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.

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.