The Dread Tax Audit: Triggers and Tips
Part 3: Deduction Triggers

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

Welcome to the third and final part of our series on how to avoid an IRS audit. In our first part, we gave you a basic outline of how IRS audits happen. Last time, we showed you how the income you report and credits you claim can make the IRS suspicious. In today’s article, we’re explaining how the deductions you claim can lead to an audit. 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.

Deduction related triggers

Deductions are closely related to credits, if anything because filers tend to approach them with an even greater degree of assumption and misapprehension, and they’re as potent a source of audit triggers. Certainly, you should claim any deduction you believe in earnest you have the right to and, as we will see below, you should be prepared to take the matter of a disallowed deduction to the courts if you think you have a convincing enough case. But you must always remember the following which we’ll wrap into

Tip 5: If your deductions seem disproportionate to your income you will set IRS alarms going!

To reiterate in simpler terms, if you’re not making the income to justify the large number of deductions you’re taking you may cause your return to be moved to the front row of those potentially selected for closer examination by an auditor. If that is the case, make sure to have detailed documentation to justify the deductions.

Speaking of documentation, typically in the form of receipts, cancelled checks, and the like, it might be useful to drop another tip before we move deeper in the thicket of deductions. Here goes,

Tip 6: There are ways to prove deductions even if you don’t have a receipt!

These could include: oral testimony that is believable and factual, which is to say, no dog ate my homework excuses; an affidavit, meaning a sworn written statement made before an officer from X that you paid him to do Y; a receipt of thanks in the case of a charitable deduction for the amount of the donation you made; a reconstructed record of the transaction. Note also that bank statements are adequate as proof of payment made via electronic fund transfer (EFT). Finally, always remember that if you’ve forgotten the details of a deducted transaction mentioning it to the IRS can earn you some beneficial and deserved good will.

Deductions are a minefield of audit triggers for three historical reasons: many of those claimed are misunderstood; quite a few are out-and-out bogus, not to say hilarious; a select few are painstaking to document and validate. Indeed, the IRS pays special attention to those items where filers have historically failed to retain adequate substantiation, so we’ll start with those, in particular everyone’s favorite: meals, travel, and entertainment.

Meals, travel, and entertainment: you’ve met those before, especially but by no means if you’re self-employed or in sales. That’s the one where you choose to serenade the attractive representative of the account you’re pitching with a night out at a reputed eating establishment, perhaps followed by front court seats at the game, etc. As you can imagine, there’s lots of room for fudging here: personal meals get filed as business; tickets for the family’s night out on Broadway get deducted; the business contact becomes a “friend” and business becomes “risky”. Well, the IRS agents are no chumps. To defuse a potentially embarrassing enquiry into your affairs, let’s first recall tip #5: if your earnings are outmatched by your deductions, if you’ve been dining at four star restaurants on a small k salary, be prepared to furnish the IRS with detailed documentation of your business related entertainments. These must take the form of receipts – any expense above $75 currently required a receipt – and information regarding the places visited or lodged at while traveling, the persons involved, the nature and purpose of meetings. Make sure then to record the amount paid, the name and location of the eatery, the cost of the cab to get there, the name of your business contact. And don’t omit the topic of discussion. To obtain the deduction you must talk business before, during, or after the meal. No reason not to enjoy yourself, clearly. But please resist the temptation to deduct an expense that your company is compensating you for. That would be a fine example of a bogus deduction, not to mention an illegal one.

Vehicle usage is another area littered with booby traps. First, be very wary if you intend to claim the full business use of your car. Most people own a vehicle for mixed usage, which makes exclusive business use both unusual and remarkably difficult to convincingly substantiate. Needless to say, it attracts and warrants all manners of unwanted attention. In such a case, pay acute attention to your records. Mileage logs must be detailed and thorough; calendar entries must be precise. Both are good advice to follow even if only an established percentage of the use of your vehicle is for business as is proper. Again, going back to a prior tip, there are ways to demonstrate usage that you may not have thought of. A written diary of miles used for business is generally acceptable. A spoken recording would also be sufficient. One final note: if your car is used as an advertising platform for your business, you can only deduct the cost of material and of the labor incurred in creating the ad, not the full cost of the vehicle.

As with your car so with your house: home office deductions are looked at carefully by the IRS. That’s foremost because, irrespective of the actual amount claimed, people often overstate their claim as they do not fully grasp the requirements to establish the proper deduction. The notion of exclusivity again comes into play: any space claimed must be used solely and regularly as your main place of business. Sole use implies that no other activities are conducted there. Thus a writer’s den would in principle be used only to produce work for publication not as a locale for drunken revelry; a jeweler’s studio only to make ornaments to sell, and so on. If you’re not sure, it might be wise not to take the deduction. And, in another glaring instance of bogus deducting, do not attempt, as some do, to deduct the full cost of your home! That would be an excellent way to beg for an audit.

We can move on to charitable deductions, another source of fine pickings for the auditor. Claiming large charitable deductions, or outrageous ones, can cause the IRS to pay special attention to your report. This is specially the case, once more, if the deduction appears out of proportion with your income. Remember: the amount of your deduction based on your income is averaged by the IRS. Any amount that falls well outside the average is deemed suspicious and up goes the red flag. If you do make an unusually large charitable contribution, it is prescient to substantiate it: attach a copy of the bill or receipt to your return, and be sure to not the dollar amount and the name of the schedule.

Here are a few more things you should remember and a few others you should know. If you donate valuable property of one sort or another, make sure to get an appraisal. Also, do not forget to file Form 8283 if your contributions exceed $500, although you may consider filing the form even if your donations fall below that amount. It is wise to hold on to any supporting documentation for the transaction such as receipts although, as mentioned above, a receipt of thanks listing the amount is usually acceptable. You should know that no deductions are allowed for body parts or, it stands to reason, quotidian trips to the blood bank would make for superb deductions. This said, it is advisable to check first with the receiving institution, hospital, etc to which you’re bequeathing that organ you no longer need: the rules may have changed in the interim. Generally, the cost of surgery and the mileage posted traveling to get it done may be deductible. Clearly, the IRS may not look kindly on your decision to have your kidney removal coincide with a trip to Hawaii when the operation could easily have been performed at a clinic near you.

Much of this is commonsensical and could all be wrapped into a final, one easier said than done surely, which is to:

Tip 7: Understand your deductions as well as your credits

Take for example the one related to medical expenses. Most people do not understand that you cannot claim all of your medical expenses as a deduction. You can only deduct the 7½% above your adjusted gross income.

Bearing greater understanding, you can always take your chances with the IRS, at worse losing the deduction and being compelled to repay all arrears with interest and fees. You could also, although we certainly do not advocate it, take up the issue in court. This is precisely what our aforementioned stripper did. Now that we have your attention again… it is enough to say that having undergone breast augmentation, allowing her to go from an elegant B cup to an all-encompassing double D, she understandably, if not wisely perhaps, chose to deduct the cost of her implants as a business expense. Her claim, initially rejected by the IRS as outrageous, was later allowed in court on the basis that it – rightly, we guess – increased her income, proof if ever that when it comes to tax things are constantly evolving.