Before you get too frightened, take heart: Although the likelihood of an audit significantly increases as income grows, a majority of Americans — those making $500,000 or less — have less than a 1% chance of being audited. The odds are now1 in 220 – a notable drop from the 1 in 90 of a decade ago. There are several simple ways to reduce your risk of attracting a second look from Uncle Sam. Here are five things to avoid if you don’t want to see a tax audit letter hit your mailbox.
Remember, Honesty Is the Best Policy
No one wants to be audited, but if you lie on your tax returns, you’re practically begging for it. So assuming you can avoid the temptation to “forget” reporting income, claim a whopping charitable deduction that never happened, or ignore the existence of your fat Swiss bank account, you’re already ahead of the game. Avoid this fate by skipping the paper returns. Going through a tax professional can drastically reduce your chances of errors, but so can using an online tax preparation program that takes care of the math for you and prevents you from moving forward until you’ve filled out all necessary fields. Remember, filing online might even be free, so there’s little reason not to take advantage. Another related red flag? Deduction amounts that are just a little too neat and even — $200 here, $500 there, $1,000 there. Uncle Sam knows you’re probably rounding, meaning you don’t have documentation to support those deductions. Interestingly, those who reported no gross income had a 4.5% chance of being audited, making them the group most likely to be audited among those making less than $10 million. Many of these filers may be reporting net operating losses for their small businesses, and the IRS wants to make sure that’s truly the case. Another related risk? If you claim the Earned Income Tax Credit (EITC), which maxes out at just over $6,700 this tax year. Many filers try to claim this lucrative credit even if they’re ineligible. You can check whether you can safely claim the EITC at the IRS website. One of the biggest is forgetting — or “forgetting” — to report all of your income. For instance, if you’re a freelancer who juggles multiple clients, make sure your taxes reflect each and every 1099 form. Missing just one can mean a world of hurt. Another tricky area is deductions. It’s easy to get deduction-happy when you’re self-employed, since “ordinary and necessary business expenses” are fair game. But realize that the IRS is far stricter about that definition than you may be. That shiny MacBook you bought for personal reasons and only occasionally use for work? You’re on thin ice. Claiming a home office deduction when you use your dining room table as your desk? Be very careful. Taking a friend out for lunch and trying to pass it off as a business expense? Don’t do it. Bottom line: To qualify as a legitimate deduction, the expense should be essential for you to do your work. Those knitted beer cozies you make in your basement and sell to friends for a few bucks each may not seem consequential enough to spur an audit, but the IRS may think differently. You need to have a legitimate profit motive for your activity to be considered a business rather than a hobby; otherwise, related losses are not fair game for deductions. One way to prove this is by turning a profit in three of the past five years (called the “3-of-5 test”), but you can also submit evidence of your attempts at making money (marketing efforts, proper licenses and permits, etc.) to help your cause. The IRS has detailed statistics showing how much people with similar incomes typically give. Vastly overshoot that number, and an audit becomes more likely. For instance, if you report $100,000 in income, somewhere around $3,300 in charitable deductions would be typical. Report $10,000 and you’re likely to raise eyebrows since that’s more in line with the amount given by people making four times as much. Cash donations are easy (and essential) to document. But regular folks may be more likely to get in hot water by overstating the value of donated items such as clothing, housewares, and furniture. That old winter coat, even if it’s in good shape, may only be worth $20 — even if you originally paid $200 for it. Be sure to consult a pricing guide such as this one from Goodwill or this one from the Salvation Army before itemizing your donations. [This article was originally published on The Simple Dollar in March, 2020. It was updated in November, 2021.]
