Red Flags

There's no surefire way to avoid being audited, but there are red flags to watch for. Here are six big ones.

1. Simple mistakes

   At a time when the vast majority of the IRS's audits are correspondence audits--the tax agency sends you a letter telling you that you owe more--a careless mistake can flag your return for closer inspection. Double-check that you've included your Social Security number or taxpayer identification number, that you've not made any dumb math mistakes, and that you've signed and dated the document.

2. Being out of line with the averages

   The IRS uses a complex mathematical formula to score tax returns for audit-worthiness. The details of precisely what goes into the formula score are top secret, but it is believed to identify tax returns that are out of line with the averages from a cross section of returns, as well as those that are out of line with a taxpayer's past history.

3. Tax shelters

   Cracking down on illegal tax shelters is one of the IRS's top priorities. Under recent regulations, you're required to disclose any aggressive moves that could be considered shelters, and the penalties for nondisclosure are significant. If you do disclose a questionable transaction, you'll probably be audited. But if you don't and the IRS finds you've engaged in an abusive tax shelter, the fines and penalties could put you out of business.

4. Big deductions

   For entrepreneurs, a big issue is just where business ends and personal life begins. Big travel and entertainment deductions can raise a red flag, as can write-offs of corporate cars and planes. The rule is that to deduct it at all you must use it at least 50 percent for business; if you don't use it exclusively for business you have to keep tabs on your work and personal travels to come up with the proportional tax benefit.

5. Family members on payroll

   Count on the IRS to look closely at business dealings with family members and other related parties. If family members are on the payroll, do they really work for the company? Is rent paid to entities owned by the business founder? If so, is that rent near the current market rates?

6. Differences between book accounting and tax accounting

   This year, corporate tax filers with more than $10 million in assets will be required to fill out the new Schedule M-3, an expanded version of the form that details the differences between accounting for book and for tax purposes. Similar forms are in the works for flow-through entities and smaller firms. Accountants believe that these new forms will give the IRS additional tools to look at discrepancies that may prove audit-worthy.

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