How To Steer Clear of a Tax Audit

Cathy Lee, CFP®

Tax Associate

The Inflation Reduction Act, signed into law on Tuesday, contains a couple of key provisions—mentioned in last week’s update. Since then, we’ve had some questions from clients that have nothing to do with inflation reduction and everything to do with keeping more of their money out of the hands of the Internal Revenue Service.

The legislation calls for additional funding for IRS enforcement. This could result in a meaningful increase in taxpayer audits after years of decreases. The aim of this provision is to bring the number of annual audits closer to historical levels (about 1% of all filers). The IRS has pledged that this won’t affect households earning less than $400,000 per year and will instead focus on large corporate and high-net-worth taxpayers.

That’s all well and good…unless you’re a household with adjusted gross income (AGI in tax parlance) of $400,000 or more. How can you steer clear of the IRS’ crosshairs?

The best place to begin is the most obvious: Always report all your income. That’s easy when you rely on your employer’s Form W-2 or 1099 to tell the story. It gets more complex when you need to self-report small business proceeds or rental income. The IRS looks closely at income from legal partnerships and LLCs. In these cases, detailed bookkeeping goes a long way. Small business owners should always keep their personal and business bank accounts separate, save seven years of receipts (our suggestion) and keep detailed notes on all deductible expenses.

The second step is to avoid looking like an outlier. Claiming excessive investment or business losses, very large expenses or outsized deductibles can send up a red flag. If you write off that $3,000 dinner, be sure you keep the names of everyone you hosted. Yes, take advantage of deductions, but be certain you have the documentation to defend your claims.

Finally, keep an excellent record of your estimated payments and other checks you’ve written to the IRS. Payments can be wrongly recorded or coded by the IRS—always write your Social Security number on any checks you send them. And double-check your numbers. For example, if you paid $8,000 but listed $10,000 on your tax form, the IRS will spot the mismatch and turn a green eyeshade your way.

Even with the agency’s increased funding, only a small percentage of people will be audited (the audit rate for those who earned between $500,000 and $1 million in 2019 was just 0.5%, though that rate increased to 2.4% for those reporting over $5 million in income). Still, it’s better to be safe than stuck fretting about an impending tax audit.

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