Of the audits that I have taken on recently -- here are some AUDIT TRIGGERS:
1. Employee Business Expenses -- that seem out of the ordinary and/or redundant as the taxpayer also has a business and a Schedule C. You really don't want to use Form 2106 - Employee Business Expenses - UNLESS you have unreimbursed expenses and a company policy to not reimburse you.
2. Excessive Mortgage Interest - The IRS will only allow you to deduct Mortgage Interest on your Schedule A up to one million dollars in property.
3. Sole proprietorships running losses while you earn wages -- If you have side jobs that are running a loss -- and you are showing losses repeatedly in subsequent years WHILE you have a job. This is a big red flag.
4. Lots of IRA transactions -- I just got done with a really labor intensive audit for someone that did multiple IRA rollovers in one year. Certainly you have the right to roll over an IRA from one bank to another without tax consequences. But if you do it excessively you might draw scrutiny. Furthermore, the IRS' system for monitoring IRA rollovers and transactions in between Roth and Traditional IRAs or even Traditional and Traditional IRAs is flawed, and they tend to take a position that is not favorable to the taxpayer. Remember, of course, that if you roll a Traditional IRA into a Roth IRA -- there will be a tax consequence.
DEFENDING YOUR AUDIT
1. BASIC AUDIT DEFENSE -- You and/or tax professional can make your case before the agent assigned to your case. This will require some disclosure and a basic sense that you create good will by admitting to certain mistakes/oversights on your return.
2. APPEALING THE AUDIT -- You will get a 30-day letter from the IRS in which you will have an opportunity to defend your case to an auditor. Once the 30-day window passes, you will receive a 90-day letter in which you can either APPEAL your audit... (Here's a link to a successful audit appeal that I did in 2010: Audit Appeal) or take the matter to Tax Court (see below).
3. OFFER IN COMPROMISE DOUBT AS TO LIABILITY If your audit was closed and your opportunity to appeal expired, you can get a new audit by filing an Offer - Doubt as to Liability. Be prepared to have NEW EVIDENCE that you didn't have in the original audit. Otherwise, this will be a huge waste of everyone's time. Here's more from my blog on : Doubt as to Liability Offer history
4. TAX COURT. If all else fails, you can always go to tax court and set precedent. But this is a very, very rare avenue for resolution of a disputed tax liability.
I do all of the above (although a separate individual on staff would do the tax court case ). Call me at 1-866-525-7302 if you have recently been audited: Jay Freeborne, Enrolled Agent, Washington Tax Services