The current Tax Audit “Hot Buttons”, are as follows:
Your tax audit probabilities increase dramatically with increasing income levels. Overall an income tax return’s audit probability is about 1.1%. If your income level is $ 200,000 or higher the probability increases to nearly 4%. Income levels of $ 1 million or greater produce tax audit rates of nearly one in eight (over 12%). This is a surprising way to reward success?
Many forms of income are reported on 1099 forms which are sent to both to the taxpayer and the IRS. When your return is filed, the IRS compares your reported income with their received 1099 forms. If there’s a disconnect, you will hear from them. This can often be the impetus for a more fulsome tax audit too.
Large claimed charitable deductions:
Charitable deductions have come under substantially greater IRS scrutiny. Inadequate substantiation for cash contributions, not reporting non-cash contributions on form 8283 or failing to secure appraisals on property contributions over $ 5,000 can attract undesired IRS attention. As with many tax issues proper records, proper records and proper records are the three (3) most important defenses.
Home office deductions:
IRS has identified home office deductions as an area with great tax deficiency potential. If you’re claiming such a deduction it’s wise to work with your H&M tax advisor to avoid unpleasant IRS encounters.
Employee/independent contractor Issues:
The magnitude of employment taxes on “common law employees” spawned serious tension over service provider classifications (i.e. employee versus independent contractor).
Many businesses err, and continue to err, on the side of independent contractor classification hoping to avoid a plethora of administrative and benefit costs and tax burdens. In 1978, the battle had raged to such a degree that Congress stepped into the fray with “Section 530” which limited the IRS’ ability to reclassify service providers as employees rather than independent contractors. Subject to satisfying a series of compliance hurdles, this area has been somewhat subdued. Recently the IRS announced the “voluntary classification settlement program” (aka the VCSP). Usually such IRS overtures are in essence a “fair-warning” that increased/intensified enforcement is commencing.
If you have long-term 1099 service providers who generally work exclusively with your business you should contact your H&M tax advisor for a determination of your business’ risk level.
Rental losses are generally deductible only against passive income, unless you meet either the small rental exception or the real estate professional exception.
The former exception is limited to $ 25,000 in losses and generally phases-out at income levels between $ 100,000 and $ 150,000.
The latter exception pertains to folks like developers, brokers, professional landlords etc. This exception requires “material participation” (or 750 hours per year) which makes proper aggregation of properties critical.
These “passive activity” byzantine rules make IRS audits of such activities particularly fruitful from the IRS’ perspective.
If you don’t meet either of the above exceptions, let us discuss with you the limitations that exist when you rent property to your own company. You can’t use the self-charged rent as “passive income” to deduct your other leasing losses.
Meals and entertainment expenses:
Besides the critical correlation between these expenses and your business, expense substantiation is frequently lacking and proper application of the statutory limits make the IRS think audits in this area are almost too easy. Records and good contemporaneous diaries are critical for success in these examinations.
Claiming 100% business use on a vehicle:
Insofar as commuting, driving to lunch or a doctor’s appointment are seldom a “business use” of a vehicle, claiming 100% business use on any vehicle except one which is unsuitable for personal use is like waiving a red flag at an IRS bull. Moreover, since employer-provided vehicles most frequently require income inclusion by the person using the vehicle, ignoring personal use reporting requirements just increase the probabilities of penalty assessments.
Hobby loss activities:
Many high income earners engage in pseudo businesses that combine a “recreational” interest with an activity masquerading as a business. The tax court is littered with the bodies of hobbies hiding behind facades that were easily detected at the audit level. If you find yourself in these waters, maintain great books and records, secure outside consultants to assist with generating profits and be willing to abandon the project when several unsuccessful years have elapsed.
Higher than average deductions:
The IRS spent decades statistically measuring tax aspects of filed returns. They’ve created correlations between income levels and certain customary tax deductions. If your deductions are decidedly outside their “standard deviation” expect to receive a visit. Expect high document production requests so if you’re on the “bubble” speak with your H&M tax advisor to aid in improving your deduction record keeping.
Cash intensive businesses:
Cash-flow audits have become very commonplace. Agents report that businesses where receipts are mostly cash frequently have unreported or underreported income as well as questionable deductions. If your business’ receipts are largely in the form of cash remember that the IRS will not only look at your business accounts but any other financial account over which you or your spouse have signature authority.
These examinations are no joking matter as they can move rapidly from a typical “civil tax” matter to one where Miranda rights are involved.
Moreover, using bank accounts to “wash” out cash transactions are subject to IRS notification. The $ 10,000 transaction limit isn’t the protection it once was as banks must report suspicious transactions, like a series of $ 9,500 transactions, the principal purpose of which was to avoid the $ 10,000 transactional limit.
Foreign bank and financial accounts:
The previous topic is a good lead-in for these subjects. Many US persons have, or have been convinced to have, funds outside the US. Disclosure of foreign bank account interests has been with us for some time, but compliance lagged which led to an “amnesty program”. The penalties were on some occasions quite high, but generally full disclosure prevented “criminal” issues. When disclosure wasn’t made, people had UBS-type experiences.
While the amnesty programs were successful, the IRS has vigorously pursued information exchange demands with banks in many “bank secrecy” nations. While disclosure isn’t that pleasant, imagine your prospects if the IRS discovers your accounts before you disclose!
This can be a particularly tough issue for US persons who have been long-term foreign residents.
In recent years this scope of inquiry expanded to financial accounts, brokerage or not, and foreign issued securities. If you have any such accounts/investments you should speak to your H&M advisor to keep a target off your back.