This article suggests pointers on reducing your chances of audit selection or how to prepare in case you are chosen.

According to information recently released by the IRS, 142,441 business returns will be audited this year, a 38-percent increase over last year. In fiscal year 2002, the IRS will audit 168,712 business returns, an additional 18-percent increase.

The IRS numbers include Schedule C (self-employed) returns; Schedule F (farm income) returns; and returns for corporations having less than $5 million in assets. In addition, the IRS says it will increase the number of individual returns greater than $100,000 gross income that are audited to 113,699 in FY 2001 and 167,282 in FY 2002.

Clearly, the IRS is stepping up its audit activity of small businesses so it's important to ensure that you "audit proof" your tax return as best you can. The IRS does not have sufficient personnel and resources to examine many returns; it selects those returns that, upon preliminary inspection, have high audit potential?those that are most likely to result in a substantial tax deficiency. In recent years, less than 1 percent of all individual income tax returns have been examined.

Red flags

Although there is nothing you can do to guarantee the IRS will not choose your return for audit, there are certain steps you can take to reduce the likelihood of audit selection. Your chances of being audited are greater if your return shows the following:

¿ Large amounts of itemized deductions; tax shelter investment losses.

¿ Prior audit deficiencies.

¿ Failure to report income received that was reported to the IRS.

¿ Complex transactions without explanations.

¿ Shares or partnership in an audited partnership or corporation.

¿ Large cash contributions to charities.

Sometimes the IRS computer selects a return based on the size of certain deductions or items of income. Other times, a return might be selected simply because of the type of income or deductions shown. And other times a return will be selected because of errors and discrepancies.

Discrepancies in the income reported on your return and what payers have reported to the IRS on 1099 forms can increase your changes of audit selection. If there is a mistake, get the form issuer to correct it. If 1099 errors are found, request that the issuer make the correction and issue corrected forms.

If you are in a business where substantial cash payments are made, the IRS is more likely to select your return for audit. There's nothing you can do about that. The IRS has found that cash businesses often under report income because income is hard to trace. Examples (besides contractors) include doctors, lawyers, storeowners and waiters, so you're in good company.

The IRS examines certain types of businesses more than others. IRS statistics indicate that businesses subject to closer scrutiny include: air charters, art dealers, bed and breakfasts, entertainment establishments, gas stations, liquor stores, mortuaries, pawn shops, restaurants and bars, taxi services and used-car dealers. That's good news for contractors because if the IRS spends more time on these businesses, it'll have fewer auditors available to audit you.

Can you prove it?

Deductions or business expenses that seem large in proportion to reported income might trigger an audit. Unfortunately, the IRS does not disclose the exact ratio, but your accountant or tax preparer should be able to advise you on this matter.

If you are claiming home office expenses or significant travel or entertainment expenses, have the records to support your claim. The IRS scrutinizes these expenses very carefully. The same is true of all business expenses if you haven't yet established a track record, and especially if your business is not yet profitable.

Make sure your math is correct. Arithmetic errors are the most common errors turned up by the IRS. If you are doing your own return with a calculator, make sure you double-check everything.

A return signed by a tax preparer that is on the IRS's list of "problem preparers" also increases the likelihood of audit selection. "Problem preparers" are those who have repeatedly violated the law. Ask your accountant or tax preparer whether he or she is on such a list. If so, consider changing accountants.

Complex business or investment transactions on your return without a clear explanation may trigger an audit. Attach a separate statement to explain an item on your return that may raise a question in an auditor's mind. Any statements you attach should be as brief and to the point as possible¿don't ramble or provide superfluous details. By attaching a statement, you're telling the IRS, "I have nothing to hide¿here's what I did."

It's often a good idea to attach extra documentation as backup for certain amounts and items on your tax return even if such documentation is not specifically required. It could head off an audit before it starts.

The computer first selects returns with high-audit potential. However, before an audit letter is sent to you, an IRS auditor will look at the return and make a decision as to whether or not an audit is worthwhile. If you have attached enough supporting documentation for certain questionable or large amounts, the auditor may be convinced that further action is not worthwhile.

For example, if your business makes a $10,000 contribution by check to a church, attach a copy of the front and back of the check and, if possible, a receipt, letter of thanks or pledge letter from the church. Another example is if your place of business undergoes a major renovation that costs $75,000. Attach copies of the front and back of the check(s), and a copy of all bills.

Credit cards are an excellent means for keeping records and collecting sufficient information to withstand audit scrutiny. If you incur business expenses, consider using four credit cards. These four cards can be American Express, Visa, Master Card, Discover or even a major automobile service station card.

One credit card should be utilized only for 100-percent-deductible business expenses, such as business supplies, business advertising and business education. The second card should be used for business meals and entertainment that are only 50-percent deductible under the tax laws. The third credit card should be used for the business automobile. Since automobile mileage and expenses are prorated by business and personal use, it's important that these expenditures be separated. The fourth credit card should be utilized for purely personal expenses.

Credit cards are perfect because much of the required information, including the date, the amounts and the payee, is already on the card receipt. For items like meals and entertainment, jot down on the back of the credit card receipt the purpose of the event and the people involved.

Preparing your return

Many tax preparers are inept, causing many taxpayers to vastly overpay their tax liability. Accountants, bookkeepers, enrolled agents and attorneys without a tax specialty may not have the time, experience, education, insight or technical skill necessary to effectively prevent avoidable tax overpayments.

A tax attorney can do something an accountant cannot do. An experienced tax attorney can thoroughly research a tax statute and master it. The tax attorney will know its legislative history and be familiar with the Treasury regulations and IRS rulings on that statute. It is unlikely that your typical accountant can take the time out of a busy accounting practice, working with numbers and preparing financial statements, to master the vast array of difficult tax law that bears on a tax statute.

Tax lawyers are trained to seek and find the ambiguity in the law. Tax law ambiguity can be used as a "sword" to attack an IRS position and also as a "shield" to protect you the taxpayer. Unless your accountant is "super good," get a tax lawyer to prepare your return. It may cost more but it's money well spent.

If you've done your homework, kept good records and your return is truthful, you don't have anything to worry about. The best defense against an audit is to keep good records and to review those records for completeness and organization.

Some IRS auditors would have you believe you must have a receipt or canceled check in order to claim a deduction. However, there are other ways to prove deductions if records are lost. Oral testimony is often enough to claim a deduction as long as it is believable and supported by the facts. Affidavits and reconstructed records are also valuable tools used to claim deductions where written records are unavailable. Cash contributions are a good example of deductions that go unclaimed because of the lack of written records. If you want to prevent the IRS from claiming you have insufficient records to claim a deduction, know your rights.

Everything claimed on your tax return must be verifiable. If the IRS audits your return and questions a deduction you have taken, the burden of proof is on you! If you cannot prove the claimed deduction by acceptable documentation, the IRS can disallow the deduction. Typically, the IRS will ask you to document deductions that appear questionable.

The message: Do not claim tax deductions you cannot readily document, but do not neglect to claim tax deductions you are entitled to.