Watch for Red Flags

What's the best way to avoid an IRS audit? Fit in with the crowd.

"Unusually large deductions will get scrutiny. The IRS has sophisticated computer programs now for targeting what they think are appropriate amounts of deductions," said Robert Nath, a tax attorney in McLean, Va., with 30 years experience, and author of "The Unofficial Guide to Dealing with the IRS."

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Combine big deductions with low income and you'll also likely raise an IRS eyebrow, said Cindy Hockenberry, a tax information analyst with the National Association of Tax Professionals.

"You don't want to have really high mortgage interest with a really low income. How can you afford the mortgage payment if you don't have any money coming in?" she said. "The IRS looks at expenses to see that they're in the range for the income you're reporting. If not, they'll look for some unreported income."

Another red flag: A lot of income from foreign sources, Nath said.

Of course, only the IRS knows for certain what will spark an audit.

"These are educated guesses, because no one really knows the audit criteria. But everybody's return gets scored as the return comes in. The more points you earn, the more likely it is you might get scrutiny," Nath said.

An audit could consist of a simple letter requesting more information or a face-to-face meeting with you lugging reams of receipts to an IRS office.

In fiscal year 2005, the IRS subjected more than 1.2 million individual filers to an audit. That's the highest number in seven years, but still less than 1% of all filers.

Want to avoid that fate? Along with avoiding outrageously large deductions, the following are some current red flags.

Falling into one of the following situations doesn't guarantee an audit. It just means you need to proceed particularly carefully to make sure you're filing correctly.

And, remember, if you do hear from the IRS, don't panic, Nath said. "Just because you get a notice doesn't mean the world's coming to an end," he said.

"The most important thing is to understand what they're asking for and give it to them," he said. "Above all: keep records, records, records. The burden is on the taxpayer in most examinations."

Is it a hobby or a business?

Another red flag: Deducting business expenses when what you're doing is more of a hobby than a business.

"We're starting to see audits on hobby losses," said Francois Hechinger, a tax partner in the San Francisco office of BDO Seidman, LLP.

"For example, people say they're writers on the side," he said. "If you can substantiate that you have a true trade or business, that you have [accounting] books and records — at one point showing a profit would be nice — those are some of the things that the IRS is looking at," Hechinger said.

Another example: "One thing I frequently see is wealthy people have horse farms or own horses," said Bernie Kent, a personal financial services partner in PricewaterhouseCoopers' private companies services group.

"The issue there is whether the losses are deductible in a trade or business, or not deductible as a hobby," he said.

Taxpayers don't have to claim exorbitant losses to garner IRS attention, Hechinger said. In one audit case he handled, the taxpayer had claimed a $3,000 business loss that the IRS considered a hobby.

If what you're doing is a hobby, the deductions are limited, and cannot exceed the income you report. See this IRS page for more information.

Match game

Some audits are generated when the IRS' computer system "scores" your return, essentially rating its similarity to tax situations that have led to incorrect filings and audits in the past.

But the agency also uses a matching program to generate audits. That program compares what you report to what others, such as your employer or broker, are reporting about you.

"You'll also get an audit if your information ... conflicts with what the state has told them," Nath said. "There are information-sharing arrangements with every state."

High-income filers who invest in hedge funds are likely used to their annual IRS letter that their return does not match what their hedge-fund partnership is reporting.

"It's been a huge horror story, starting back in 2002 or so. We spend a lot of time trying to reconcile" the data, Hechinger said.

Hedge funds are often set up as partnerships, and partnerships report each partner's share of income and expenses on a Schedule K-1.

"The IRS is trying to match what's showing up on the K-1 to what's showing up on the individual's tax return," Hechinger said.

Often, the individual is reporting the same information in different places on her tax return, Hechinger said.

"What we have to do is line-item by line-item for each one of these Schedule K-1s explain where this is being reported on the return," he said. "It's generated a slew of notices in the past. We have to spend probably two to three hours reconciling, so it can be quite expensive" for the taxpayer.

There's not a lot taxpayers can do to avoid this type of IRS attention, other than make sure they keep very good records to make the audit less onerous.

Revenue generator = potential audit item

One sure test of whether the IRS will pay close attention to any given item: How much does it represent in lost revenue?

Based on that test, some say the alternative minimum tax is clearly an audit red flag.

"It's certainly an income generator for the government," said David Sands, a certified public accountant with Buchbinder Tunick & Company, LLP, in New York.

"A lot of taxpayers are just ignoring" the AMT, he said. "It's an area that's going to be closely watched. It's generating more and more revenue," he said.

Still, "it may not trigger a face-to-face audit, but you're certainly going to have some correspondence-type audits."

See story on paying AMT.

Giving charitably? Keep documents

If you're a generous-minded taxpayer, the IRS may demand documentation from you.

In some audits, "when you've made a contribution in excess of $250, they want to see the letter from the charity substantiating the fact, to make sure no goods or services were received in exchange. I've had a couple of audits like that," Hechinger said.

Taxpayers don't need to send that letter with their return, but if audited, they'll need to present it, he said.

In his experience, the IRS "disallowed some of the deductions, if you didn't have the letter from the charity substantiating the fact that you didn't receive something in return."

Another possible red flag: The new rules on donating a car to charity. The deduction available to you is the lesser of: The fair market value of the car or what the charity sold the car for.

Previously, "you had people that said they contributed a very expensive car, but it's really a junker and when the charity sells the car they only get $100 or $200," Hechinger said.

The IRS "could have a program looking for that. I wouldn't be surprised. It's a hot ticket item ... a change in the law," he said.

In most cases, when the taxpayer claims an auto-donation deduction for more than $500, he must attach a letter from the charity.

See this IRS page for more information.

Casualty losses

Reporting casualty losses is a complex task, and thus "tends to be a red flag," Kent said. "Because the rules are so complex people frequently get that wrong."

Often there's a question of whether the taxpayer's situation qualifies as a casualty loss, Kent said.

Also, some taxpayers neglect to subtract out their insurer's reimbursement payment. Other times it's difficult to place a value on a lost item. "What's the value of two large trees that got knocked over due to lightning?" Kent suggested.

Tax shelters and scams

Every year, the IRS publishes its list of top tax scams. If you're using any of those, prepare to hear from the IRS.

"Those are almost no-brainers. Your returns going to get pulled and they're going to come after you," Sands said.

See the IRS list of "dirty dozen" tax scams.

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