Home-business expense and charitable deductions may trigger audit

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Have you ever wondered how the IRS chooses whom to audit? We’d all love to know. After all, the IRS performs hundreds of thousands of audits every year — about 1 percent of all tax returns in 2012 — and that number seems to be rising.

The exact method used by the IRS to flag a tax return for an audit, however, is a closely-held secret. We do know that one way is through a computer-based scoring system called the Discriminant Information Function, or DIF. The DIF compares each tax return to the average return among similarly-situated taxpayers. Basically, the program appears to evaluate whether the exemptions, deductions and credits being claimed on a particular return fit within the expected norm.

The exact formulas used in the DIF are confidential, but researchers have been able to spot some trends. What factors could put you at risk for an IRS audit? Here are a few to keep your eye on:

  • High income: According to Crain’s Wealth, the risk of an audit is higher than average for taxpayers earning more than $200,000 per year — and higher still for those earning $1 million or more.
  • Above-average deductions: The DIF is likely to flag your return if you deduct more than average for your income group, so keep good records.
  • Strategic or in-kind charitable donations: Any one-time charitable donation of more than $250 requires documentation. Also, many taxpayers donated appreciated stock in 2013 in order to limit capital gains, and word has it the IRS will be scrutinizing those gifts.
  • Deducting small business expenses or reporting a negative gross profit: The IRS is well-aware that entrepreneurs are prone to be aggressive when deducting business expenses, and it will be checking. And, according to a tax expert from the American Institute of CPAs, a small business return with costs that exceed income is “guaranteed to be audited.”

If you do receive an audit letter from the IRS, keep in mind that you’re not being accused of any wrongdoing or of owing any additional taxes — yet. At the same time, bear in mind that the IRS is represented by a team of tax specialists, CPA’s, and tax attorneys — you’ll need to talk to your own tax lawyer right away to level the playing field.

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