Red Flags That May Lead to an IRS Audit

It's everyone's nightmare: opening the mailbox and finding a letter from the IRS. Its scary stuff, especially if the letter is to advise you that you are going to be audited.

Your hands shake and sweat, your imagination runs wild with terror.

But if you have audit-proofed your income tax return--check my previous article--you might not feel so intimidated.

I was audited my second year in business. I was thrilled because I viewed it as a learning experience. I figured if I was going to be representing taxpayers in audit, its better to cut my teeth on my own case.

Today many audit requests are being handled over the phone: The IRS agent will call to schedule an appointment and then follow up with a letter requesting certain documentation and confirming the date and time of the audit appointment.

Thanks to the current administration approving an IRS budget increase of more than $600 million in 2009 for enforcement (this included more auditors and more collection personnel) instances of audits are on the rise.

Existing personnel who may have been displaced by office closures or technology, are being retrained as enforcement personnel. So beware, with so many newbies and the complexity of the tax code, audit determinations may not be accurate. If you choose to represent yourself, and you dont like the results, dont sign off on the audit until you have reviewed the case with a competent tax pro.

The good news is that many audits are only for a few line items on your tax return. Its not necessarily the strip search that we have all come to fear.

One question that will resonate is: Why? Why me? The IRS usually will not tell you the reason. In fact, it could be a result of random selection. Otherwise, there could be many reasons:

1. Your numbers are a big departure from the National Standards.

2. A red flag slapped them awake: excessive automobile expense, travel, meals and entertainment, etc.,

Know this: home office, which was a raging red flag in the 90s, is no longer a big issue with the IRS. With the loosening of the tax law and the increase in freelancers, self-employed workers and telecommuters taking the deduction these days, the IRS expects to see home office expense more often than not. If you have one and are being audited, they will likely want to check it out to make sure you are not abusing the law.

3. There's a big swing in income from one year to the next. If income plummeted, the IRS might think youre hiding something. If it increased substantially, it might think you were previously hiding something and finally decided to come clean.

4. You fall in a targeted industry: Every year the IRS selects its latest group of victims. One year it audited attorneys incorporated as Sub S. Another year, it audited cash businesses, next trusts with offshore accounts, and so it goes.

5. You filed an amended income tax return for the year in question to take additional deductions, some of which may trigger red flags (see above).

6. Failure to include income that was reported to the IRS by a third party. Maybe you got a K-1 or a W2 showing income that you failed to include on the tax return. This normally results in a mail audit, a letter called a CP2000 that is about 12 pages of confusing rhetoric sandwiched around a description of the missing documents and a computation of the new tax liability.

If the CP2000 pertains to a stock transaction, do not the pay the bill. They only have information regarding the sale price (cost basis will be provided by brokers to the IRS beginning with the 2011 tax year). You are allowed to deduct your cost and pay taxes on the remainder or enjoy the loss against your other taxable income. See your tax pro.

If the audit will take place at the IRS office, the auditor will likely allocate the hours. He or she will review the requested documentation and normally wrap things up within that time frame. If you failed to bring every requested item, or cannot prove the validity of your deductions, the audit may run over and could require a second appointment or a mail-in of missing documentation.

If the auditor wants to hold the audit in your home, then he or she likely wants to verify a home office deduction or if there is no home office, she wants to go on a fishing expedition to compare your lifestyle with the financial story your tax return tells.

If  the agent wants to hold the audit at your place of business, the motive is to make sure you have a valid business with perhaps a little pulse taking as to your sales volume and likely deductions. Know this: you have the right to decline either location. And for good reason. Its unsettling to you and your family or to you and your employees. You may require that the audit be held at the auditors office or at the office of your tax pro. The auditor may still want to do a tour of a home office or the business and she has the right. Although video footage may provide the information she seeks.

The big question now is: Do you want to hire a tax pro or do you think you can handle it yourself? We will take a look at that next week.

Bonnie Lee is an Enrolled Agent admitted to practice and representing taxpayers in all fifty states at all levels within the Internal Revenue Service. She is the owner of Taxpertise in Sonoma, CA and the author of Entrepreneur Press book, Taxpertise, The Complete Book of Dirty Little Secrets and Hidden Deductions for Small Business that the IRS Doesn't Want You to Know, available at all major booksellers. Follow Bonnie Lee on Twitter at BLTaxpertise and at Facebook.