The saying, “the only thing we have to fear is fear itself,” attributed to Franklin D. Roosevelt, may not hold true when one is faced with an IRS audit notice. Although receiving a notification does not always indicate an impending audit, the IRS’s authority to collect taxes can be frightening.
The IRS uses various methods to screen tax returns, including random selection and automated checks for inconsistencies.
The Importance of Precise Tax Reporting
Their goal is to ensure accurate reporting of income, expenses, deductions, and credits. Discrepancies can lead to audits or adjustments resulting in refunds or tax payments.
Here’s how to avoid common red flags that trigger IRS scrutiny:
- Math errors: The IRS catches millions of these annually. In 2022, nearly 16 million math error notices were issued, with the top errors related to pandemic stimulus payments and child tax credits. While a math error alone might not trigger an audit, it could raise other issues during a manual review.
- Unreported income: The IRS compares your return with documents like W-2s and 1099s. Mismatches can result in an IRS notice (CP2000) requesting additional taxes or a potential refund. The “automated underreporter” program flagged nearly 1.6 million cases in 2022, generating over $8.7 billion in additional taxes.
- Unusual deductions: Statistical formulas compare your deductions to similar returns. While claiming allowable deductions is encouraged, significant deductions out of proportion to your income can raise red flags. For instance, claiming high charitable contributions on a low income might trigger an investigation.
- Excessive business deductions: Overstating business expenses is a common mistake. “You can’t write off the entire cost of a vacation with minimal business conducted,” says IRS spokesman Eric Smith. Deductible business expenses must be ordinary (common in your industry) and necessary for your business.
- Consistent business losses: Business owners should consult tax professionals and reference IRS Publication 334 (Tax Guide for Small Business). The IRS may question if your business is truly profit-oriented or more like a hobby. If the IRS deems it a hobby, deductions to offset other income might be limited.
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Tips for Responding to IRS Correspondence
The good news? Most taxpayers are more likely to receive a math error notice or an underreporter letter than an audit. Filing electronically and double-checking your return can help avoid these.
If you do receive a notice, don’t panic. The IRS offers resources and assistance, including opening Taxpayer Assistance Centers on March 16th. Remember, you can upload documents or scan a QR code to respond to the IRS online.
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