Even though tax season is well behind us, there are steps you can (and should) take today to make the possibility of a future IRS audit a remote possibility. Keep in mind that after December 31st passes, you may not be able to alter your tax strategy for the prior year. That’s why it’s so important to be aware of audit risk before it becomes a problem.
What are the risks?
Your overall chances of being audited by the IRS are only 1.11% according to the IRS. But if your income is between $300,000 to $1,000,000 your chances are almost 3 times greater. And if you earn more than $1,000,000 per year your chances are almost 12 times greater. It makes sense for the IRS to spend more time auditing wealthier people. That’s where the money is.
But high-income earners aren’t the only individuals that fall under the IRS’ watchful eye as you’ll see. Here’s what you can do to cut your risks to the bone:
1. Investment Expense
If you are a stock trader you have to report your gains and losses. According to the Investor’s Business Daily, you’ll get more deductions if you report them on Form 8829. If you go this route, the deductions will flow to your Schedule C rather than listing them out on separately on Schedule A which is widely used for miscellaneous itemized expenses.
The only caveat is that you can only use Schedule C for trading gains and losses if you are a trader. Also, only expenses greater than 2% of your adjusted gross income can be used for tax deductions.
What you need to do now.
Keep careful records. You might qualify as a trader for some investments and as an investor for other securities. Ask your tax preparer about this if you want to avoid getting a nasty letter from the IRS. And don’t start thinking about this next year. The last thing you want is to have to scramble around searching for data. Get set up for this now friend.
2. Cost Basis
Brokers are required to report cost basis for mutual funds, stocks and bonds. All you have to do at this point is to call your broker and make sure that they are compliant. If they aren’t they are breaking the law. If that’s the case, it’s probably a good time to find a new custodian.
This may not seem like a big deal now but it will be in 10 years from now if you need your cost basis and can’t find it. Selling old securities is one of the IRS audit flags the tax police love to use. Don’t let them trip you up.
3. Foreign Accounts
In the good old days you only had to report bank accounts you had in foreign countries. Now you must report assets you hold outside of the United States as well. And you have to report all those assets on form 8938. Get familiar with the forms now and make sure you have all the information necessary to complete those forms.
4. Self Employed
If you are an independent contractor or sole proprietor you use Schedule C to report income and expenses. But just by filing Schedule C your odds of an IRS audit jump to 4.3% (assuming your income was between $100,000 to $200,000).
If you run your own small business and are sure you want to do so as an independent contractor make sure you keep meticulous records – and be ready for an audit. If you are not fixed on the idea of being an independent contractor, consider some other business formation.
Have you ever been audited? What was it like? What was the main reason you were audited? What do you differently now?