UNDERSTANDING DIF The IRS identifies returns warranting a closer look by using a computer program that compares a taxpayer’s deductions to others in the same income bracket. The program is called DIF, which stands for “discriminate index function.” The DIF gives each tax return a computer-generated score indicating the likelihood of questionable items. For example, if IRS statistical data shows that the average person in your income tax bracket claims $500 in charitable donations, and you claim $5,000, the DIF is likely to flag your return. The more your return deviates from the norm, the higher your score and the more likely you will be audited.

UNREPORTED INCOME One of the most important steps you can take to avoid an audit is to report all of your income. IRS computers match the taxable income reported on a taxpayer’s return with the information it receives from employers and from 1099 forms issued by banks and brokerage firms. To help ensure you don’t miss reporting any taxable income, compare the reported income on your 2004 return with the previous year’s return. Additionally, be sure you have correctly recorded all income from all 1099 forms.

BUSINESS EXPENSES AND THE HOME OFFICE DEDUCTION Being in business can trigger an audit, especially if you’re a sole proprietor filing a Schedule C. That’s because the IRS has determined that self-employed taxpayers have more opportunities for hiding income and for converting personal expenses into business expenses. Your return may be flagged if you claim large deductions for business travel and entertainment, take a home office deduction, or show a large overall loss. Your best defense is to retain all receipts for business meal and entertainment expenditures of $75 or more. For expenses less than $75, a detailed diary notation is sufficient. And if you’re thinking about taking the home office deduction, be forewarned that the rules are complex. You may want to consult with a CPA to determine your eligibility before claiming the deduction.

CASH INCOME Waiters, taxi drivers, hairdressers, and people who work in the gaming industry are prime audit targets because they receive much of their income in the form of cash tips. To protect yourself, keep accurate records. IRS publication 1244, Employee’s Daily Record of Tips and Report to Employer, available at www.irs.gov, includes a worksheet for recording daily tips.

ITEMIZED DEDUCTIONS Towards the top of the list of items that trigger an audit are itemized deductions that are unusually high based on your income. For example, if you were to report $40,000 in income and show $15,000 in mortgage interest, it’s likely the IRS will take a closer look.

DIVORCE, DEPENDENTS, AND ALIMONY If you’re divorced, the IRS allows only one parent – usually the one living with the child – to claim the child as a dependent. Otherwise, you need a tax waiver signed by the custodial parent to take the write-off. You should also be aware that the IRS matches tax deductions for alimony payments by one former spouse with the taxable income reported by the other.

DON’T AVOID LEGITIMATE DEDUCTIONS Don’t let fear of an audit discourage you from taking legitimate deductions and credits. If you have some unusual items on your return, you might want to send along an explanation or documentation. Finally, remember that one of the better defenses for avoiding an audit is to have your tax return prepared by a CPA.