In the United States, the taxation system is a voluntary one. This means that we report our income and deductions to the government and we calculate the tax that we owe. In return, the Internal Revenue Service (IRS) is allowed to audit our tax returns to make sure that we follow the tax laws.
How does the IRS decide which returns to audit?
The IRS only audits a small percentage of income tax returns each year. When you file your return, the information is entered into the IRS computer system and each item is assigned a DIF (Discrimination Information Function) score. The DIF score helps the IRS to determine which returns will be audited. The DIF score considers your income, your family size, where you live, and how you earn your money.
The more unusual your tax return is, the higher your DIF score will be. For example, if your total income is $45,000, you live in an area that is expensive, and you have four children, your return is more likely to be audited. Or, if you report income of $30,000 but deducted on your return $20,000 of charitable contributions, your return would also be much more likely to be audited. Quite simply, the DIF score is used to find tax returns where it is likely that people are under-reporting income or over-reporting deductions.
What are the top reasons a tax return will be audited?
Home office deduction. Many people deduct home expenses because they use a portion of their home for business. If you do this, the IRS will probably carefully examine a tax return claiming home office expenses. This is because the IRS has found that taxpayers and tax preparers often use home office deductions as a way to change non-deductible expenses, such as rent, mortgage payments, electricity, heat, etc., into expenses that may be deducted. Even if you really do use your home as an office, you should make sure to keep all receipts, bills, and invoices related to your home office if you take home office deductions.
Job expenses. If you work for someone else and receive a yearly Form W-2 (the form showing your wages for the year and the taxes withheld from those wages), you may deduct from your income expenses in connection with your work. You may only deduct those expenses if the total is greater than 2% of your adjusted gross income, they were ordinary and necessary, and your employer did not and will not reimburse you (give you money back) for them. The IRS usually assumes that, if an employer does not reimburse an employee for a specific type of expense, the expense was most likely not related to the job. If you deduct job expenses, you should keep all records of expenses and write down how the expenses were necessary for your job. This is because there is a greater chance that you will be audited.
Rental losses. Rental losses are subject to complicated rules. These rules make it difficult for most taxpayers to figure out their deductions correctly. In most cases, losses from rental activities may only be deducted if you are getting income from the rental activity. Because of these complicated rules, taxpayers who file a return with rental losses are subject to more IRS audits than those who do not claim these deductions.
Schedule C expenses. If you are running a legitimate business and have a reasonable expectation of earning a profit, you are allowed to deduct your ordinary and necessary business expenses from the operation of the business. However, if you deduct expenses that are more than the income earned from the business, this will trigger an audit. In fact, because there is so much abuse in this area, the mere reporting of business expenses on a Schedule C increases a taxpayer’s chance of being audited by 50 percent. People who fill out a separate corporate income tax return are not as likely to be audited.
Charitable donations. In the past, many taxpayers have wrongly used this deduction because the IRS did not require that the taxpayer show documents that proved that they made donations to a charity. However, the rules on taking a charitable contribution (donation) deduction have changed and are now stricter.
Remember, if you report your income and expenses honestly, even if you are audited, you should be able to defeat any proposed IRS changes. However, keep all records and respond to all IRS notices.
This information last reviewed: Nov 2, 2011