Although audits are a fact of taxpayer life, they're not particularly pleasant, and they can take up a lot of otherwise free time. So what should preparers say to their clients about audits?
For starters, remember that every year a small percentage of individual and business returns are selected at random for audit, according to Cathy Mueller, director of Peoples Tax and Business Services.
"The odds of a return being selected for a random audit are very low," she said. "However, the probability of a return being selected for audit due to a 'red flag' is much greater. Therefore, it is helpful for preparers to explain to clients the common red flags that might trigger an audit before they file the return."
For example, taxpayers reporting business income and expenses on Schedule C are more likely to be audited than other individuals, she indicated.
"The higher a taxpayer's self-employment income, the more likely he or she is to be audited. If Schedule C income is more than $1 million, the chance of an audit is 10 times greater than if it is less than $25,000."
Mueller suggested that the owner of a small business might reduce the risk of an audit by incorporating. However, all the implications of incorporating should be considered before making the decision, she cautioned. "Comparing the corporate tax rate with your personal tax rate is important when deciding between a C corporation and an S corporation," she said.
Here are some of the factors that clients should be aware of that might cause their individual or small business return to be selected for audit, according to Mueller.
Income reported to the IRS, but not on the return: If the IRS received Form 1099s reporting income paid to the taxpayer that is not reflected on the return, the taxpayer can expect to hear from the IRS.
Deductions higher than the norm: "If a taxpayer's business expenses or personal deductions are more than the average amount claimed for the taxpayer's income level or type of business, the return might be scrutinized and possibly selected for audit. However, you can reduce the risk of audit by including with the return documentation of the deduction and possibly an explanation as to why an expense was reasonable and necessary."
Categories scrutinized by the IRS: "The IRS has identified certain types of expenses, deductions and credits that are frequently exaggerated or claimed without justification," said Mueller. “Deductions targeted by the IRS may change from year to year. Some of the items that may be questioned include automobile, travel and entertainment expenses; office at home deductions; itemized deductions such as mortgage interest and charitable contributions; the Earned Income Tax Credit; filing status and dependency exemptions; casualty and net operating losses; and rental activities."
