Soon millions of taxpayers will be filing their 1981 tax returns. Hands down, the most common question at this time of year is, "Will the IRS audit my tax return?"
The answer is that your chances of being audited depend on many factors, including Lady Luck. The higher your income, the greater your chances. Increasing deductions in relation to income also brings the long arm of the examiner closer.
The Internal Revenue Service indicated in a recent report that a computer picks most returns that are audited. The computer gives each return a score by assigning numerical weights to items on the tax return. The precise items and weights, unfortunately, are a closely guarded secret. But the higher your score, the better your chances of an audit.
No one has figured out how to crack the computer program, but we do know that unwelcome points are scored if your deductions are out of line. (See box for the latest national average deduction figures based on 1979 returns.) Keeping close to the national average, however, doesn't free you from the obligation of maintaining good records to document your deductions.
AVERAGE DEDUCTIONS CLAIMED IN 1979
gross income Contributions Interest Taxes Medical
$20,000-$25,000 $583 $2,589 $1,699 $590
25,000- 30,000 654 2,792 2,053 549
30,000- 40,000 795 3,110 2,526 518
40,000- 50,000 1,115 3,069 3,327 514
50,000-100,000 1,793 5,131 3,675 696
100,000 or more 8,958 11,896 13,409 1,223
You may also want to consider the following list of audit triggers that the staff of the tax and legal publisher Matthew Bender believe to be the top 10 for personal returns:
1. Total gross revenue of $100,000 or more, or a substantial loss, from a proprietorship or partnership.
2. Total income before tax shelter activity of $50,000 or more.
3. Tax shelter activity.
4. Preparation of the return by a preparer on the IRS's list of "problem preparers."
5. Travel and entertainment expenses.
6. Business automobile expenses.
7. Casualty losses.
8. Significant barter income. (Note that failing to report any of your barter income won't necessarily keep you safe. The IRS has a "barter project" for investigating deals that are not reported.)
9. Home office deductions.
10. Losses incurred in "businesses" that seem to be hobbies.
If you do get audited, you have a new incentive to settle quickly this year. Starting February 1, the IRS will be charging 20% interest on taxes it concludes you owe.
The current interest rate is 12%. The new rate was set in accordance with last year's Economic Recovery Tax Act, which requires the IRS to establish a rate every year equal to the prime rate charged by banks. When the rate was set for 1982, the prime was hovering around 20%. It doesn't matter that the prime has dropped since last fall; 20% is the rate that will be in force throughout the new year.
The IRS's new interest-rate policy can hurt you badly. Most audits take place a year or two after a return is filed. And fighting with the Internal Revenue Service can take four to six years or more. Thus a high IRS interest rate can easily mean you'll pay more in interest than the amount of the delinquent tax. The IRS has a substantial new advantage in negotiating with you.
There's just one bright spot. If it turns out that the IRS owes you money, the new policy means the government will be paying interest to you.
DON'T LOSE YOUR INTEREST DEDUCTION
Here's an interest tax trap you probably don't know about.
Suppose you owe the Nice Bank $20,000 for 90 days. The $1,000 interest comes due. The bank allows you to pay the interest and the old note by signing a new $21,000, 90-day note. According to the Internal Revenue Service, the $1,000 is not deductible. "Why?" you scream. Because the IRS says the interest is not really being paid if you borrow the interest due from the original lender. Unfortunately, the Tax Court recently supported the IRS on this. (See Battlestein v. IRS, 47 AFTR 2d 81-390.)
Is there a way to avoid this? Yes. Borrow the $1,000 from a second lender to pay off Nice Bank. Then you will be meeting the requirements of the court by paying cash instead of increasing your debt to the original lender.
PREVENT THE TAX BITE ON SERIES "E" BONDS
Here is a neat little gimmick that can prevent taxes on all those Series "E" Savings Bonds that Aunt Martha gave your kids: At the end of each year, file a tax return for the child and elect to treat the year's increase in the bond's value as interest income.
In most cases, your child will be in a zero-tax bracker and the earnings will escape tax-free. If the child held the same bonds until they matured, without declaring the interest income every year, all the income would funnel onto his tax return at one time. By that time the child would probably be an adult in a bracket where the tax-man's bite would be painful. But since the income was "made taxable" by your election, when the bonds mature years later all the proceeds will be collected tax-free.
The principle and tax-free accumulations are nice to contemplate as your child grows up.