The best way to beat a federal tax audit is to avoid it altogether. Of course, there's no surefire way of preventing an audit. Still, you can ways to discourage one.
Here are five tips to help you avoid a tax audit:
1. Always File on Time
File your taxes on time, even if you have a loss or you owe no taxes, advises Hal Shelton, SCORE volunteer, angel investor, and author of Amazon bestseller The Secrets to Writing a Successful Business Plan.
"If you have been filing taxes every year and all of a sudden you don't, that's a red flag," he says.
You won't need to pay if you have a loss, but you will have an opportunity to offset those losses against previous or future earnings.
2. Follow the Rules
"The best way to avoid an audit is to not be doing anything obviously fraudulent or illegal," says Al Clark, COO of BlueRidge AI, an adviser to startups, and former VC investor. "For most people this amounts to just not taking bad advice."
Bad advice is abundant on what deductions are permitted. For example, new clothes are deductible if they are only worn on the job, like a nurse's scrubs. Deducting your home office is only allowed if you use it strictly for self-employed work.
"Each time you submit something that isn't quite accurate, you're rolling the dice," Clark says. "If you follow the rules pretty closely, you've got less to worry about."
3. Avoid Careless Mistakes
Once you know and follow the rules, make sure you aren't making careless mistakes. This is especially true if you work in a cash-based business like bartending or taxi driving. Make sure to document everything accurately and avoid mistakes that cause you to amend your return.
No matter what is happening in your life, don't forget things that tax authorities are likely to care about.
"The biggest mistake you can make is to forget a tax form that showed a bunch of income and you wound up not reporting enough income," says Chuck Jaffe, a syndicated financial columnist and the host of the talk show Money Life.
After a brutal year in which his wife's mother died, his brother died, and he had a heart attack, Jaffe forgot to deposit the five-figure check to roll over an IRA his wife had cashed out. The resulting audit taught him the important lesson that failing to report tens of thousands of dollars in income is one of the most glaring red flags for the IRS.
4. Hire a Professional Tax Preparer
It's always a good idea to hire a tax preparer, but especially if your situation is complex or when tax laws have changed recently. Your tax return is more likely to be error-free if prepared by a pro, and the process will help you understand what kind of deductions are legal and appropriate for your situation.
To find a trustworthy tax preparer, gather some recommendations for pros who know your area of business and do interviews. Ask how many of their clients have been audited, and look up whether they have received any disciplinary actions from the IRS or professional boards.
Remain vigilant by reviewing their work carefully and asking any questions you have about what they prepare.
5. Explain Yourself Upfront
The IRS analyzes tax returns using the concept of "comparables," which means looking at how an individual's income or deductions compare to others within the same industry. Numbers way outside of the norm may trigger a tax audit.
"If you're a server at The Palm, and you report $10,000 in tips, and every other server there is doing $30,000 in tips, that's a red flag," says Shelton.
Discrepancies between tax years can be cause for concern. If you rack up expenses one year while writing a book and then rake in lots of income when the book becomes a bestseller early the next year, the difference in those two years' reporting will be cause for concern.
Shelton recommends adding a statement to your return in the form of a cover letter if your situation may raise eyebrows. It's far better to explain up-front than when you're eventually audited.
Of course, it's far better to do everything you can up-front in order to avoid being audited. Following these tips is a great place to start.