What's the scariest phrase in the English language? At this time of year, many would argue it's "IRS audit."
Before you get too frightened, take heart: Although the likelihood of an audit significantly increases as income grows, a majority of Americans — those making $500,000 or less — have less than a 1% chance of being audited. The odds are now1 in 220 -- a notable drop from the 1 in 90 of a decade ago.
There are several simple ways to reduce your risk of attracting a second look from Uncle Sam. Here are five things to avoid if you don't want to see a tax audit letter hit your mailbox.
IRS Audit Risk No. 1: Filing an Error-Filled Return
Hey, you're human, and maybe you made a mistake in your math. Perhaps you forgot to fill in some personal information or flubbed a digit in your Social Security number. Unfortunately, whether it's a simple error or a whopper, it raises your risk of an audit.
IRS Audit Risk No. 2: Making a Lot of Money — or Only a Little
Taxpayers at the extremes are more likely to attract the attention of the IRS. In 2015 — the last year for which the IRS knows the actual audit rates (because the IRS can still open audits for more recent years) – those who made more than $10 million had an 8.2% chance of being audited, whereas the rate for those between $1 million and $10 million was 2.5%. Average Joes and Janes with incomes between $25,000 and $100,000 had a less than 1% chance.
Interestingly, those who reported no gross income had a 4.5% chance of being audited, making them the group most likely to be audited among those making less than $10 million. Many of these filers may be reporting net operating losses for their small businesses, and the IRS wants to make sure that's truly the case.
Another related risk? If you claim the Earned Income Tax Credit (EITC), which maxes out at just over $6,700 this tax year. Many filers try to claim this lucrative credit even if they're ineligible. You can check whether you can safely claim the EITC at the IRS website.
IRS Audit Risk No. 3: Being Self-Employed
Self-employment itself may not raise your risk of an audit, but it brings a host of opportunities for missteps.
One of the biggest is forgetting — or "forgetting" — to report all of your income. For instance, if you're a freelancer who juggles multiple clients, make sure your taxes reflect each and every 1099 form. Missing just one can mean a world of hurt.
Another tricky area is deductions. It's easy to get deduction-happy when you're self-employed, since "ordinary and necessary business expenses" are fair game. But realize that the IRS is far stricter about that definition than you may be.
That shiny MacBook you bought for personal reasons and only occasionally use for work? You're on thin ice. Claiming a home office deduction when you use your dining room table as your desk? Be very careful. Taking a friend out for lunch and trying to pass it off as a business expense? Don't do it.
Bottom line: To qualify as a legitimate deduction, the expense should be essential for you to do your work.
IRS Audit Risk No. 4: Passing Off a Hobby as a Business
Relatedly, the lines between pursuing a hobby that may generate occasional cash and running a legitimate business can be quite blurry. But problems arise when you try to deduct losses arising from your hobby as if it's a business.
Those knitted beer cozies you make in your basement and sell to friends for a few bucks each may not seem consequential enough to spur an audit, but the IRS may think differently. You need to have a legitimate profit motive for your activity to be considered a business rather than a hobby; otherwise, related losses are not fair game for deductions.
One way to prove this is by turning a profit in three of the past five years (called the "3-of-5 test"), but you can also submit evidence of your attempts at making money (marketing efforts, proper licenses and permits, etc.) to help your cause.
IRS Audit Risk No. 5: Being Too Generous
Giving to charity is a noble and wonderful thing. However, if you overdo it, you're likely to arouse the suspicions of Uncle Sam.
The IRS has detailed statistics showing how much people with similar incomes typically give. Vastly overshoot that number, and an audit becomes more likely.
For instance, if you report $100,000 in income, somewhere around $3,300 in charitable deductions would be typical. Report $10,000 and you're likely to raise eyebrows since that's more in line with the amount given by people making four times as much.
Cash donations are easy (and essential) to document. But regular folks may be more likely to get in hot water by overstating the value of donated items such as clothing, housewares, and furniture. That old winter coat, even if it's in good shape, may only be worth $20 — even if you originally paid $200 for it.
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