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How to Reduce Your Audit Risks

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Best practices for reducing the likelihood of an audit, and how to be prepared in the event of one.

Jane G. Ditelberg, Director of Tax Planning
Thomas W. Bassett, Manager, Global Tax Services

If you ask Americans about things that make them nervous, IRS audits would fall pretty high on the list. According to one recent study, respondents were more afraid of tax audits than of identity theft. Over the last year, funding for the IRS and the role of tax audits has been in the news, leaving many wondering if they would be prepared if their own returns were audited.

The bad news is that higher-income taxpayers, in general, are audited at a higher rate than average, and the IRS expects to focus additional resources provided to it by the Inflation Reduction Act on assessing the tax compliance of wealthy individuals — as well as that of large corporations and complex partnerships. The good news is that there are best practices that can help reduce your risk of an audit and prepare you in case one does occur.

Northern Trust prepares and files approximately 1,000 individual tax returns and 12,000 trust or estate income tax returns each year. As taxpayers or tax preparers, we inevitably participate in all types of income tax audits regularly. Based on our experience, here are a few tips on how to reduce the likelihood of audit and be prepared in the event of one.

  • File electronically and carefully avoid math errors. In 2021, the IRS sent nearly 16 million automated notices for math errors on returns. However, if you receive a notice of a math error, do not assume that you are the one that made the mistake. As the information from paper returns is entered by hand or by scanner, the IRS sometimes makes math errors and transposes numbers — so checking against your copy of the return is important. Keeping good records can help you challenge the IRS’ errors, and filing electronically can reduce the chance of input errors.
  • Include all income reported to you on your return. The IRS receives information on income paid to taxpayers in various ways, such as through W-2s and 1099s, information returns and K-1s, and even reported gaming winnings from casinos. If you omit any income already reported to the IRS, its automated matching system will flag it, and you can expect to receive an IRS CP-2000 notice a few months after filing. If you see an error on a 1099 or other report of income, you should request an amended form from the issuer rather than not reporting the income on your return. Omitting income is not only a good way to invite the IRS to request additional tax but also review other items on your return.
  • Carefully consider whether to deduct expenses for businesses that are chronically unprofitable. There is a very fine line between business enterprises that have never generated profit, and hobbies, which are activities pursued for pleasure or other reasons not related to profit. The IRS is skeptical of claims that unprofitable endeavors really are actual businesses eligible for expense deductions, rather than hobbies where expenses are not deductible. This applies especially to enterprises such as yacht or plane leasing, horse racing, ranching, interior design, art galleries or art collecting. Deducting these expenses will increase your chance of an audit, so the best defense is having good records of your business plan and prospects for profitability.
  • Keep records to substantiate your deductions. Given that income sources and amounts are typically identified in matching, auditors often look closely at deductions. While some of them are easy to substantiate, others are not. This is when keeping good records can help significantly in the event of an audit.
    • Ensure you obtain an appropriate receipt for every charitable deduction. The receipt must include the name of the 501(c)(3) organization, confirm the contribution is deductible, and state that no goods or services (or only nontangible religious services) were received in exchange for the donation.
    • If the deduction is for a contribution of property other than cash and requires an appraisal to establish the value of the gift, carefully evaluate the qualifications of the appraiser. Your tax advisors can consult IRS publication 526 for when this applies.
    • Carefully consider and plan for donations to charitable auctions. Ask the charity, before you make the donation, if and what type of receipt you will receive, as these receipts are often lacking. Also, be aware that if you donate something that, if sold, would generate ordinary income (e.g., use of a rental property), the deduction is limited to your basis, which is often zero.
    • Make sure your documentation is easy to access and well organized so that you can locate it when requested.
    • Retain substantiation documentation past the expiration of the period during which the IRS can audit your return. The typical recommendation is to keep it seven years.
  • Avoid the “Dirty Dozen.” Annually, the IRS publishes a list of what it considers the worst tax scams. By describing these transactions, the IRS is putting taxpayers on notice that it will look to audit returns reporting these transactions.
  • Avoid tax preparers who “draft a return” and then will not sign it. The IRS and state tax authorities are growing concerned that there are tax preparers who are “hiding” from the tax authorities. A paid tax return preparer should sign any return they work on and should provide their PTIN or Social Security number in the appropriate box on the return. If they will not, you should question why they are preparing returns but not disclosing that to the IRS — and avoid them.
  • Be cautious with Listed Transactions and Reportable Transactions In addition to the Dirty Dozen, the IRS publishes “Listed Transactions” that it considers improper tax avoidance techniques. Listed Transactions are a subset of what are called “Reportable Transactions” for which the IRS requires additional disclosures on a taxpayer’s return, as well as disclosures and records from material advisors to the transaction. Even if you typically prepare your own return, professional return preparation is recommended when dealing with any of these issues due to the type of scrutiny the returns will face.
  • Respond to notices promptly. The IRS sends out thousands of notices to taxpayers every week, sometimes more than one per return. Many of these notices ask for information that was already on the return. Some are inaccurate. It is generally a bad idea to ignore letters and notices from the IRS, as the matter will escalate and can eventually lead to liens, garnishment and other procedures that are much more challenging to resolve. By following the IRS process and responding promptly, you can usually resolve the matter quickly and much more easily.
  • Enlist expert advice. If you receive notice of an audit, consider consulting an experienced tax professional to advise and/or represent you before the IRS. Regardless of the audit issue, a tax expert can make the process go more smoothly and help protect you.
  • Keep travel logs and calendars. States that impose an income tax are vigilant in identifying residents who should be paying tax. If you split your time between two or more states, you need to be prepared to defend a challenge to your determination that you are not a tax resident of the other state or states. Keep copies of your travel calendars, schedules and supporting documentation, such as plane tickets or hotel bills, so that you can document your time spent in each state if you are challenged about your tax residency and/or “domicile.”

Tax compliance reviews and inquiries are a necessary part of the American self-reporting income tax regime. So is fearing an audit. However, you can reduce the chance of audit significantly by paying careful attention to detail and recognizing whether you are reporting a transaction of special interest to the IRS. And if you do get audited, having accurate and complete records and professional advice can make the process go more smoothly.

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Disclosures

© 2024 Northern Trust Corporation. Head Office: 50 South La Salle Street, Chicago, Illinois 60603 U.S.A. Incorporated with limited liability in the U.S

This information is not intended to be and should not be treated as legal, investment, accounting or tax advice and is for informational purposes only. Readers, including professionals, should under no circumstances rely upon this information as a substitute for their own research or for obtaining specific legal, accounting or tax advice from their own counsel. All information discussed herein is current only as of the date appearing in this material and is subject to change at any time without notice.

The information contained herein, including any information regarding specific investment products or strategies, is provided for informational and/or illustrative purposes only, and is not intended to be and should not be construed as an offer, solicitation or recommendation with respect to any investment transaction, product or strategy. Past performance is no guarantee of future results. All material has been obtained from sources believed to be reliable, but its accuracy, completeness and interpretation cannot be guaranteed.

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