How to avoid IRS trouble, as the tax deadline nears

On the Money
From the  March 3, 2006 print edition

It’s March Madness, the time of NCAA basketball tournaments. College basketball fans across the country hope their favorite team will emerge victorious from the Final Four.
It’s also the final full month of tax-preparation season.
Millions of taxpayers also hope their final tax returns aren’t one of the estimated 1.5 million returns chosen for audit. Here are things to scrutinize so that your 1040 filing is more like a relaxed free throw than an exasperated flail from half-court.
First, a little bit of back-to-basics regarding income reporting.

• Report all your income on the proper forms and on the correct lines. For example, W-2 income belongs on Form 1040, line 7; income from residential or office rent goes on Schedule E; and 1099-MISC non-employee compensation should appear on a Schedule C, etc.The IRS utilizes automated matching techniques. If you receive a W-2 or 1099, (especially a 1099-B), the sender also has filed a copy with the IRS. It’s important to show all the amounts on your return to avoid unmatched records in the IRS’s computer systems.
• 1099-INTs are particularly tricky. Report the income on Schedule B exactly as it appears on your 1099-INT, rather than combining it under one heading. You may be asked to explain why you haven’t reported it all when, in fact, you have.
• Include tips and cash payments on your return, especially if your profession is known to involve substantial currency payments. Underreporting your income is the most dangerous audit invitation.
• Declare hobby income on Form 1040, line 21 rather than attempting to take hobby expenses as a business loss on Schedule C. Hobbies vs. business draw the attention of auditors.
• Annual income over $100,000 makes you special in the eyes of the IRS. During the fiscal year 2005, audits of taxpayers taking home more than $100,000 annually reached 221,000.

To remain inconspicuous in the deduction arena, heed the following.

1. Keep charitable donations proportionate to your annual income. IRS Service Center computers can, and do, compute means and standard deviations. For non-cash contributions, such as donating college textbooks to the local library, avoid inflating the value. Automating matching tools abound to generate comparisons of donated items.
2. Self-employed persons or small-business owners draw an inordinate amount of attention. The self-employed are tempted to blur the distinction between personal and business expenses, such as a mileage deductions or designating the basement of your home an office.Generally avoid the home office deduction if you can. An arms-length lease agreement with your own small corporation avoids this potential exposure.
3. The IRS closely looks at unusually high deductions compared to your own income. If you earned $100,000 from your day job, but “invested” in the real estate market and claimed an $80,000 loss, you might become an audit candidate. Systems look for offsetting deductions against reported income.
4. Deductions and expenses on your return also are weighed against other taxpayers in the same income bracket. Many tax-preparation software programs will do these calculations for you based on known averages.
5. Double check for inadvertent duplicate deductions; review Schedule A, Schedule C and Schedule E for duplicate entries.
6. If you know the deduction exceeds the average, file an explanation with your return. For example, if your tenants damaged rental property, list repair costs under “Other Expenses: Tenant Damage” rather than under the generic “Repairs.” In extreme cases, attach a copy of a document that will substantiate your deduction.
7. While some audits are random, most are the result of statistical comparisons. Though one large deduction can trigger an audit, the taxpayer has the right to take all legitimate deductions, and questions can be answered by providing adequate documentation.
8. Finally, make your return easy to handle. File electronically instead of hand-writing your return. Avoid attaching unnecessary forms to your tax return unless you absolutely have an extraordinary situation.

According to the Internal Revenue Service:

• There were 1,216,000 audits of individual returns in 2005, a 20 percent increase over 2004.
• Audits of individuals with incomes over $100,000 surpassed 221,000, the highest figure in 10 years, and well over double the 92,000 completed in fiscal year 2001.
• Audits of small businesses organized as corporations numbered 17,867 in 2005, up from 7,294 a year earlier.
• Audits of larger corporations — those with assets of more than $10 million — increased 14 percent from a year ago to 10,878.And one last shot in overtime: The No. 1 factor that draws attention to your filing remains — believe it or not — forgetting to sign the return.

© C. Stephen Guyer for American City Business Journals Inc. All rights reserved.