If we do not report all our income and over deduct expenses to reduce taxes, what is the risk of an audit by the IRS?

Question: Can you settle an argument between my husband and me. He’s a marketing consultant who works from home and he’s paid as an independent contractor. He says we’re being foolish to report all his income, since the odds of being audited are so tiny and is completely random. He also says we should be able to take half our groceries as tax deductions, since we do entertain clients, and deduct our full internet access, telephone, and utilities since he works at home. I say that if do that we’re playing with fire, because I think we’ll have a higher chance of being audited. Who’s right?

Response: You both are, though in this case, if you wanted me to declare a winner, I’d pick you—not just because your position is more law-abiding, but because as practical matter, it’s also much wiser.

You husband is right in that overall, very few tax returns are audited each year—the rate is usually between 1 and 2 percent. However, you are right in that audits are not random, and there are a number of things which can increase the odds of being audited—many of which your husband is doing.

First, a tax return may be audited if there’s a mismatch between information reported on the return and information received from third-party documentation, such as forms 1099 (payment to independent contractors). Presumably many, if not all, of your husband’s clients issue him 1099’s—if they want to deduct what they pay him as a business expense, they need to document and report it correctly. If those forms are compared to your taxes and there is a discrepancy, an audit may be triggered.

Second, the IRS will conduct an audit if there is a suspicious or questionable treatment of some item(s) on the tax return. Excessive deductions for the size or nature of a business are something that raises a red flag, as are certain types of deductions relating to home-based businesses (the IRS is very sensitive to the potential for abuse).

Third, if there is a report of possible tax fraud or abuse. If your husband brags about his tax-avoidance schemes and someone is resentful, offended, or doing their civic duty, they may report him.

Fourth, there is a computer program called the Discriminant Inventory Function System or DIF. As tax returns are processed, it assigns a score to them based on certain criteria. The IRS is pretty close-mouthed (understandably) about these criteria, but they probably include factors such as the number of itemized deductions and the size of deductions related to income. If the system flags a return, it will be audited.

So while overall, the odds of an audit may be less than 1 in 50, if there are the sort of warning signs  about your return that are described above, it’s much more likely—and the odds of a good outcome if audited are much less.

Answered by Steven Zweig

Additional Resource:

• IRS publication - Examination of Returns, Appeal Rights, and Claims for Refund,
• Tax Audit Articles

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