The Dread Tax Audit: Triggers and Tips
Part 2: Income & Credit Triggers

Tax Audit Triggers & Tips:
Part 1: Audit Rules – Part 2: Income & Credit Triggers – Part 3: Deduction Triggers

Welcome to the second part of our series on how to avoid an IRS audit. In our opening installment, we reviewed the IRS audit process from a broad viewpoint. This time, we’re explaining how the income you report and the credits you claim can lead to an audit. In our final article, we’ll tackle the topic of suspicious deductions. Read on, and find out how and why the IRS moves your tax return to the top of the audit stack, and what you can do to avoid getting audited.

Income-related triggers

It is not impossible for the straight as an arrow nine-to-fiver who has his taxes deducted from his salary by the company he works for, and customarily opts for the standard deduction, to get roped into an audit, but in all probability, he won’t. He might though if he filed his own return and got tangled in his math. Which allows us to introduce our first tip; it’s usually dropped in somewhere at the end but we believe in pushing it up front. You don’t want a simple mistake of arithmetic to get your return moved to the front of the audit line. So,

Tip 1: Get your numbers right when doing your return!

And while we’re at it, remember that 1099 that went AWOL? So, here’s

Tip 2: Gather up all your records!

But if anyone, at least potentially, can get audited, some professions or ways of earning an income are much likelier to be targeted for an audit. This is because the IRS assumes, based on past instances, a measure of unreported income in such cases. Examples of professions that activate IRS suspicion are, foremost, those that primarily involve cash transactions. These would include bartender, taxi driver, hair dresser, barber, party stripper – What was that, you ask? Worry not, we’ll meet her again: she’s has a surprising part to play at the end of our story – etc. Tip #2 is meant for them. So, if you get paid in cash,

Tip 3: Make sure to have proof of payment for cash earned!

Proof of payment must include the amount paid, the name of the payee (that’s you), and the date on which the payment was made. Professionals who manage their own books, doctors, lawyers, accountants, and so on, also fall under the same rubric. And, remember that in our days of blissful interconnectedness the IRS will look at your bank account deposits; you want to make sure your calculated income comes close to the total of your deposits.

Staying with deposits in relation to audit triggers, please note that large cash transactions, of amounts close or in excess of $10,000, involving banks, currency exchange, or casinos, and flagged as suspicious by the institution get pointed attention from the IRS. If you walk in a casino looking to exchange a large sum of cash for chips, be prepared to substantiate the legality of your transaction.

Finally, be sure to report any offshore accounts you may have opened. And if this is the first instance of such reporting to the IRS, make sure to keep detailed reports of the date at which the account was opened.

If you choose to file sweeping losses on your Schedule C for an activity which, however dear to your heart, could be construed as a hobby, such as sailing, horse-breeding, or winemaking, you render your return substantially more attractive to the potential auditor. That’s because a hobby is a hobby is a hobby until it can be demonstrated to be profit-generating at which point it can legitimately be called a business. The number of years during which the activity must be shown to have garnered a profit is at least three out of five, but be aware that the exact number varies depending on the hobby. So, get that filly racing, sell some of those bottles of precious elixir, or use that boat to teach fledging mariners. And, it goes without saying, keep thorough documentation of all expenses incurred tending to that hobbyhorse of yours.

Credit-related triggers

You should always remember the following about government-issued credits: they have a shelf life. In other words, they are set to expire at some point, either because on your side, for instance, children who could once be declared dependents no longer are, having moved out of the ancestral home to their own pads, or because the powers that be choose to rescind the credit. Credits taken on a return are scanned for applicability by the IRS and can potentially raise all of the kinds of audit inviting red flags. Therefore, another noteworthy tip goes:

Tip 4: Make sure you understand clearly what a credit is about before you opt to claim it!

Let’s run through a pertinent example. You should watch out if you take the homebuyer credit as a homeowner or first-time homebuyer. You need to know that as a first-time homebuyer you must attach a copy of the settlement to your return – that would be Form HUD1, which must be complete and conforms at a minimum with the local laws of your state. If you have been a homeowner of long standing and are taking the credit, you should attach proof of prior ownership. It must show that you have lived in your previous home for a period of five consecutive years during an eight-year stretch ending on the date of purchase of your new home. Documentation of this five year span can be any of the following: a copy of Form 1098 documenting mortgage interest paid on your prior home; your property tax records; your homeowner’s insurance records. Note that a certificate of occupancy is not by itself admissible. If you think about it, there are good reasons why this particular credit gets the IRS buzzing. People often get the dates and time specifications wrong. For 2010, for instance, many may miss the fact that while the homebuyer credit was extended to September 30th this also meant that their contract had to be finalized by the 20th of September for them to be entitled to the credit. Or, in a flagrant misunderstanding of its purpose, some may believe their vacation homes or rentals are eligible for the credit. They are not, period. Only if the home qualifies as your principal residence does it qualify for the homebuyer’s credit.