Greg's Corner

How to Avoid an IRS Audit and Stay Compliant

By Greg Collier

Receiving an IRS audit notice can be a stressful experience, often bringing with it concerns about additional taxes, penalties, and the time-consuming process of providing documentation. While some audits are random, many result from specific patterns or inconsistencies in a tax return. Fortunately, these triggers are well known, and taxpayers can take steps to minimize the risk of being audited.

One of the most common reasons for an audit is failing to report all sources of income. Employers automatically report wages through W-2 forms, but income from investments, freelance work, rental properties, and other non-traditional sources must be accounted for separately. Discrepancies often arise when taxpayers overlook 1099 forms or fail to track self-employment earnings accurately. Keeping organized records and ensuring that all sources of income are reported can help prevent this issue.

Another red flag for the IRS is a significant fluctuation in income from one year to the next. While changes in financial circumstances are normal, large swings, especially for self-employed individuals or business owners, may prompt closer scrutiny. If a business experiences a sharp decline in revenue due to losing a major client or other external factors, it can be helpful to include an explanation with the tax return to clarify the reason for the fluctuation.

Businesses that consistently report losses also tend to attract IRS attention. While it is common for new ventures to take time before turning a profit, a business that continues to operate at a loss year after year may be seen as a hobby rather than a legitimate enterprise. The IRS requires businesses to demonstrate a profit motive, and maintaining detailed records of revenue-generating activities can help establish credibility.

Deductions are another area where taxpayers need to exercise caution. Certain deductions, such as large charitable contributions, rental property losses, or home office expenses, require careful documentation to ensure compliance with IRS rules. A charitable donation that significantly exceeds the typical amount given by others in a similar income bracket may raise questions. Home office expenses are only eligible for those who are self-employed and use the space exclusively for business purposes. Having thorough records to justify deductions can prevent unnecessary scrutiny.

Estate tax returns are also frequently audited, especially when assets appear to be undervalued. The IRS employs valuation experts who review these filings, and any discrepancies in the reported value of real estate, art, or closely held businesses can lead to an audit. Obtaining multiple appraisals from qualified professionals can help substantiate asset valuations and avoid potential disputes with the IRS.

Even with careful preparation, some audits are unavoidable. The IRS conducts audits through three primary methods, correspondence audits handled via mail, office audits that require a visit to an IRS facility, and field audits that involve an in-person review at the taxpayer’s home or business. In all cases, the IRS provides advanced notice and specifies the documents they need to review.

While hiring a tax professional can be beneficial, taxpayers remain responsible for the accuracy of their returns. Reviewing all information before filing, maintaining organized financial records, and being prepared to provide supporting documentation when necessary can go a long way in preventing audit complications. Understanding the common triggers for an IRS review and taking proactive steps to ensure compliance can help taxpayers navigate tax season with confidence.