The IRS has a computer program that may earmark you for an audit. No one knows the exact formula fingering auditees, and the IRS isn’t telling. But tax experts have noticed a few red flags that tend to trigger audits:

1. Reporting a high income. According to CNNMoney.com, “In 2007, the IRS audited 29.2% more individuals making over $200,000 than it did in 2006. One out of every 11 individuals with incomes of $1 million or more faced an audit.” High income earners likely have more complex tax returns, which puts them at greater risk for making mistakes. Since these individuals also make more money, catching a mistake is far more lucrative for the IRS.
2. Reporting a low income. Every W-2 or 1099 that you receive is also sent to the IRS. This means the government knows how much you made in wages, interest, dividends, etc. Don’t lie. You may not get caught, but if you are discovered, the penalties are steeper than the taxes you need to pay.
3. Claiming the Earned Income Credit. The requirements for claiming the EIC are very stringent. This credit helps families in severe financial distress. The IRS doesn’t look kindly upon scammers when it comes to claiming undeserved credits.
4. Being self-employed or owning a business. If you are self-employed or run your own business, the IRS will be scrutinizing your deductions since it’s especially easy to abuse deductions in this area. You should be especially careful if you reported a loss on your return. Claiming a loss year after year may raise the question of whether you are running a legitimate business or claiming losses on a personal hobby.
5. Claiming home office deductions. Read IRS Publication 587 [PDF] carefully if you plan to claim home office deductions. In a nutshell, you need to be able to prove that your home office is your principal place of business and is not used for anything else. Be conservative in your claim, and document everything with receipts.
6. Claiming above-average medical expenses. Medical expenses must exceed 7.5% of your Adjusted Gross Income (AGI) before you can claim a tax deduction. Be sure to document significant medical expenses with receipts, hospital bills, and insurance paperwork.
7. Claiming casualty losses. To claim a casualty loss, it must exceed any insurance reimburement by $100 (and that $100 is not deductible). The loss must also be incurred by sudden events such as theft, fire, or hurricane. Gradual and foreseeable wear and tear do not qualify. The claim must also exceed 10% of your AGI after insurance payments have been received (and you can’t claim that 10% as a deduction - only losses in excess of that amount). With so many restrictions, it’s easy to make a mistake here - and the IRS will take notice.
8. Claiming excessive charitable donations. I’m not saying that there’s such a thing as too much philanthropy. But the IRS will certainly take notice if you donate more than 10% of your income or if you donate property. You’ll need a receipt for cash gifts under $250 and a letter from the charitable organization for cash gifts over $250. You’ll need to fill out IRS Form 8283 for non-cash gifts over $500, and non-cash gifts over $5,000 require appraisals.
9. Completing your return by hand. Messiness, errors, and omissions are immediate red flags for the IRS. A good way to avoid this is to use a reliable tax software. Even if you like double-checking all the calculations by hand, consider doing your taxes once with a software anyway for redundancy. If the numbers all match up, why not just file the electronic copy?
10. Showing discrepancies from last year’s return. The IRS will notice if your name changes from last year’s return, if you suddenly start claiming more deductions, or if your income changes drastically. Sometimes this can’t be helped - for example, you lose your job. Just be ready with an answer and supporting documentation.
11. Showing discrepancies from state return. Your reported income should not vary between your state and federal returns. After all, what you put on tax forms should match exactly what you see on W-2s, 1099s, and other forms that are sent to the IRS as well as to you. So report everything for both state and federal returns.

Are you at risk? Don’t be afraid to take all the deductions you are entitled to. Just make sure you have the paperwork to back it all up.

Resources

• “Red flags for tax auditors” at CNNMoney.com
• “Top 5ive Tax Audit Red Flags” at AOL Money & Finance / SmartMoney.com
• “Tempting the tax auditor” at Bankrate.com