5 ways to avoid an audit

By Jeff Schnepper

Why me? You just got the invitation to a "party" that you hoped you'd never attend -- an IRS audit.

How did this happen and how can you prevent it from happening again? We'll get to the former question when we answer how to minimize the chances of an audit and how to survive one.

Rule 1: Check your arithmetic

Few audits are generated by mathematical mistakes alone. The Internal Revenue Service computers automatically correct both mathematical errors and mistakes on the amount you can take as a deduction. One common -- and expensive -- error is to claim 100% of your medical expenses as a deduction. (You may deduct only the excess over 7.5% of your adjusted gross income.) However, too many math errors can indicate a sloppy return, and that could lead to a full audit.

While the advice may seem obvious, don't give the IRS any additional reasons to look at your return.

But how do you get picked?

An IRS computer program compares your deductions to others in your income bracket and weighs the differences. This secret IRS formula, called the DIF Score, is used to select returns with the highest probability of generating additional audit revenue.

For example, a taxpayer with a $50,000 salary would rarely have $10,000 in charitable contributions. This doesn't mean that, if you have only $50,000 in income and actually have $10,000 in charitable contributions, you shouldn't claim those deductions. It means only that if that is the case, be prepared to prove those deductions.

The DIF formula considers not only your income and deductions, but also where you live, the size of your family and your profession. Rarely will a family of five living in the Hamptons have an income of $30,000 or less. It may happen, but if it does, the IRS will want to know how. This leads to . . .

Rule 2: Arrange your finances so they don't stand out

If you think you may be audited, see if your situation is likely to attract the tax man's attention. Here are groups that often do invite inquiries:

The self-employed. If you are self-employed, you have more opportunity either to "hide" your income or "create" deductions by converting personal expenses into business expenses. If so, be prepared to substantiate your expenditures as deductible expenses. The IRS is aware of the myriad "business vehicles" that go away to college every September, and the probability of your being audited is enhanced.

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And, by the way, the IRS says it audited 1.38 million taxpayers in 2007, up 7% from 1.29 million taxpayers in 2006. That's the highest number since 1998.

The 2007 figure represents an audit for one of every 97 returns filed. But only one of every 561 returns resulted in a face-to-face audit. The rest were correspondence examinations.

Preliminary 2008 numbers show 1.39 million individual taxpayer audits, but only 310,429 of those were field audits. The rest were again correspondence examinations.

Those who get their income in cash. The IRS has specific audit programs aimed at specific professions and occupations. Because they receive much of their income in cash, people who work in the gaming industry, waiters and even doctors are prime audit targets. The more cash you receive and the higher your income potential, the more likely the IRS is to find additional tax dollars by reviewing your return.

There are a number of areas of potential abuse that attract the IRS. In recent years, the IRS has been targeting these areas for audit:

• Offshore credit card users.

• High-risk, high-income taxpayers.

• Investors in abusive schemes and promotions.

• High-income non-filers.

• Unreported income.

Continued: Substantiate, substantiate, substantiate

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