A tax audit can be painful, scary and costly. Naturally, you should make every legit effort to avoid one. So here are tips from leading financial advisors about how to do just that.
The risk-reward trade-off favors taking every possible precaution. The average tax audit costs $3,500 to $10,000, according to one estimate. The hassle factor is huge. The IRS can hit you with up to 150 different penalties after an audit, one tax-prep website notes. You risk paying a penalty of 0.5% of what you owe every month. And you can end up owing 3% interest on unpaid penalties.
Further, it looks like the IRS is getting ready to reverse the trend of fewer audits in recent years. The tax agency not long ago said it is hiring 2,500 new auditors.
And the risk of getting ensnared in an audit does not end on Tax Day. The number of taxpayers still working on their returns because they got an extension is climbing. The number expected to use an extension for 2022 is 15.2 million, according to the latest IRS data. That's way up from the 11.6 million who got extensions for 2020 and the 13.6 million and counting who did so for 2021.
Tax Audit: How To Avoid One
Worse, the IRS has automated systems that flag suspicious returns. That means the IRS knows what it is looking for.
So, to minimize your odds of getting sucked into the black hole of an audit, apply these seven tips when they apply to you:
Make sure all of your numbers match. "Differences between what is reported on government Forms 1099 and what you report on your return is a sure-fire way for the IRS to have questions," said Matt Masterson, wealth advisor at RegentAtlantic. And questions can lead to audits.
Report cryptocurrency gains and losses. If you do not report digital currency gains, you're asking for trouble. "The sale or exchange of cryptocurrency works the same way that selling a stock does," said Angela Anderson, a certified public accountant with the JustAnswer.com Tax Chat. Cryptocurrency transactions are reported on the Schedule D and the Form 8949. These are the same forms used to report the sale of stocks, mutual funds and certain other capital assets as well.
Report cryptocurrency transactions other than sales. "Just spending your crypto can create a taxable event and result in a capital gain or loss," said Hayden Adams, director of tax and financial planning, Schwab Center for Financial Research. "Not all crypto transactions are reported to the IRS, but you still need to report those transactions on your return, even if a 1099 is not issued." Unreported crypto income can even raise criminal legal consequences, Adams says.
Don't Wave Red Flags At The IRS
Avoid waving red flags at the IRS when it comes to deductions. That means following established guidelines about what the IRS deems deductible. "Be careful when you name a deduction," said Tom Wheelwright, tax expert and author. For instance, don't call an event you attended a seminar if it was continuing education. "The IRS feels that seminars are not deductible," Wheelwright said. "There are very specific rules for when education is deductible. The most obvious of those rules is that it must be for continuing education for a current profession or business, not for a new profession or business."
Have documentation to explain big deductions. "If you have large deductions, keep good documentation to support them," Adams said. "When I was at the IRS, I saw some tax returns where people attached copies of their support, such as a letter from a charity stating your donation amount. This can at times avoid an audit." Adams worked for eight years at the IRS as a senior auditor for complex flow-through entities such as partnerships, S corporations and LLCs as well as high-net-worth individuals.
Don't Act Suspicious
Be specific about expenses. For one thing, whenever possible categorize expenses instead of lumping them under general expenses. "The IRS might think you're trying to bury (questionable) expenses if you lump them together rather than properly itemizing them," said Rachita Wadhwa, lead tax preparer and planner, Potentia Tax. "Minimize the use of an 'Other Expenses' category and itemize specific expenses like 'marketing' or 'Travel.' "
Avoid numbers that look doctored. Being specific about expenses also means avoiding the use of rounded numbers ending with a 0 or 5. Those make the IRS curious and cast doubts on the numbers' veracity, Wadhwa says.
Follow Paul Katzeff on Twitter at @IBD_PKatzeff for tips about retirement planning and actively run portfolios that consistently outperform and rank among the best mutual funds.
