your automobile expenses are high, you could transfer some of them to advertising, travel, or education. There is no penalty for mis-classifying your expenses, as long as you can properly defend them. The Service will simply decrease one category and increase the other in the course of an audit, resulting in a change to your return, but with no additional tax assessed.

If you have large deductions in these categories, you may avert attention by classifying some of them as the less-frequently used category “cost of goods sold.” Any expenditure that was directly related to the production of income could be considered cost of goods sold. This category is used by retailers to deduct the cost of products sold in the store, and by contractors to deduct labor and materials that went into their jobs. Many other businesses may use this category, which is frequently a large percentage of gross receipts. On the other hand, be sure that your cost of goods sold is not too high in relation to your gross receipts, or you will run into another audit flag. While it is possible (especially for a contractor) to pay more for materials and labor than the revenue on the job, it is a sure audit flag if your cost of goods sold exceeds your revenue. Better to claim some of the labor as overhead on Schedule C line 26.

4.  Look Closely at the Relationships

The relationships between income and expenses have a great bearing on the DIF score. For example, losses from self-employment (reported on Schedule C) result in more frequent audits than losses from rental properties (reported on Schedule E). Rental property is not as profitable as a business, the actual ownership of a rental property is often verified by third party reporting of mortgage interest, and rental losses are subject to a limit of $25,000 per year for most taxpayers, a limit which is frequently reached.   Self-employment losses are less common, do not always have third-party verification, have no annual limit, and there is a much greater frequency of audits resulting in additional tax assessment. A business loss is especially inviting to the IRS when it appears on a return with a lot of other income (wages, interest, etc.). It is more tempting for a high-income taxpayer to exaggerate expenses when there is real savings.

Here is a list of relationships that should be approached with care:

1)      A business loss (Sch C) that exceeds 10% of other income on the return

2)      A service business without payroll expenses that shows a loss

3)      Medical deductions over 10% of total income

4)      A large deduction for pension contributions when there is little income.

5)      Claiming head of household with 5 children in a high-rent zip code and little or no income.

(Read Part 1 Here)
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