How not to irk the IRS: avoiding these six red flags can keep you off the audit hit list - includes interview with IRS Commissioner Margaret Milner

Black Enterprise, Jan, 1994 by Patrica Carey

As tax season approaches, there's actually some good news from the Internal Revenue Service: Your chances of being subjected to a full-scale audit are lower than ever. Between 1984 and 1992, the portion of returns audited fell from 1.27% to just .91%.

But don't take this news as an invitation to cut corners on this year's return. One reason the numbers are declining is that the IRS has become better about spotting returns that, well, irk them.

As part of its modernization program, the agency is using computers to cross-reference the reams of tax documents that individuals, businesses and financial institutions are required to file. In 1992, IRS watchdogs contacted 5.3 million taxpayers about discrepancies. Their efforts roped in $4.3 billion in additional taxes, interest and penalties.

Alas, there are no guarantees that you won't be audited, but filers can take steps to reduce the odds. (Not surprisingly, the IRS doesn't reveal its audit criteria, but financial planners and accountants have their theories about what prompts the auditor's axe to swing.) If you want to play it safe, scan your return for the following red flags:

1 Mismatched documents. The number of documents filers submit to the IRS has grown from 668 million in 1984 to a cool billion in 1992. That means the IRS has more ways than ever to verify the information on your tax return.

Obviously, you want to begin by making sure you've included on your return all the income reported on your W-2 forms (employee compensation) and 1099-MISCs (nonemployee compensation). Also, make sure that you've reported any capital gains. For instance, it's easy to overlook a stock sale that took place at the beginning of the year, notes Janet L. Kovanda, certified financial planner and owner of Birmingham Financial Services in Westmont, Illinois. If you do, the IRS will assume the entire sale was capital gains and send you a notice, demanding the extra tax, interest and penalties. Then it's up to you to sort things out and get the bill adjusted accordingly - a hassle any taxpayer would rather avoid.

A little-known document that can get you snagged is Form 1099-S, on which real estate agents report house sales. You're required to file Form 2119 the year you sell, even if you had no capital gain or don't owe any capital gains tax. If the IRS receives a 1099-S but can't match it to your form 2119, you're likely to be contacted. "Some taxpayers mistakenly believe that they don't have to report the sale if they've bought a more expensive house within two years," says Kovanda.

2 High deductions. Each year, the IRS publishes information revealing average deductions for filers in your income bracket, such as mortgage interest or medical expenses. Ask your accountant or tax advisor whether any of your deductions seem unusually high. "Reportedly, when the IRS does its first scan of tax returns, it looks for expenses that are above average and takes a closer look at those returns," says Patrick Renn, a certified financial planner with Consolidated Planning Corp. in Atlanta.

On the other hand, if your deduction is legitimately above average, don't make the mistake of not taking it. Just be firm that the deduction is defensible and well documented, advises Elda Di Re, senior manager of Ernst & Young's personal financial tax counseling practice.

3 Schedule C. Unfortunately for the self-employed, just filing Schedule C may be the biggest red flag of all. Consider these figures. Normally, if you earn between $50,000 and $100,000, your chance of being audited is about one in 100. File schedule C, with about the same income, and the odds nearly double to a frightening one in 50. "If you're self-employed, it's very hard to avoid an audit," says Renn. "It's almost guaranteed that if you file Schedule C long enough, you'll get audited."

Experts agree that the IRS carefully scrutinizes Schedule C. Among the agency 's favorite red flags here: A too-small bottom line. A large discrepancy between gross and net income may arouse suspicions of expense padding or improper deductions. The IRS is particularly likely to challenge travel and entertainment expenses and home offices (more on this below), so make sure your documentation is good.

Running in the red - a negative bottom line - is a sure attention grabber, particularly if it continues for several years. Generally, if your business loses money three (or more) out of five consecutive years, the IRS will assume it's just a hobby. In that case, you can deduct expenses only up to the amount you earned. This doesn't mean that you can never take a deduction for a persistent money loser - but the onus is on you to prove that it's a legitimate business. Di Re suggests fortifying your case with a business plan, careful records, and business bank accounts separate from your personal accounts. "Do everything in as business-like manner as possible," Di Re advises.

4 Home offices. A recent Supreme Court decision has made it more difficult to deduct the expenses of operating and maintaining a home office. The case involved an anesthesiologist who practiced at three hospitals for a total of 30-35 hours a week and used an office at home for filing, billing and other administrative work.