What Is a Tax Audit?
The majority of Americans file their tax returns and call it a day. But for a little less than 1% of tax filers, the process doesn't end right there. If your tax return is flagged for an audit, you may need to provide more information to the Internal Revenue Service to put the matter to rest.
A tax audit is a further examination of your tax return. There are different reasons why the IRS might choose to audit a return, and if your income exceeds $500,000 or if you report no personal income at all, your audit risk increases. But what you should realize is that a tax audit isn't necessarily cause for panic.
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Why does the IRS audit tax returns?
The IRS wants to collect its fair share of taxes, and so it sometimes needs to examine returns more closely to verify their accuracy. If something on your return seems unusual, the IRS might flag it for an audit. As an example, let's say you report an income of $50,000 a year and take a $12,000 deduction for charitable contributions. Most people don't give 24% of their income away to charity, so even if your deduction is perfectly legitimate, it might trigger an audit.
How does the IRS find these outliers? The agency relies heavily on technology to spot those returns that don't quite look right. Specifically, it uses two systems: Discriminant Function System (DIF) and Unreported Income DIF (UIDIF). The DIF score rates the potential for change based on past IRS experience with similar tax returns, while the UIDIF rates returns based on the potential for unreported income. The higher a return scores on either system, the more likely it is to be selected for an audit.
What happens if you get audited?
Most IRS audits are conducted via mail through a fairly simplified process. The IRS will typically request further information to back up your return, and if you have the supporting documentation, there's a good chance you'll come away unscathed. In fact, getting audited by the IRS can actually work out in your favor. Case in point: In 2015, almost $1 billion in refunds was given out to tax filers whose returns were audited.
Who gets audited the most?
You might assume that higher earners are the ones most frequently targeted, but unless you really make a lot of money, your chances are relatively low. The odds of getting audited increase once you make more than $500,000, and those who earn above $10 million have the greatest off-the-bat audit risk by far. But earning too little money can also raise your odds, especially if you wind up with no income to report on your tax return.
How to stay off the list
While IRS audits aren't typically the harrowing experience most tax filers expect them to be, most of us would probably rather avoid them. To reduce your chances of getting picked, check your deductions carefully and keep detailed records and receipts to support your claims. Furthermore, don't just guess at your deductions or use round numbers unless there's a record of that math.
Say you're claiming a medical expense deduction but misplaced your records for the year. You might remember spending roughly $5,000, and so you might put down that amount as a deduction on your taxes. But what's the likelihood that your medical bills for the year magically worked out to exactly $5,000? Even if your number is mostly accurate, putting it down could land you on the IRS audit list.
Furthermore, if you're self-employed and eligible for business deductions, be judicious about what you claim. It's one thing to deduct office supplies and equipment, but if you go overboard with business meals and entertainment, it could raise a red flag.
Additionally, filing your return electronically can help you avoid making errors and triggering an audit in the process. The IRS states that less than 1% of electronically filed returns contain errors, whereas the error rate for paper returns is 21%.
Finally, always report all of the income you earn, whether it's a check for freelance work or an interest payment from your bank. Whenever you get a 1099 form listing income you've received, the IRS will get a copy as well, and if your return doesn't reflect what the IRS is seeing, it could get you into trouble. Remember, when it comes to taxes, honestly is always the best policy, and it could be the one thing that ultimately keeps you off the audit list.
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