Red flags that tempt the tax auditor
What's the DIF?
When it comes to avoiding prying IRS eyes, it's best to be just one of the crowd. "Don't draw any more attention to your return than you need to," says Robert G. Nath, author of "The Unofficial Guide to Dealing with the IRS." "Simple, plain-vanilla returns are fairly safe."
The IRS says there are several ways a return can be selected for audit and the first is via the agency's computer-scoring system known as Discriminant Information Function, or DIF. The IRS evaluates tax returns based on IRS formulas, and DIF is based on deductions, credits and exemptions with norms for taxpayers in each of the income brackets.
The actual scoring formula to determine which tax returns are most likely to be in error is a closely guarded secret. But Nath, a tax attorney in the Washington, D.C., area, says it's no mystery the system is designed to screen for returns that could put more money in the government Treasury.
How do your deductions compare?
Tax experts believe one discriminant information function component looks at average deduction amounts. This allows IRS examiners to spot inconsistencies, such as a high mortgage interest deduction and low income.
Tax specialists at CCH Inc. examined 2010 return statistics, the latest complete data, and came up with the following itemized deduction averages. These are for illustrative purposes only. CCH experts note that the IRS takes a dim view of taxpayers who base their claimed deductions on these figures. The numbers can be useful, however, in giving you a general idea as to whether certain deductions on your return might seem out of line.
Check average deduction amounts
|More than $250,000||$30,408||$47,178||$23,194||$19,651|
Allison Einbinder, owner of Dollars & Sense, a tax and accounting firm in Oakland, Calif., recommends that all filers review the differential comparisons. How you stack up against a national standard, she says, will give you an idea of whether the IRS might take a closer look at your return.
So what is likely to trigger a discriminant information function red flag?
- Higher incomes.
- Income other than basic wages; for example, contract payments.
- Unreported income, such as investment returns.
- Home-based businesses, especially when in addition to salary income, and home-office deductions.
- Noncash charitable deductions.
- Large business meal and entertainment deductions.
- Excessive business auto usage.
- Losses from an activity that could be viewed as a hobby rather than a business.
- Large casualty losses.
Returns claiming the earned income tax credit, designed as a tax break for lower-income wage earners, also catch IRS eyes. The credit's complexity often results in legitimate mistakes on returns. Some filers, however, have been caught making false claims to increase the payment the credit provides.
Schedule C filers who report a business loss also are likely to face more questions from the IRS. The agency wants to be sure that it was indeed the economy, and not an effort to trim taxes, that produced the bad business results.
Don't cheat yourself
But don't let fear of a potential audit discourage you from filing for tax credits or taking legitimate tax deductions.
Although some tax return actions are likely to flag your return, Nath says that doesn't necessarily mean you'll be audited.
Even if your return is questioned, it's not a foregone conclusion that you'll end up owing the IRS. As long as your deductions and expenses are legitimate and you have documentation, Nath says, they will be allowed.
The groundwork you put into preparing your return will pay off in an audit situation. "Be confident in what you entered," says Einbinder. "That's easy when you have good records to support your tax return entries."
And even if an audit doesn't go your way, don't despair. "You have rights to contest audits," Nath says, "at every level of the process." Read Bankrate's story on how to prepare for an audit in case you get summoned.