What factors can cause an IRS audit?
Matching programs. Information returns (such as Forms W-2 and 1099) are matched to your tax returns, using your social security and other identifying numbers. Discrepancies usually generate an IRS notice requesting you to explain the differences. Unclear or evasive answers can generate a tax assessment, or you may be summoned to the local IRS office to explain the differences to an auditor.
Occupation. According to the IRS, returns filed by certain taxpayers, such as self-employed individuals and farmers, understate taxable income at a higher than average rate. Therefore, higher percentages of these returns are audited.
Statistical analysis. The IRS uses computer software to analyze hundreds of variables to arrive at ratings (called DIF scores) for tax returns. The program compares actual returns filed to "typical" taxpayer profiles. Unusual features, such as higher than average deductions, result in higher DIF scores, which increase the likelihood of an audit.
You can reduce your chances of being audited by filing an accurately prepared return with appropriate supporting documentation.
How can my chances of audit be reduced?
If you want to reduce your chances of being audited, make sure your return is accurately prepared. Attach supporting documentation to your return for any extraordinary items.
Could my business be reclassified as a hobby if audited?
The IRS is suspicious of any business activity that looks like it provides personal enjoyment, such as antiques, photography, horse racing, etc. If you make a profit in any three out of five consecutive years (two out of seven years for horse activities), your activity is presumed to be a business, and any business losses are deductible.
If you fail to show a profit, you may still qualify to deduct your losses if you are running your business with the intent of making a profit. For example, the way you keep records, the amount of time you spend in the business, and your financial risk in connection with the activity are some of the factors the IRS will consider.
Even if your hobby doesn’t qualify as a business, your hobby income must still be reported on your income tax return. If you itemize your deductions, you can write off your hobby expenses up to the amount of your hobby income.