New Year's Prep

It finally dawned on me that blog posts about IRS audits may not exactly reflect the holiday spirit – but somewhere in between glasses of eggnog it also occurred to me that this is good material for formulating valuable New Year’s resolutions.  With that thought in mind I’ll move on to this week’s focus for avoiding audits – the areas of your tax return that can trigger extra attention.

Charitable deductions top the charts of almost all “likely audit trigger” lists.  Charitable contributions that are inconsistent with your income level are a red flag.  The IRS releases information about what the US averages are (which I’ve included below).  Please let me emphasize here that if you have good documentation then you should take deductions even if they invite scrutiny.  That’s better than paying extra taxes .  Charitable contributions of more than $250 require acknowledgement from the charitable organization, and there are special provisions for non-cash donations.

Right behind charitable giving on the IRS hit parade is the home office deduction.  Historically many people who claim expenses for work at home really aren’t eligible in the first place.  It’s only allowed if you use the space exclusively and on a regular basis as your principal place of business.  If you’re not self employed the home office use can only be claimed if your employer doesn’t give you work space. 

Next to your home, your most expensive possession is your car – again an area where the IRS often finds deception.  If you use your car for your business more than half of the time you can deduct the business use.  However, if you claim you use your car exclusively for business and you don’t have another car, the IRS won’t believe you.  Again, if it’s legit take the deduction.  Just make sure you can prove the business use. 

Schedule C, the portion of an individual return that’s used for sole proprietors is another area where the IRS has had much audit success.  Often the sole owner doesn’t have time to keep good records, so even without fraudulent intent can end up flunking an audit exam.  The first safety tip is -- expenses in line for like-sized businesses in similar industries.  If your meals and entertainment stand out from the usual that’s even worse.  If your industry is one where some people do it just for fun, you have to make sure you turn a profit within a reasonable amount of time.  If you don’t meet their standards the IRS will consider it a hobby instead of a business.  You can still take losses, but not beyond your gains. 

Gosh, you’d think I’d be done with this topic, but unfortunately more goodies to come.  At least this should get you started on some resolutions and hopefully help you pay less taxes ( avoid penalties) in the  New Year.

Audit Triggers and a Safety Catch

While the odds of hearing from an IRS auditor are still pretty low – a little more than 1% of returns get audited – there is a growing focus by the Service on doing more to close the tax gap. (In case you don’t know, the tax gap is the difference between what is believed to be the amount of taxes that should be collected vs. the amount that is actually collected.)  One area of concentration now is trying to better target auditees, hoping to give auditors a better collection rate.  In general there are two paths for nomination to the sampling pool that audits will be pulled from.  One is to make more than a million dollars a year. The other is to have entries on your tax return that are either associated with a high incidence of fraud or outside of the normal range for that particular item.

There are mitigation strategies for all of the above.  Today’s post will focus on the areas of your tax return that can act as audit triggers.  This topic is worth a multi-part post, so we’ll get to others later. First thing to remember is that the IRS’ most effective tool for closing the tax gap is third party reporting.  Any time you participate in an activity that is going to generate an informational return (1099 is the most common) that raises the chance your info will get a second look.  This extra attention is in response to a study that suggested 60% of under-reported income comes from self-employment.  If what you put on your return doesn’t match the informational return, you are going to hear from Uncle Sam.  It’s worth noting here that self-employment income isn’t the only way to get noticed in this manner.  Your bank and investment advisors are all required to disclose information about your activities with them.

This year the IRS is all over people who can claim an earned income tax credit and people who did take a home buyer credit.  In both cases, this is an easy issue to manage.  You’re either eligible or not.  If you can prove it, you’ve got nothing to worry about.  If you don’t have good paperwork start saving to pay the money back.  Depending on how much money is involved you may want to enlist help from a lawyer or accountant if you think you messed up on either matter.

Last but not even close to least for the start of this topic is if you file a Schedule C (sole proprietor) or Schedule E (rent or royalty income) you are the IRS equivalent of a scantily clad woman walking down the street.  Regardless of your intent – you are going to get noticed.  The way to minimize annoyance from the IRS version of a catcall is possession of good records.  If you have documentation to verify what you put on the return, you’re all set.  If you don’t, my recommendation is a visit to both your accountant and your local house of worship.  

Search Audit Optimization

For anyone who gets a headache thinking about the latest in Search Engine Optimization, I've got news of a migraine headed your way.  While the odds of being audited remain low, the IRS is working diligently to better identify audit targets who are likely to produce unpaid taxes. We’ve already discussed the study being done on payroll taxes and how that adds thousands of tax compliant businesses to the pool of people who will get audited.  The IRS has determined that small businesses (less than $250,000 in assets) are filled with non-compliant tax payers, so they’re launching a new random study to find areas where this alleged non-compliance occurs more often.  This adds another 2,500 companies into this year’s pool.  Results from all these studies are destined to fall into the IRS version of the Google algorithm, presumably generating more yield per auditor.

While I’m being snarky in my comments here, the fact is the IRS auditors are getting more productive.  According to my Kiplinger letter subscription, Treasury inspectors say their average tax deficiency per exam is up 58% in the past five years.  However, they acknowledge that in fact the increase is mostly driven by whistle blowers.  (The past 5 years have been tough on employer / employee relations.)  About a third of companies selected for audit get through without paying a penny.  However, before you get too happy about that, (also from Kiplinger) the number of penalties assessed and their size is growing.  In the same 5 years accuracy penalties assessed to individuals went up 800% and businesses saw that number triple.  (Yes, that could be a reason why you need a good accountant.)

As if all this isn’t enough, the IRS is asking Congress to expand its power to levy  as a way of getting money it believes is owed.  Part of the argument is that taxpayers can effectively slow the collection process under the current procedures, and in 93% of cases studied by the IRS, the levy was warranted.  First of all that’s just one sample -- and as we know from mortgage backed securities, how the sample is picked really matters.  Also getting back to those accuracy penalties assessed on individuals – 25% of the $1 billion assessed in 2010 was later reversed by the IRS.  Oops. 

Auto-Tax

You have to wonder about the IRS.  In the same week they announce a plan to discuss a real time tax system that would provide feedback on your return before you file,  they also acknowledge $153 million in refunds that they can’t get to people because they don’t have a correct mailing address.  The US found Osama Bin Laden, but they can’t find taxpayers who filed and overpaid taxes?!

The average size of the undelivered refund check this year is $1,547.  I’m thinking that means at least some of these people are actively trying to get the checks that the Service can’t get to them.  According to the IRS people who e-file get their checks – it’s just snail mail that creates a problem.  If you are one of the folks whose refund has gone missing,  the Where’s My Refund tool on the IRS website has an address updating feature.  Don’t know if that will solve the problem, but it’s probably worth checking.

This brings us to the crux of most IRS problems, which is that they have different information about you than you have about you.  Somehow they’ve decided that automating that disinformation will make the situation better.  Like much of the “logic” around the tax code, I don’t follow that line of reasoning.

This new system would pre-populate key information on your return, so you would know if your view of what you earned matches the IRS records before you send in the return.  According to the Commissioner, the average taxpayer has between 10 and 15 information returns associated with their tax filings, so this is a big chunk of information. Given the current state of affairs, this would at least let taxpayers know when and where there’s an issue.  What it wouldn’t do though is give you any way to solve the problem. 

Right now not every information disconnect results in a problem with the IRS.  Under the proposed system, every mis-step would be flagged.  This might solve the nation’s unemployment problem, as the IRS would need to hire lots more people, but net at the end of the day I’m not sure that more taxes would be collected.  My guess is pharmaceutical companies that sell sedatives and psychologists would also benefit should this new system be implemented.  We’ll see…

Giving Thanx$

With Thanksgiving on the mind it seemed appropriate to consider tax breaks we can be thankful for in 2011, while acknowledging they may not be available in 2012. So here are my top-5 thank yous to Uncle Sam.  At the top of the list is the payroll tax cut.  While it’s not big, it’s persistent and easy to deal with.  No paying an accountant to see if you’re eligible, no forms to file (beyond the usual payroll taxes) and no risk you’ll be audited to see if you qualified. 

Next in line is the fact that tax rates are at historic lows:

 A family of four in the exact middle of the income spectrum will pay only 4.7 percent of its income in federal income taxes this year, according to a new analysis by the Urban Institute-Brookings Institution Tax Policy Center. This is the third-lowest percentage in the past 50 years, after 2008 and 2009.

There is still some juice left in the energy tax credits.  It’s not what it’s been in past years, but it’s a tax credit, which is much better than just a tax deduction.  For 2011 the Nonbusiness Energy Property Credit is 10% of the cost of energy efficiency improvements you make to your home.  There’s a lifetime limit of $500, so if you used this earlier, you’re probably done.  If it’s new windows that are your energy saver, the credit is maxed out at $200.  Better get moving if you haven’t done anything yet.  The credit expires if the work is done after 1/1/12.  There’s a more serious credit called the Residential Energy Efficient Property Credit.  You get 30% of what you spend to invest in alternative energy equipment for your home.  Examples of qualifying installations include solar, geothermal, wind and fuel cell operated energy systems.

For thank yous 4 & 5 the focus is small business.  Investors in new issues of Qualified Small Business Stock that hang onto the stock for 5 years can exclude anywhere from 75% to 100% of the gain. (It all depends on when you bought the stock.)  If you make this investment after 12/31/11, you’re back to a 50% exclusion.

The Section 179 deduction for capital equipment purchases may seem like a constant tax benefit, but it’s actually not always as generous as it is in 2011.  You can deduct up to $200,000 on up to $5,000,000 worth of equipment purchased in 2011.  For brand new equipment you can also look to 100% bonus depreciation to reduce taxable income.  As it stands now the amount you will be able to deduct in 2012 is likely to be lower, and the list of what purchases qualify will get much shorter.

Now go grab some leftover turkey while you still can!