Want to vastly reduce your chance of getting audited? Procrastinate.
People who file their tax returns in August rather than April are remarkably less likely to be singled out for examination by the Internal Revenue Service--even when their returns would otherwise have a very high probability of being audited, says Amir D. Aczel, a statistics professor who wrote "How to Beat the IRS at Its Own Game."
Aczel, who claims to have broken the IRS' secret audit formula, advises taxpayers to "audit test" their returns. ou shouldn't fear or forgo a legitimate deduction just to reduce your chance of being audited, accountants add. But if you score high on the audit test, you should take extra care to substantiate each claim and maintain the records to prove it.
What makes you likely to be audited are mathematical ratios, says Aczel, who began studying the IRS when he suffered through a particularly unpleasant government exam. That's because the IRS doesn't have enough time or enough examiners to look at every tax return to ferret out cheating.
Consequently, the agency has a computer look for mathematical anomalies--deductions that are unusually high compared with income--and score each of the roughly 120 million returns filed annually based on something called "discriminant function" analysis. The resulting grade--the DIF score--essentially sorts the returns for audit, leaving those with the highest scores on top, the lowest on the bottom. IRS auditors then work their way down the pile, cherry-picking the "high DIF" returns that appear to include some cheating.
Roughly 90% of all audits are triggered by the ratios reported on Schedule A (itemized deductions), Schedule C (profit or loss from a business) and Schedule F (profit or loss from farming), according to Aczel. Far and away the most troublesome form is Schedule C, which is filed by millions of people who own their own small companies or who moonlight by operating a small business after work, he adds.
It's worth mentioning that while some experts doubt that Aczel has truly cracked the IRS' closely guarded audit formula, they acknowledge that Schedule C is behind a large number of audits. Why? The IRS thinks that a high percentage of people who run their own businesses either under-report their income, exaggerate deductions or misclassify their hobbies as profit-making enterprises so they can write off personal expenses.
"The whole idea is to get 100% voluntary compliance, but you are never going to get that because some people are always going to cheat," says Gary Iskowitz, a former IRS examination chief who is now a partner at Iskowitz & Koo in Los Angeles. "Because you have limited resources, you put your auditors in the areas of greatest noncompliance. Schedule C businesses have the highest noncompliance rate of all the different audit categories."
However, filing a Schedule C alone doesn't put you at risk, says Aczel. It's only when the deductions on the form exceed a certain percentage of your self-employment income that the audit risk increases. Specifically, once your deductions exceed 52% of income, you hit a "caution point," Aczel says. Any additional anomalies on your return can push your 1040 over the audit edge. When deductions exceed 63% of income, you are sure to be computer-tagged for audit, he adds.
On the itemized-deduction form, the caution point hits when deductions exceed 35% of income. The critical point is at 44%, he says. On the farm income form, the caution point starts at 59% and the critical point at 67% of income.
This doesn't mean you'll immediately be audited when your deductions exceed these ratios. It simply means the computer will place your return on the top of the pile. That pretty much guarantees that an IRS agent will look at your return sometime in the next 18 months and consider whether you should be called in for an audit.
So what do you do if you score high and your deductions are all legitimate? Keep good records and, when appropriate, provide more information than necessary, so the IRS examiner who looks at your return can easily determine you're not a cheater, Aczel suggests.
For instance, your DIF score might rocket because you started your own business and have high expenses and low income in the first year--or because you bought a major piece of equipment.
There's nothing wrong with including an extra sheet of paper that indicates what you bought and how you accounted for the expenditure on your tax return. Make sure you know the rules, however. If you expense an item that needs to be depreciated, or if you use the wrong depreciation schedule, you're simply flagging your own errors and giving an IRS auditor the impression that you don't know what you're doing. He or she may consequently spend more time with your return looking for additional mistakes.
Kathy M. Kristof welcomes your comments and suggestions for columns but regrets that she cannot respond individually to letters and phone calls. Write to Personal Finance, Los Angeles Times, Times Mirror Square, Los Angeles, CA 90053, or message email@example.com on the Internet.