Five Ways To Avoid A Tax Audit

Each year the Internal Revenue Service (IRS) pulls out thousands of tax returns because something just doesn't quite add up.

Sometimes the IRS will just inform the taxpayer that he or she made a mistake and owe more -- or less -- money. In other cases, the return is subjected to a full-blown audit. That can be a nerve-wracking experience, and an expensive one too. It's best to avoid them, if at all possible.

Unfortunately for the taxpayer, audits are becoming more common. The IRS recently reported that its audits were up 11 percent for the year.

It's during hard times that taxpayers sometimes feel the pinch and are more likely to cut corners and try to pay a little less than they owe. Likewise, as tax revenue goes down, the government will look for more income by increasing audits.

Tax attorneys like Edward Gonzalez, who practices in the Washington, DC, area, say it's never a good idea to try to slide one by the tax man. The small savings on taxes just isn't worth the risk of triggering an audit.

He offers five pieces of advice for staying in the IRS' good graces and avoiding an audit:

1. When it comes to your taxes, honesty really is the best policy.

Report all income, even when you don't get a 1099 or W-2. Deposit all cash, religiously, into the business account. Don't take cash, bypass depositing it into an account, and use it to pay expenses. If the agent sees a lot of this, it'll make the case easier for unreported income. Remember: The burden of proof is on the taxpayer. Ignorance and sloppiness are not an adequate defense. Regarding deductions, don't try to reach. Always ask yourself: Is this a defensible position? Am I clearly entitled to the deduction?

2. Beware of "constructive dividends."

This is a favorite of the IRS, according to Gonzalez. Small business owners often use the corporate account to pay for personal goods or services, such as a car used for the personal errands of the owner, non-business meals, vacations, home improvements, and so on. IRS and the state tax agents know it, and look for it. If it's personal, report it in your personal income tax return or reimburse the company and make sure to give it only the correct tax treatment as compensation, or dividend, in consultation with your accountant. This is often one of the charges in a tax criminal case.

3. Use a reputable tax preparer.

Tax is very complicated. Furthermore, the law changes every year. The person preparing your return should have credentials (education and experience). Mistakes, including math errors, in one part of the tax return increase the odds that the whole return will be audited. Don't pick someone because she promises to get you the biggest refund or the lowest tax bill. That's a red flag signaling a fraudster. You don't want to be questioned by the IRS when it investigates this scammer's entire client list.

4. Keep good records.

Of course this is something you should have done throughout the year, but you can still heed this advice for the coming year. Keep your receipts, especially for expenses you deduct. You will be asked for them during an audit. Remember: To deduct actual mileage you must keep a "contemporaneous" log, i.e. at the time of the trip, not a reconstruction weeks afterward. Likewise, you want to have invoices for any payments you make.

Otherwise, on audit, how do you prove the deduction you took for office supplies wasn't just money you pocketed? Bring the paid bills from Staples. Meticulously deposit all your income into an account and pay your bills out of that account or designated credit cards. If you're self-employed, or have a side-line business in addition to your employment, do not commingle income and expenses of your business with your personal. Keep and use separate accounts, ATM cards, and credit cards for your personal transactions and your business transactions.

"One of the biggest problems we face as tax practitioners working with small businesses is the lack of good record-keeping," Gonzalez said. Just keeping "books" makes such a difference for business planning and profits, as well as defending an IRS audit.

5.  Keep regular books if you have a business.

It's good business practice, too, to keep books during the year. Many get into tax trouble because they didn't pay estimated taxes during the year and so don't have the cash (or available credit) to pay when they file the tax return for the year. Had they paid estimated taxes during the year, this would have been avoided. From a business point of view, they would also had a better idea of profitability had they taken into account tax "accrual" expenses building up during the year. So many contractors under-bid because they don't take taxes into account, and end up subsidizing the buyer with the tax liability they will later face!

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