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Date: March 12, 2008
Subject: G&G Tax T.O.W - Hottest Audit Targets

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G&G Associates
Tax & Financial Consulting Services

Hottest Audit Target

IRS audit rates are rising now. Moreover, the IRS is targeting its audits more effectively after conducting in national research program on taxpayer behavior.
Here are the most dangerous areas of audit risk now-and how minimize the danger they pose to you.

Self Employment- the IRS clear number-one audit priority is examining the tax returns of people who own sole proprietorship small businesses and file Schedule C with their tax returns.

Why: IRS research shows sole proprietors underpaid their taxes by far more than any other group.

Example: Small Business sole proprietors underpaid by a total of $68 billion, compared with only $30 billion for all large corporations, in 2001 (the year that the national research program examined), says the IRS.

Former IRS Commissioner Mark Everson had a publicity stated: “Our increased focus will be on those individuals who are filing 1040s and are running business that are not incorporated… Typically, that individuals who are filling Schedule C.”

The highest audit risk is faced by those who report net losses form their businesses. The IRS believes that many such people...

• Underreport income and inflate deductions to manufacture deductible losses.
• Aren’t running legitimate businesses at all, but only hobbies or sidelines that have no real profit motive behind them.

Danger: If the IRS selects such a business loss for an audit, the audit can spread to become a full examination of the individual’s entire tax return-even if the loss was only a small-dollar amount reported from a sideline solo practice new year-end as a proprietorship.

Start-up costs created a perfectly legitimate small business loss for it. Even though the loss was insignificant relative to the doctor’s total income, the IRS selected it for audit-and the audit spread to become a full examination of three years of his returns.

Self-defense: If you report a loss on Schedule C, be able to show that your business is legitimate, not a mere hobby, by showing that it has a profit motive. Also, visit G&G Associates website audio library to make sure you are taking your deductions correctly. If you have G&G Associates prepare your tax return you will not have to worry about that because we make sure you are doing this.

How: Have a written business plan that explains how you intend to make a profit, keep a diary showing the amount of work you put into a business to make it profitable, operate the activity in a “business like manner” by having segregated business bank accounts, keeping full accounting records, obtaining all required licenses and so on. Be aware that the loss might be examined by the IRS, and keep full records documenting how it was actually incurred.

Also, if a loss will be small not important to you as in the case of the doctor-try to avoid incurring it (and the heightened audit risk it involves) by steps such as postponing deductible expenditures until after year-end. (Perhaps in the following year, your business will turn into a net profit.)

Schedule C filing that report profits incur heightened audit risk as well. The key to the degree of audit risk is whether deductible expenses reported on the Schedule C are so large as to be out of the line with industry averages. The more by which such deductions exceed the averages, the more likely it is that the IRS will select the return for audit.

Useful: The IRS does not publish such deduction averages. However, the Government Accountability Office has published data obtained from the IRS about the average deductible expenditures of proprietorships is different industries by size of business and how they operate (such as with or without a home office). The data is from 2000, but probably still provides a generally accurate picture. If your business deductions are unusual or large for its industry, be prepared to defend them to a tax examiner.

Personal items:

The IRS audit rate for personal returns not reporting business income remains generally low, about 1%. But two major audit triggers do exist for personal returns that greatly increase audit risks. Mismatched information returns. IRS computers match information returns (W-2s, 1099s, etc.) provided to it by payers of income to the individual tax returns of the income recipients.

If the numbers on the information returns are missing from or disagree with what is reported on a personal return, the IRS will inquire about the difference.

Safety: Be sure that you include the numbers from all information returns to your tax return, and if any discrepancies exist, attach a written explanation of them.

Unusually large deductions- If deductions on your personal return are so large as to be far out of line with the average for your income level, the IRS is likely to select your return to check those deductions.

The IRS does publish average deductions by income level for personal return.
Example: In 2005, tax payers with income from $50,000 to $100,000 took average charitable contributions deductions of $2,703.

The latest average deduction data can be can be found in the IRS’s “Statistics of Income” on it website at Click on “Tax Stats.”

If you have unusually large legitimate deductions don’t fail to take them just because the IRS may ask about them-but do the prepared to answer the IRS’s questions if it contacts you.


Gary Gray
Tax & Financial Consultant, RFC
G&G Associates
877-817-6031 toll-free
866-361-3872 toll free fax

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