Last Call on Avoiding an Audit

Risk of a tax audit generally goes up when you operate in an environment where cash is king.  The connection between an all cash business and opportunity for tax evasion is pretty obvious.  Another factor that keeps the IRS focused on these types of businesses is the potential for record keeping snafus that make it likely they’ll be able to find a way to make it worth the auditor’s time to spend time with you.  Even if you are pretty diligent about record keeping, the rules do keep changing, making it more difficult to make your case that you’re being honest.

This year if you have a cash intensive business that also takes credit cards you have more recordkeeping  worries to keep track of when you get a form 1099 K from your payments processor.  This form will show all the funds that were sent you business based on credit card transactions.  The IRS will start from the position that this is all taxable income to you.  If it includes non taxable funds such as sales tax, you have to deduct that on your return.  If you give discounts or cash back that isn’t reflected in the credit card total – it’s up to you to do the reconciliation.  Once again good record keeping is the essential ingredient for success here.  

Another third party reporting item that can trigger additional IRS attention is cash transactions of $10,000 or more involving banks, casinos, car dealers and other businesses.  Recent IRS research indicates these large cash transactions tend to be associated with productive audit leads, so if you’ve had this type of transaction in the last year, make sure you’ve got everything buttoned up in terms of your record keeping.  Also make sure that you disclose money held in foreign bank accounts.  If this is the first year you are volunteering that information,  locate the documents verifying that you opened the account in tax year 2011. 

Speaking of double checking things, do take a second look at your return before you sign and send.  Math errors are the leading cause of IRS communication with taxpayers.  Even though miscalculations don’t necessarily lead to a full blown audit, when they’re in your favor, it does increase the risk the entire return will be pulled for an audit.

Once again, let me emphasize, it’s important and correct to take advantage of every opportunity for tax avoidance available to you.  The flip side of that equation is that is the more options you have to not pay taxes, the more you have to focus on maintaining records that show your deductions are legitimate.  You don’t have to hold on to this information forever.  The regular statute of limitations for revisiting a tax return is 3 years.  If you have an underpayment of 25% or more it jumps to 6 years.  If the IRS believes fraud is involved, there’s no limitation.  

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.

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!

Roth Around the Clock

I remain a big fan of the Roth conversion – that is converting a traditional IRA into a Roth.  Still it’s worth noting that if you converted to a Roth in 2010, the time to change your mind about that move ends on October 17^th of this year.  The reason to convert in the first place is a belief that you’ll pay less tax on the money in the IRA if you pay taxes now rather than when you are forced to take minimum distributions of that money.  (IRAs defer taxes, but they don’t prevent them.)  If anything has happened since 2010 to change that belief, now is the time to act.    

When you convert an IRA you have to pay the taxes Uncle Sam didn’t collect when you first salted that money away.  In 2010 our Uncle was feeling generous, so he provided the option to pay those taxes over two years.  Also, there are income restrictions that stop some people from contributing to a Roth (For 2011, Adjusted Gross Income of $179,000 if married filing jointly, $122,000 for singles and $107,000 for married filing separately).  A rollover though, is open to everyone.  So if you think the Roth version of tax deferral is good for you, but can’t qualify for regular contributions, conversion is a back door that remains perpetually open.   

The problem is the time lag between the conversion and the tax payment.  Let’s say when you cashed out of the IRA in 2010 the value of your account was higher than it is now.  If you stay put, you’ll pay taxes on money you may never get to spend.  Given the recent market volatility this is not just an academic argument.  The other area of risk is the protracted recession has put financial pressure on people who might not have expected to be short on funds when tax bills come due in 2012.  For those folks the idea of paying the taxes early may still look good, but may be impractical.

 You are allowed to undo or “recharacterize” the conversion.  You can put the funds back in an IRA.  If you made the move in 2010 though, the clock is ticking.  The Wall Street Journal article on this topic says Vanguard Group had a 423% increase in conversions in 2010 and Fidelity reported similar results.  If you recharacterize, the money goes back into a traditional IRA.  You can change your mind a second time, but you can’t reconvert in the same year you “unconverted” (I’m not sure that’s actually a word, but presumably context communicates the meaning).  If you’ve already filed your 2010 return, you’ll have to amend that as well as deal with the 2011 paperwork. 

The Journal article goes on to say that the conversion levels in 2011 were way down, and the number of recharacterizations hasn’t spiked despite the reasons to think they might.  The thought is that people who had the wherewithal to pay all those taxes in 2010 are generally still doing well enough to handle the commitment.  Also, the same market volatility that can cause one to recharacterize can raise the value of the account when you’re required to take minimum distributions and increase your tax bill yet again.  If you’re interested, there are more details about this on my most visited website (sad but true) http://www.irs.gov, look for Publication 590. 

One other “gentle reminder” in terms of dates…  October 15^th is drop dead for filing individual 2010 taxes.  No exceptions.