A piece of IRS software called the Discriminant Inventory Function System analyzes tax returns for oddities and discrepancies. Based on a closely guarded formula, the system assigns each return a score that determines whether or not the IRS will audit you.
Here are some common red flags:
significant income increase or decrease
significant deduction-to-income ratio -- say, $80,000 in deductions on a $100,000 income
business deductions consisting of fancy dinners and pricy trips to the Moulin Rouge
low tip income for workers who traditionally make a lot of money from tips
income exceeding significant benchmarks, such as $100,000 and $1,000,000
computational mistakes and typos
incorrect Social Security number
incorrect reporting of income, deductions, et cetera.
late filing without applying for an extension with Form 4868
not paying your full tax liability without applying for an installment agreement with Form 9465
Obviously you can't avoid an income change if you get a better-paying job. And if you're self-employed, you're self-employed. But you can still do some things to decrease the likelihood you will be targeted for examination:
Keep Good Records: Three years is the statute of limitations on auditing returns that were filed on time. So, theoretically, the IRS could audit you for a return you filed three years ago. If you keep good records, you'll be able to answer any inquiries the IRS might have.
Explain Yourself: If your trip to the bowling alley is a justifiable business expense, include the receipts, a written explanation and any other appropriate documentation with your return. If you think the IRS might be curious, take care of it before they have a chance to ask you about it.
Just Because You Spent Money Doesn't Mean It's a Deduction: Don't go overboard with your deductions, especially if you're self-employed. Also, don't estimate your deductions -- use exact amounts based on receipts.
Beware of Tax Software: Tax software is great for returns at the simpler end of the spectrum. When you start getting into deductions and complex sources of income, consider verifying the accuracy of your return with a tax professional.
Compare: Compare your tax liability to the national average for your occupation. If there's a big difference between your tax liability and the rest of the country's, take another look at your return.
Be Tidy: A sloppy return is sure to get a thorough check by the IRS, especially if the all-important numbers are illegible.
Check and Recheck Your Return: Nip mathematical errors in the bud before you file.
There's no sure way to avoid an income tax audit. In fact, every year the IRS conducts a number of random audits to serve as benchmarks for its examinations. The best things you can do are file on time and pay what you owe. When it comes down to it, punctuality and accuracy are the only things the IRS really wants.