Top 5ive Ways to Avoid an Audit

GETTING AUDITED BY the IRS is a nightmare scenario for anyone — no matter how meticulous and honest they are while preparing their tax return.

But if you think you have to be caught stowing away cash in an offshore bank account to trigger an audit, you better think again. One tiny error on your tax returns can have the IRS knocking on your door. In 2007, the IRS audited approximately 1.4 million returns, a 7% increase from 2006 and the highest number on record since 1998.

The best way to avoid an audit (and to deal with one) is to keep detailed records, such as receipts and bank statements that substantiate every claim, loss and deduction in your returns.

Here are five common red flags that catch the IRS's eye and how to avoid them.

Not Including All of Your Income

No matter what, the two things that you should always strive to do are file your taxes by the April 15 deadline (Oct. 16 if you qualify for the extension) and make sure you report all of your income. Proceeds from stocks and bonds that you've sold, dividend earnings, brokerage and bank accounts and any other interest-earnings investments must be reported, says Maureen McGetrick, accountant and partner at New York-based BDO Seidman. Forget to include a mere $200 and the IRS might take a closer look at you, she says.

People who claim the earned income credit — a tax break for lower-income individuals - are also likely to face an audit, says Mark Luscombe, a principal analyst at CCH Tax and Accounting. That's because income requirements for this credit are very strict. You qualify if you have one child and your adjusted gross income was less than $33,241 in 2007 ($35,241 if you are married, filing jointly) or if you have more than one child and earned less than $37,783 ($39,783 if married, filing jointly). If you don't have children, your adjusted gross income needs to have been less than $12,590 ($14,590 if married, filing jointly). Ultimately, this tax break can provide much needed relief to families that are in financial distress. The maximum credit is $4,716 for filers who qualify and have two or more children.

On the other end of the spectrum, the IRS is also auditing more people with high incomes. During 2007, the IRS audited some 293,000 returns of individual with incomes of $100,000 or more and around 113,000 returns with incomes higher than $200,000. That's a 13.7% and 29.2% increase, respectively, from 2006.

Reporting a Small Business Loss

Bad news for the self-employed and small-business owners: If you're showing a loss for the year, you run a high chance of being audited, says Brittney Saks, co-author of "PricewaterhouseCoopers' 2008 Guide to Tax and Financial Planning." Typically a loss on your schedule fee (the form where you report your business income) from $5,000 to $10,000 is an audit red flag, says Karla Dennis, CEO of Cypress, Calif.-based Cohesive, a tax preparation and consulting firm.

If you get audited, you'll have to prove that your business — whether it's full-time or a sideline venture — is legitimate and that its goal is to make money. You'll need detailed records, including all documentation related to income and expenses, a business plan, business bank accounts, and a business license, which you'd receive from your local municipality, says Dennis.

"The question that the IRS will try to answer is whether you're engaged in a small business or a personal hobby," says Luscombe. Some categories, especially if they're leisurely, like painting or writing, can raise many questions, he says. On the other hand, the chances of you getting audited because you lost money from, say, your sewer excavation business are low, he says. Generally, the activity is presumed to be a business, and not a hobby, if profits resulted in three of the last five years.

Deducting for Charitable Contributions

If you want to claim a deduction for your 2007 charitable contributions, you'll need to show evidence of your donation. As of January 2007, you'll need a receipt or bank statement to get a deduction on a cash donation of less than $250. For $250 or more, you'll need a written letter from the charitable organization, says McGetrick.

You'll also need a letter for any used clothing or household items you donate to an organization. The letter must include a good description of the product (a photo of the item also helps), the date that you donated it and the method you used to value it, says Saks. One way is to visit a thrift shop to find out how much the items can be resold for, she says. Keep in mind that noncash gifts need to be in good condition or better in order to receive a deduction. If they're worth more than $500, you'll need to fill out form 8283.

Filing for a Home-Office Deduction

Just filing for a home-office deduction [link: http://www.smartmoney.com/tax/workbusiness/] raises a red flag, says Luscombe. "The IRS feels there's a lot of potential abuse for reporting personal expenses as business expenses," he says. But that doesn't mean you shouldn't take your deduction if you're entitled to it.

In order to qualify, you'll need to prove that your home office is your principal place of business, that it's strictly for meeting with customers or clients, and used exclusively for business, says McGetrick. You won't be eligible for a deduction if you use the office for business during the day and as a family room at night or if your employer is offering you work space at the company office.

Excessive Write-offs

There's nothing wrong with claiming deductions that you're entitled to as long as they're not outrageously high compared to your specific income brackets. If the IRS sees that your deductions are disproportionately high compared with your income, it will raise their eyebrows. One thing is for sure: If you're going to take deductions, make sure you have the documentation to back them up.

The table below shows the average deductions made by different income groups in 2005 (the most recent available) based on their adjusted gross income, which includes your gross taxable income, such as wages, interest and dividend income, and capital gains, adjusted by deductions. Use this as a guide to assess where your deductions stand.

Average Deductions by Adjusted-Gross-Income Level
	$30K - 50K	$50K - 100K	$100K - 200K	$200K & Up
Interest expense	$7,582	$8,946	$11,927	$21,165
State and local income and sales taxes	$3,623	$5,812	$10,504	$39,321
Charitable contributions	$2,158	$2,703	$4,056	$20,434
Medical expenses	$5,626	$6,144	$9,727	$30,952

Source: IRS Statistics of Income Bulletin (Winter 2006-2007) & CCH 2008 U.S. Master Tax Guide