5 Ways to Avoid a Tax Audit

Don’t stay up at night worrying about having your taxes audited, or imagining horrible interrogation scenarios with tax agents and windowless rooms. Fewer than 1% of returns are ever examined, and the vast majority of those are done through the mail and not in person. More reassuringly, more than one in 10 of those audits result in “no change” in the amount the taxpayer owes.

That data and more is included in the Internal Revenue Service’s most recent data book. In 2009, the IRS received 187 million returns, and it audited 1.7 million returns in fiscal year 2010, producing a 0.9% audit rate. So breathe.

But then dig a little bit deeper, and realize that there are some financial behaviors that can increase your chances of having your return questioned. One is claiming the earned income tax credit, a complicated tax break aimed at the lowest income levels. Roughly one-third of the audits focused on that provision. The rest of the audit-bait behaviors tend to concentrate on higher income levels.

That doesn’t mean that you should deny yourself legitimate deductions just because you’re afraid of the tax man. But it does mean that if you have the kind of return the IRS will think is funny, you should be prepared. Here are some red flag behaviors and how to protect yourself from the troubling audit.

Earning a lot. The IRS audited 8.4% of returns claiming more than $1 million in income last year. Perhaps that’s because high-end returns are complex and offer more opportunities for hiding income or padding deductions.

If you had a great year in 2010, just make sure you document your legitimate deductions, and claim all of the income you received.

Hiding income can be considered fraud, while claiming a bad deduction can simply be interpreted as an error.

Being self employed. If you run your own business, you already know that there are myriad expenses you can legitimately deduct. Others – not so much. The IRS knows it’s likely to find questionable deductions on those forms, so it focuses on them. Folks who earn less than $200,000 but don’t have businesses stand a 0.5% chance of being audited. Add a business and those chances go up considerably. If you had a business and between $100,000 and $200,000 in income, you stood a 4.7% chance of being audited last year. If you’re self employed, make sure you can justify miscellaneous categories like restaurant meals, client gifts, publications and the like.

Failing to match. Let’s face it, the IRS already knows how much you make, because it gets 1099 forms and W-2 forms from the people who pay you. So if you’ve received notices that $100,000 in income was reported to the IRS for you, but you’re only claiming $60,000, be prepared to explain where that other $40,000 went. If someone sent you a 1099 or W-2 that you think is wrong, ask that they correct it and send a corrected form to the tax agency.

Going overboard on deductions. If you’re deducting more in mortgage interest and charitable gifts than it seems like you can afford, that’s a red flag. The IRS might suspect you are hiding income. “Itemized deductions over 30% of your adjusted gross income are risky because it will appear like you had little cash left to pay the basics — like groceries,” said the California Society of CPAs.

That doesn’t mean that you shouldn’t take legitimate deductions. You may have had a particularly bad year, in which you had to drain savings to pay your mortgage. Just make sure you can defend your income and your deductions. You could also check the average deduction levels of other people in your tax bracket, just to get an idea of how your writeoffs compare.

Going over the same ground. If you’ve been examined before, there’s a decent chance the IRS is pulling your return out of the pile, suggests CCH, a tax research firm. “The IRS will remember,” it warned in guidance to taxpayers. Make sure that you’re squeaky clean in the way you treat the area of your return that created problems before.