How to Minimize the Risk of an IRS Audit

"Your federal tax return has been selected for examination."

Few pieces of correspondence evoke as much anxiety as an audit notice from the IRS. After all, not only can IRS audits be extremely time-consuming, but they often result in additional taxes, interest, and even penalties.

Certain taxpayers—business owners, the self-employed, and the wealthy—historically have been flagged for examination. That's because the tax returns of the affluent are generally more complex—and therefore more likely to contain red flags for the IRS, where I worked for eight years as a senior auditor.

Income derived from regular wages automatically have taxes withheld, and employers report those taxes to the IRS. However, taxes aren't normally withheld from nonwage income—including business income, capital gains, dividends, interest, rental income, and royalties—making it more prone to discrepancies and examination by the IRS.

Here are the most common forms that report income to the IRS.

Individuals whose income fluctuates significantly from one tax year to the next can also find themselves in the IRS' sights. This can be the case for those who are self-employed or own a business. Big changes in income are a huge red flag for the IRS because they sometimes signal underreported income, either in the current year or in previous years.

Turning a profit can be challenging for any business, especially those just getting off the ground. However, the IRS will take notice if you claim losses year after year or if a loss is substantial. You're less likely to be audited in the first few years, when losses are normal and expected. Over the longer term, though, businesses are supposed to make money—and if yours doesn't, the IRS will want to know why.

While your deductions may be well founded, some may nevertheless trigger a second look by the IRS. In particular, be mindful of:

• Outsize charitable donations: The IRS flags charitable deductions that far exceed the average donation of those at a similar income level. Be aware, too, that such deductions are capped to 60% of your adjusted gross income (AGI) for cash donations and 30% of AGI for stocks and other property.
• Passive losses on a rental property: If the costs to operate a property exceed the rental income it generates, you may not be able to claim a loss—unless:
  • You own at least 10% of the property, you're personally involved in managing it, and your modified adjusted gross income is less than $100,000—or:
  • You're a qualified real estate professional (meaning you spend at least 750 hours annually on such work and it accounts for more than 50% of your annual working hours) and you take an active role in the management of the property.
• Unqualified home-office deductions: Unless you're self-employed and conduct the majority of your business from your home, you cannot deduct any home-office expenses. People who work from home may assume they can take this deduction. Unfortunately, regular employees don't qualify, even if they pay out of pocket for all or part of their home-office setup.

Estate tax returns tend to be audited at a fairly high rate. The biggest reason? Undervalued assets. The IRS has seasoned valuation experts, and if they think the estate has valued its assets too low, an audit could be just around the corner.

Even if you hire a tax professional to prepare your return, the accuracy of your filing ultimately falls on your shoulders. I can't tell you how many people just sign their professionally prepared income tax returns and never review them.

Going through these steps may help reduce the likelihood of an audit, but if one is unavoidable, it also can help ensure your tax return stands up to scrutiny and potentially make for a smoother audit process. If you followed the rules, retain good documentation, and have a trusted tax advisor to represent you, the process can actually go quite smoothly.