An unexpected letter from the Internal Revenue Service can make your stomach drop, but you can take steps to reduce your audit risk.
Taxpayers overall face a low audit risk: The IRS audited 1.1% of all individual tax returns filed in 2010, or 1.6 million returns of 141 million filed.
The vast majority of those audits—1.2 million—were done by mail. Just 392,000 involved an in-person meeting with the IRS. That's not necessarily good news. Taxpayers often are confused by IRS correspondence, and with such audits they don't have the benefit of working with one single agent, the National Taxpayer Advocate says.
But the risk of an audit skyrockets for some. Fully 12.5% of taxpayers whose income topped $1 million faced an audit. And self-employed people who filed a Schedule C with gross receipts of $100,000 or more faced an audit rate of about 4%—four times higher than average taxpayers. Here are seven red flags:
Sole proprietors filing a Schedule C can reduce their audit risk by sticking to the facts—or at least making sure their expenses and income are not dramatically different from similar businesses.
For example, one Chicago-based hot-dog-stand owner said his cost of goods sold was 50% of gross receipts, says Robert McKenzie, a partner in the law firm Arnstein & Lehr. "I know Chicago hot dogs are great, but he had a high cost."
The IRS found the hot-dog salesman was reporting his expenses but only part of his revenue. He faced "a lot of tax and penalty," Mr. McKenzie says.
Check out BizStats.com for an idea of whether your numbers are out of line; Mr. McKenzie says the IRS tells its agents to review that site for average business costs.
Taxpayers who claim large deductions attract attention. "Anything that is significantly above what persons in your income bracket might deduct is likely to be looked at," says Mr. McKenzie.
"The mantra I preach to my clients is keep good records," says Audrey L. Griffin, an enrolled agent in Centerville, Ga. "You're going to get the best possible, honest, legal result and you have nothing to fear."
The IRS may decide your business is a hobby—especially if you have other income sources. For example, Mr. McKenzie says, the IRS disagreed with an executive who, in addition to his annual salary of $500,000, deducted expenses for his yacht, claiming it was a business charter operation.
In another case, a young man with annual trust-fund income of $300,000 decided to become a race-car driver. He wrote off his costs, including the car, maintenance and the like.
In both cases, the taxpayers settled with the IRS for a partial write-off, Mr. McKenzie says.
If you show income from your job or business and claim rental-property losses, be wary. IRS rules limit deducting those losses in the current year, unless you prove you're actively involved in managing the property.
"It's a real hot item right now: Audit people who make significant income from their jobs and also claim rental losses," Mr. McKenzie says.
In one case, the wife of a real-estate attorney—a stay-at-home mom with three young kids—managed the family's rental properties, but the IRS said the couple couldn't deduct rental losses in the current year. On appeal they won their case, Mr. McKenzie says.
"We were able to prove yes, he couldn't have devoted 50% of his time [to the rentals] and made $600,000 a year, but she could," he says.
Ms. Griffin's clients often insist that 100% of their driving is related to business and thus their costs are 100% deductible, but when she digs deeper she finds they often use that same car for non-business purposes.
"Then it's not 100%, which is the reason the IRS requires you to keep mileage records," she says.
You may be able to claim a deduction for expenses related to your home office, including home-insurance and utilities costs, but be prepared for the IRS's attention.
"I would not discourage a client from taking that deduction if they qualify. I just try very hard to make sure they know the requirements and keep good records," Ms. Griffin says.
But is it worth it? You would claim a deduction for a percentage of the housing expense related to the square feet of office space divided by the home's total square footage. "It may be a very small percentage and it may not be worth raising this red flag," Ms. Griffin says.
Among people who claimed the EITC—a refundable credit worth up to $5,751 in 2011 for moderate-income taxpayers—2.2% of returns filed in 2010 were audited.
There's a "high level of noncompliance," Mr. McKenzie says, often because fraudsters exploit this benefit to line their own pockets. For instance, scammers will provide an extra Social Security number so taxpayers can claim an extra dependent—and increase their credit.
It's a valid tax credit—just mind the scams and stick to the truth.
Write to Andrea Coombes at firstname.lastname@example.org
—Andrea Coombes is a personal finance editor for MarketWatch. Read more at marketwatch.com.