Imagine this scenario: there's an office retirement party, and everyone is giving money for a going-away present. It's time to pay, but you don't want to give twenty bucks if everyone else is only coughing up five, right? Taxes work the same way: we all have to pay them, but no one wants to pay more than is required.

You hear about all these deductions for home offices, dependents, and charitable donations, but how do you know if you can take that deduction or if you're inviting an IRS tax auditor? Here's a quick checklist so you know where you can avoid taxes and when you're crossing the line into tax evasion.

Income
Tax Avoidance: There really is no way to avoid being taxed on income. If you made money somewhere, you need to report it to the IRS. Don't forget about interest, income and alimony; not reporting alimony is a major audit trigger.

Tax Evasion: If you think the IRS won't know you made that money, you're wrong; whoever paid you interest, income or alimony is deducting it on their end, and the IRS will match it with your tax return. Report all your income; there will be opportunities for you to make deductions later. (Tax rates are going up, so it pays to find sources of income that the tax collector can't touch. Here are 20 of them in Earn Tax-Free Income.)

Exemptions and Earned Income Credit
Tax Avoidance: Have kids? Congratulations, you just got yourself a tax break. You can claim them as exemptions, as well as yourself and your spouse if you're married. Each of your children may also give you an additional child tax credit, as well as Earned Income Credit (EIC) if you qualify.

Tax Evasion: Don't claim more exemptions than you're allowed. If you share custody for instance, make sure your former spouse is not claiming your child as an exemption too. Claiming children as exemptions can qualify you for EIC, if you meet the certain requirements.

Overstating your exemptions on your tax return (by falsely claiming a child as a dependent, say) will trickle down into deductions for EIC, which is why it's so important to get your exemptions right. EIC claims are one of the most common IRS audit triggers, so double-check your exemptions before filing. (Be sure to double check your federal income tax return for these common mistakes that could cost you time and money. Learn more in The 10 Most Common Tax-Filing Mistakes.)

Small Businesses and the Self-Employed
Tax Avoidance: Owning a business or being self-employed can be a great way to generate income, but it comes with its share of expenses. Thankfully, the IRS allows you to deduct those office supplies, mailing expenses and brochures you printed for clients.

Make sure you keep good records of deductable expenses and that your business is a profit-making venture instead of an income-generating hobby. The rule of thumb for the IRS is that your endeavors should deliver a profit three out of five years in operation.

If you drive a car as part of your business, you can deduct this expense too. Just make sure you keep a log of the miles you drove, and the purpose of your trip. The more detailed your records, the happier the tax man will be.

Tax Evasion: Think you can deduct that office you work out of? Be careful - home office deductions are one of the most common IRS audit triggers, because so many people claim this expense without qualifying.

Here's the truth about home office deductions: the only time you can deduct an office as an expense is when it used solely for business. If you have another office you work out of, or if you also use the space as a guest room or living room, forget taking the deduction. You don't qualify, and claiming the deduction equals tax evasion.

Charitable Donations
Tax Avoidance: Charitable donations are a great way to do something nice for your community and get a tax break at the same time. Even those garage sale leftovers you're hauling to Goodwill are tax-deductable, as long as you have a receipt. Make sure you keep good records of these donations, as they're a common IRS audit trigger.

Tax Evasion: Think your late Aunt Emma's china collection you donated is worth five hundred dollars? You'd better back that up with some records, because the IRS will want to see them. Any time you donate a big-ticket item make sure you have a fair market valuation to support your claim.

Cars and collectors' items are common donations that will need records - don't fudge the numbers, or you'll be sorry when you get audited. (Being generous can be financially rewarding! Learn more in Give To Charity; Slash Your Tax Payment.)

The Bottom Line
Be sure to check with the IRS (http://www.irs.gov/) for more details on the specifics of these and other deductions. It's important to keep your records for seven years as required, just in case the tax man decides it's your turn for an audit. With these tips, you'll be sure to pay the taxes you have to and not a penny more - without getting in trouble with the IRS.

Related Articles
  1. Taxes

    What's Wrong with the American Tax System

    American's are highly taxed and we still run a deficit. We explain why.
  2. Professionals

    Advisors: Warn Clients About These Audit Triggers

    There are several factors that may increase the risk of an audit, especially with high-net-worth clients.
  3. Retirement

    Top Tips for Minimizing Taxes on Social Security

    Social Security benefits are taxable under certain circumstances. Here are some ways retirees can lessen the tax burden.
  4. Professionals

    Retirement Plan Options for Small-Business Owners

    Small-business owners and self-employed individuals are responsible for funding their own retirement. The SEP-IRA and solo 401(k) are tools to consider.
  5. Taxes

    Employers: Don't Forget IRS Form 941

    Your obligations as an employer include various employment taxes. Use this form to report them.
  6. Taxes

    20 Medical Expenses You Didn't Know You Could Deduct

    To lower your tax bill, be sure not to miss out on these commonly overlooked medical tax deductions.
  7. Retirement

    How IRS Form 5498 Helps You

    If you have an IRA, you'll be getting this form. Here's the useful information it contains.
  8. Taxes

    Top Tips for Minimizing Taxes on Severance Pay

    A look at the top ways to lessen the tax burden on severance pay.
  9. Taxes

    What's IRS Form 1040 For?

    Most U.S. taxpayers will be familiar with the 1040. By the end of filling it out, you'll know how much tax you owe, or what your refund is.
  10. Economics

    Explaining Endowment Funds

    An endowment fund is money set aside to earn revenue to fund some type of charitable activity.
RELATED TERMS
  1. Duty Free

    Goods that international travelers can purchase without paying ...
  2. Structured Transaction

    A series of transactions that could have been treated as a single ...
  3. Tax Deductible Interest

    A borrowing expense that a taxpayer can claim on a federal or ...
  4. Deferred Tax Asset

    A deferred tax asset is an asset on a company's balance sheet ...
  5. Proof of Charitable Contributions

    Substantiation required by the Internal Revenue Service for a ...
  6. Quid Pro Quo Contribution

    A charitable donation for which the donor receives something ...
RELATED FAQS
  1. Are spousal Social Security benefits taxable?

    Your spousal Social Security benefits may be taxable, depending on your total household income for the year. About one-third ... Read Full Answer >>
  2. How do you calculate penalties on an IRA or Roth IRA early withdrawal?

    With a few exceptions, early withdrawals from traditional or Roth IRAs generally incur a tax penalty equal to 10% of the ... Read Full Answer >>
  3. Are credit card rewards taxable?

    Credit card rewards are taxable in the United States some of the time. The Internal Revenue Service (IRS) classifies credit ... Read Full Answer >>
  4. Are Social Security benefits taxable after age 62?

    Eligibility to collect Social Security benefits begins at age 62. Many seniors, to collect larger benefit amounts, wait until ... Read Full Answer >>
  5. What are the best free online calculators for calculating my taxable income?

    Free online calculators for determining your taxable income are located at Bankrate.com, TaxACT.com and Moneychimp.com. Determining ... Read Full Answer >>
  6. In what instances does overhead qualify for certain tax allowances?

    Businesses are just as keen as anyone else to keep their tax burdens low by any means possible. Overhead expenses often qualify ... Read Full Answer >>

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!