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Audit-proof your 2012 tax return

How to avoid drawing scrutiny from the IRS

Last updated: February 2013

The average taxpayer has a 1-in-100 probability of being formally audited by the IRS in a given year. Those odds rise if, among other things, you itemize deductions, report profits or losses on a home business or rental property, or have an income of $200,000 or more.

And the IRS conducts many more informal reviews for problems like math errors and mismatches between the income taxpayers show on their tax forms and what their employers and other income providers report. Those raise your chances of being contacted by the IRS closer to 7 in 100. But you can take steps that will help you survive an audit in some key areas.

Business expenses

Home-business owners using Schedule C and employees claiming unreimbursed expenses on IRS Form 2106 should scrupulously record telephone, travel, meal, and entertainment expenses for business.

“The deductions that can be personal in nature are the first ones the IRS is going to look at,” says Robert S. Seltzer, a CPA and personal-finance specialist (PFS) in Los Angeles. If you’re just starting a business, for instance, don’t expense research trips. “I don’t have an issue writing off a trip for a writer who sold a script about South America,” Seltzer says. “But it’s harder to defend a freelancer who hasn’t made money of that kind.” Other tips:

Is it a business or a hobby? Unless you can claim income periodically, don’t deduct a $1,200 Nikkor lens for the photography hobby you hope will some day pay off, especially if you get a W-2 from another job. A rough rule of thumb is to show a profit on Schedule C in at least two years out of every five.
Define your home office. Applying too much of your home’s square footage toward a home business sends the wrong signal, Seltzer says. And it should look like an office and be used exclusively for business. “If it’s also where your children do their homework and your spouse checks e-mail, I don’t think it meets the standard,” says Dan Morris, a partner at Morris & D’Angelo, a CPA firm in San Jose, Calif.

Rental income

If you own rental property, take care completing Schedule E for supplemental income and loss. How much you can deduct for expenses and losses depends on how actively involved you are in managing your property and how well you can prove it. Other tips:

Know when to depreciate. Repairs and new equipment that extend a property’s life or add to its value aren’t considered maintenance. Depreciate them over a number of years rather than expensing them in a single year, says Jodi Robinson, director and tax-practice leader for CBIZ MHM, an accounting firm in the Kansas City, Mo., area.
Document personal use. To fully deduct the expenses related to a vacation rental, you and family members can’t use the home more than 14 days, or 10 percent of the days the unit is rented at the market price, whichever is greater. If you own a second home that doubles as a rental, hold on to credit-card bills and travel documents to prove you and your relatives stayed only for the allotted period.

Charitable donations

Sums that stand out can raise suspicion. For example, deducting a large charitable contribution—say, $20,000—if your adjusted gross income is $40,000 is permissible by the IRS but might appear out of place.

Keep dated receipts for cash gifts of $250 or more and for noncash items you donate, such as furniture and clothes. If you give an item worth more than $500, you’ll need to fill out Form 8283. Donations worth more than $5,000 require a written appraisal. Check IRS Publication 561 for details.

Records are the key

No matter what you’re deducting, always keep or scan original receipts. Your credit-card bill alone won’t necessarily identify the item or services purchased. And hold on to your records for at least seven years. Renee L. of Seattle, a retired, self-employed screenwriter, says saving receipts and keeping a detailed calendar have helped her fight four IRS audits. “Because I’ve had that calendar and receipts, I’ve never been assessed a dime,” she says.

Audit help from tax-prep software

The two leading do-it-yourself products provide varying levels of help with audits:

H&R Block at Home. Under its free “Worry-Free Audit Support,” a representative will explain letters from the IRS and help you prepare for an audit. If needed, you’ll be assigned an enrolled agent, a tax expert who can represent you before the IRS. He or she also might settle claims on your behalf, arrange for an appeal, or discuss payment options.

TurboTax. Several editions include the Audit Risk Meter, which flags items on your return that could trigger an IRS letter. The free Audit Support Center recommends how to respond to letters. With the Audit Support Guarantee, a tax professional will explain your audit letter and tell you what to do. For $39.95 and upwards, TurboTax’s Audit Defense Plan provides a tax pro to handle audit negotiations up to the highest level of appeals. The plan, which you must buy before you get an audit letter, also offers information and advice on payment options.