I have heard that there are some practices that are seen by the IRS as "red flags" for special attention or even an audit. What are they and how should I be prepared?

While the IRS does not publish a list of audit "red flags," it certainly appears to be the case that there are certain signs that are more likely than others to draw special scrutiny. Some of these signs, like having a high income, are things that taxpayers can do little to address. Others can be addressed in various ways in order to alleviate IRS concerns before the matter reaches the stage of a potential audit.

Here are some key items to be consider:

• Giving too much to charity. Since the deduction for charitable contributions is unlimited and is reported to the IRS only by the taxpayer, it can be a source of some abuse. The IRS is likely to give special attention to taxpayers claiming very high levels of charitable gifts. Maintain detailed records and receipts of all claimed gifts.
• Errors on returns. A carelessly put together return is probably the most easily avoidable "red flag." A return filled with errors will draw special scrutiny because it means the taxpayer is more likely to have made larger errors as well. Common mistakes that should be avoided include: incomplete returns, missing schedules, regular use of round numbers (e.g., $200 instead of $197), disagreement between state and federal returns, use of incorrect Social Security numbers, and arithmetic errors, among others. Ensuring that your return is complete and accurate is the easiest way to keep out of trouble.
• Unreported income. Remember that the IRS receives copies of all 1099s and W-2s that are issued to you. They will check them against those that are reported by you, and missing income is virtually certain to draw an IRS response.
• Higher than average deductions. The IRS knows the typical amounts for deductions at various income levels; deductions well above these amounts can generate a closer look. Since this can often be a particular problem for the self-employed, make sure that your various deductions and expenses are well-documented.
• Unexplained fluctuations in income. The IRS is particularly concerned if income shows a sharp drop from previous years. Such a drop could mean that some income is not being reported. Even though it is not required, it is a good idea to provide an explanation of such a drop when you file your return. Unless you are selected for an audit, the IRS does not compare your return from one year to the next.
• Participation in bogus tax shelters. There are many illegitimate tax "shelters" and other schemes that are promoted by shady individuals trying to make money on the complexity of the tax code. If the IRS determines that you are participating in such a scheme, everything else on your return is likely to be called into question as well.
• Home offices. The ability to take a deduction for a home office is actually quite narrow. The aggressive use of this deduction could lead to the increased risk of IRS scrutiny. Make sure that you have discussed with a tax professional whether you meet the criteria for the home office deduction and whether the deduction is worth the audit risk.
• Family members on the payroll. While there is nothing wrong with employing family members in the business, there have been instances of business owners either paying family members for little or no work, or paying highly inflated wages. In order to claim these wages as business expenses, make sure that you can substantiate that any family members were paid proper wages for real work.
• Excessive entertainment deductions. The IRS believes that some business owners have a hard time separating business and personal expenses, particularly in the entertainment sphere. Expect special scrutiny in this area, and make sure not just that all expenses are documented, but that their business purpose is documented, as well.

A key item to remember in most of the situations above is to explain anything that might seem to be unusual. While many requests for additional information and decisions on which returns to look at more carefully are generated by computers (and the formulas built into their programs), the decision to actually audit a particular return is still made by an actual human being. A simple explanation now can go a long way to preventing a lot of grief later.

Also, remember that no matter what you do, you may not be able to escape an IRS audit. Some audits are still purely random and in no way based upon factors under your control. Still, if you follow some key advice and maintain clear records, your chances of an audit are lower and your chances of surviving one unscathed are greatly improved.

Disclaimer: The National Small Business Association is in no way providing tax advice. The organization only is providing information. Before filing your tax return or proceeding with any official action, please consult a tax professional.