Retirement Basics: Understanding Tax Efficiency

Each year, the IRS audits over 1 million tax returns. With agency resources shrinking, the IRS is more selective when choosing which tax returns to audit. Knowing what the IRS is looking for can help you understand and reduce your audit risk. Here are five of the biggest reasons the IRS may choose to audit your return:

Your income is high or low.

The reasoning is simple – higher earnings may lead to bigger errors and lower earnings may mean incorrect deductions. The adjusted gross income (AGI) range with the least audit risk is $25,000 to $200,000. As your income moves toward the extremes in either direction, the chance of an audit increase.

You fail to report all your income.

The IRS Automated Underreporter Program matches W-2 and 1099 information with the information you report on your tax return. When a mismatch occurs, expect to receive an automated CP2000 notice from the IRS notifying you of the discrepancy and the additional tax amount due.

You own a business.

Rules regarding business deductions are confusing and constantly changing. The IRS knows this. Incorrectly deducting personal expenses or having your business classified as a hobby, thereby eliminating deductions, can get you in trouble with the IRS. Cash heavy businesses are under increased scrutiny due to higher fraud rates. Solid tracking processes and good records are necessary for income and expense substantiation.

You make a math error. 

The IRS identified over 2.5 million math errors on recent tax returns. The biggest culprits were tax liability and credit calculations. Math errors can create a two-fold problem for you – additional tax owed and more scrutiny applied to other parts of your tax return.

You claim the earned income tax credit.

cording to a report by the U.S. Treasury Department, 21 to 26 percent EITC payments are paid in error. Numbers that large are sure to get the IRS’s attention. Eligibility confusion and calculation errors are mostly to blame.