Avoid an Audit

Many taxpayers open any correspondence from the IRS with trembling fingers, fearing it might be a dreaded audit notice. How can you avoid such fears? The first step is to make sure that you're filling out all of the forms properly. But here are some other ways to help avoid audit triggers.

1. Matching. Your revenues must equal or surpass the amounts on the total of the 1099 forms you receive. The IRS matches your return with all income attributed to your Social Security number. Next, be ready to explain any and all bank statement income. "Auditors will start by asking for your bank statements," says Roger Rainey, a CPA in Plano, Texas. "Those documents tell the story." (The IRS even notices whether filers' ZIP codes are located in expensive neighborhoods.)

If your revenues are low, be particularly careful when you take substantial deductions. One of Rainey's clients triggered an audit by taking a Section 179 deduction for the purchase of six trucks during a low income year. "Make sure you follow the rules to the letter," Rainey says. "Auditors may start by focusing on a particular item, but that can easily run into other areas."

2. Apportioning Expenses. Construction projects often straddle two or more tax years. Should you recognize income and expenses proportionately, or wait until completion? It will depend on whether you have chosen a cash or accrual method of accounting, but in either case you must be consistent. Do not yield to the temptation of taking expenses now, if you wait until next year to account for revenues.

Perhaps you have made substantial improvements on a property you intend to sell next year. Suppose you gutted an old house, sheet rocked the floors, painted, plumbed, rewired, and installed new doors and windows. You must capitalize those expenses as an inventory item on your books, until the house actually sells. The IRS takes a dim view of contractors who argue that they prefer to take the expenses sooner, with a view to recognizing a large gain on the eventual sale. They will usually have to amend their returns, an expensive nuisance.

3. Contract Labor. If you use contract labor, be sure to file 1099's for anyone whom you pay more than $600. Suppose you claim $10,000 in total. Have you hired at least 20 individuals? "That's easy for the IRS to check out," Rainey says.

4. Home Office. Taxpayers often believe taking a home office deduction serves as a red flag for an audit. "It's not true that you are more likely to be audited for claiming a home office deduction on Form 8829," Rainey says. But make sure you meet the requirement that you regularly use part of your home exclusively for your business. You must not perform any other domestic activities in the designated office space, such as leisure activities.

If you do get audited, it may be helpful to hire a CPA, rather than face the stress and worry. That way, you need not meet directly with the auditors, and your CPA can gain time for a second round of information gathering as necessary. Set up a meeting as soon as possible with your accountant or advisor to give yourself ample time to prepare.