Bob Dylan says in his song Tight Connection to My Heart,
"What looks large from a distance, Close up ain’t never that big."
Well, that’s a pretty useful, and accurate, way of looking at the IRS!
Fear of the IRS and a potential audit can be paralyzing for people. The best antidote to fear is to understand the IRS system and how to navigate it.
So, here’s some practical advice for pre-empting audits and avoiding IRS red flags. And getting rid of a lot of unnecessary fear, to boot!
1. Maintain Accurate Record Keeping
Keeping thorough and accurate records can’t be understated. Whether you’re an individual or business owner, maintaining documentation for income, expenses, and deductions strengthens your defense in case of an audit. Retain receipts, bank statements, and relevant contracts for at least seven years, as the IRS can audit returns from previous years.
2. Avoid Common Red Flags
Certain actions in tax filings may increase your risk of an audit. Avoid these common red flags:
- Different Card Expenses: When you have a home office, your business expenses coming off of different cards can seem suspicious.
- Large, Unexplained Tax Credits and Deductions: Claiming large tax credits and deductions that are not reasonable and substantiated can trigger suspicion. Ensure all credits and deductions are legitimate and supported by documentation.
- Non-Attachment of Cost Segregation Reports: Cost-seg reports missing when claiming depreciation deductions immediately attract the IRS’ attention and suspicion as there are no details to substantiate the claim.
- Amended Returns for Refunds: These attract the IRS’ attention and suspicion quickly, which may result in a protracted and more detailed scrutiny of all other related details. When amended returns are reasonable, they need to be thoroughly substantiated and effectively supported with enough documentation proof.
- Perfect Figures: Perfect, round figures everywhere are unrealistic and will attract suspicion as to the authenticity of your records.
- Unreported Income: All forms of income, whether from employment or freelance work, must be reported accurately.
- Excessive Business Expenses: Report reasonable business expenses that align with your revenue, ensuring they are necessary, ordinary and well-categorized.
3. File Taxes on Time
Non or late filings can raise questions about the accuracy of your return and increase your chances of penalties or audits. Even if you can’t pay the full amount, always file on time and work out a payment plan with the IRS. Timely filing minimizes unnecessary scrutiny.
4. Seek Professional Help
Tax laws are complex and often change. Working with a CPA or tax professional ensures accuracy, helps you identify deductions, and provides peace of mind. Proactive tax planning early, rather than retrogressive tax-filing, allows enough time to work out how to leverage the tax code to create the best cashflow and wealth retention for your enterprises and plans.
5. Understand the Audit Process
The IRS uses a system known as the Discriminant Index Function (DIF) to identify returns that could be pulled for audit. The higher the DIF score, the more the chance of being pulled for an audit, and the more the need to have a solid tax plan. While not all flagged returns lead to audits, filing an error-free, accurate return is your best defense.
Of course, it goes without saying that if you enjoy celebrity status, you will, almost certainly, be on the IRS radar! Well-known public figures can be made an example of in case of tax non-compliances.
This deterrent tactic, while effective in catching true tax-defaulters, creates a disproportionate fear in the rest of the public, which can cause people to avoid well-strategized and reasonable tax planning, simply out of ignorance and fear.
Remember the real enemy is ignorance, not the IRS!
6. Be Prepared for Audits
If selected for an audit, remain calm and provide requested documents promptly. Here’s what to keep in mind:
- Stay Transparent and Focussed: Be clear and truthful in your responses. Don’t answer unasked questions! Provide only the information asked for.
- Have Your File Ready: It pays to have gone through the tax plan worked out between you and your CPA thoroughly, and that you have all your documents and details ready and supported in your file.
- Involve a Professional: A tax professional can assist in navigating the audit process and handling communications with the IRS.
- Know Your Rights: Taxpayers have the right to representation and can appeal IRS findings if necessary.
- Don’t give in to fear, intimidation or pressure: There are legal processes the IRS has to follow including sending letters and notices, and it is best to operate and respond within these.
Conclusion
Tax compliance as well as proactive planning requires diligence and a good understanding of the system. By maintaining proper records, avoiding red flags, and working with professionals, you can reduce your tax liability and avoid audits, and retain more of your wealth. If you’re ever unsure, consult with a tax professional to ensure you’re on the right track.
