Lowering Your Odds of Facing IRS Audit

April 15th is less than a month away, which means it's tax time. And what does everyone fear at this time of the year? The IRS knocking on their door with a big bad audit. But you can take steps to try to avoid an audit this year -- and every year. Financial adviser and "Early Show" contributor Ray Martin discusses some of the common mistakes people make that raise red flags to the IRS.

Reducing the Chance of an IRS Audit

The chances that your tax return will be audited are pretty low. According to the most recent Department of Treasury data, the IRS examined slightly less than one percent of all individual tax returns, which is down from about five percent in the mid-1960s. But the chances of an IRS audit can increase substantially, depending on your income level, types of income, amount of deductions, your income earning activities and changes you have made since your last tax return was filed.

An IRS audit, while not on the list of fun things to do, is not something to be feared. If you have kept complete and accurate records of all of your deductions and have reported all of your income, you should be fine. In fact, in about 25 percent of audits, the IRS makes no changes or issues a refund.

But here is the bottom line: no one like an IRS audit and you'd want to know what can trigger an audit so that you can avoid it…right???

Audit Triggers to Avoid

Incorrect Data: The most common reason for the IRS flagging individual returns is incorrect reporting of Social Security Numbers for filers and dependants. Incorrect tax return reporting of income and taxes paid from forms W-2 and 1099 also are a sure fire way to set off IRS computers.

Filing Late: Not filing returns on time or not filing a particular year will catch up to you. Instead file a form a Form 4868, Application for Automatic Extension for Time to File U.S. Individual Income Tax Returns. This must be filed no later than April 15th. PLEASE NOTE: While this gives you an automatic 4-month extension, until October 15th to file your return, it does not give you an extension to pay any taxes due. Filing a proper extension does not make your return more likely to be selected for audit.

Paying Too Little: If you do not have the money to pay the taxes due, don't just send in a lesser amount without an explanation. This will trigger an IRS notice and it could also lead to a more invasive IRS review of your return. Instead, file Form 9465 Installment Agreement Request with your return. You'll still have to pay interest and possibly a late payment penalty for any taxes not paid by April 15th. However, the IRS will work out a payment plan for up to 60 months at a lower interest rate for the balance that you owe.

Math Errors: These are also high on the list of audit triggers. Using a tax professional or a computer program to prepare your return should help you avoid this problem.

Also, certain combinations, such as not reporting some gains on the sale of a home when business-use-of-home deductions were claimed on past returns will trigger an IRS flag. Also, reporting large amounts of self-employment income, typically in excess of $100,000, on Schedule C seems to get the IRS' attention. According to the IRS, often these filers load up on dubious deductions and have fewer records justifying the write-offs they claim.

And be sure to use the mailing labels and envelopes provided to you by the IRS. This will prevent another common tax filing error: sending your tax return to the wrong IRS processing center.

For more on tax audits, go to Page 2.

IRS Audit Checks and Triggers

First the IRS runs a check called Document Perfection - Every tax return is checked for errors in math and tax calculations and for clerical errors such as incorrect SSNs and addresses. If a mistake is detected, a notice of the error and a recalculation of the tax due is sent to the tax payer.

Next is the Document Matching Program - This compares the information you report with the information suppled by your bank, your employer and others on forms W-2, 1099 and other forms and documents. If you omit an item from your tax return which is picked up by the IRS' computers, the IRS will send a computer generated notice that includes a recalculation of your tax and the additional interest and penalties you will owe. Typically these notices are sent two to three years after the return in question is filed, so when you receive these, you will need to find your returns and records to verify if the IRS is correct in their assertions. Typically, these omissions are honest mistakes by a taxpayer and, although the IRS maintains their position that they could assess a negligence penalty, the law does not allow them to presume negligence and automatically asses such penalties.

Discriminant Function System (DIF) - Basically the DIF is a computer program that assigns a numeric value or score of selected items on tax returns. When the total score of all selected items exceeds a minimum set by the IRS, the IRS computers will single out the return for a possible audit. The exact items and scoring convention is a more closely guarded secret that the formula of Coca-Cola, but some of the items believed to be on the list include:

• Large amounts of income not subject to tax withholding.
• Unusually large amounts of deductions claimed than seem reasonable when compared to your income.
• A large number of dependent exemptions claimed in conflict with reported SSNs, tax withholding allowances, etc.
• Indicating a change of address when not reporting a sale of your residence and not changing your home related deductions.

Finally, the IRS also runs special audit programs such as its Market Segment Specialization Program, or MSSP, where the IRS uses its computers and specially assigned and highly trained agents to scrutinize tax returns that report income from a selected list of business categories, especially those with income from self employment reported on Schedule C, that are categorized in one of several business market segments on an list maintained by the IRS.

I've Been Audited-Now what do I do?

First of all, DO NOT take a combative attitude; you can probably take care of the problem through mailings. The 2007 figure represents an audit for one of every 97 returns filed. But only one of every 561 returns resulted in a face-to-face audit. The rest were correspondence examinations. Preliminary 2008 numbers show 1.39 million individual taxpayer audits, but only 310,429 of those were field audits. The rest were again correspondence examinations.

This means that if you get audited, the chances are you will be able to take care of it with written correspondence with the IRS. Most audits start with a letter from the IRS. The most important thing you can do is answer that letter BEFORE the due date. If you agree with the IRS' assesment of your situation, send back the form with your enclosed payment.

If you think the IRS is wrong, send them correspondence BEFORE the due date, and provide a substantial answer to their question. If this does not take care of the problem, you may be called in for a face to face audit. If that happens, prepare prepare a response and consider the strong possibility that you need to hire a professional to represent you in the audit.

Items and Circumstances that can frequently draw the IRS' attention include:

• Reporting income and taxes withheld on your tax return that does not agree with the information on the Forms W-2 and 1099 that you received - the IRS receives the same information ad their computer systems will check this.

• Total income from self employment, reported on Schedule C, of $100,000 or more. According to one recent study, the IRS has concluded that individuals filing Schedule C are most likely to under report their income and overstate their deductions.

• Claiming deductions that are unusually large in relation to your income. According to a report of IRS inquiries, the IRS selected a taxpayer's return for audit when the tax payer claimed over $18,000 in unreimbursed business expenses when he reported only $25,000 in gross income.

• Married taxpayers filing separately who both claim the same deductions. Many such taxpayers should split or allocate the deductions that are paid for jointly.

• Taxpayers returns that fall into a series of industries or activities that, based on past IRS audit experience, have a higher incidence of noncompliance. This includes tax returns of auto dealers, taxi and air service operators, attorneys, gas retailers, etc.