Stephanie Taylor Christensen at Minyanville writes: Whether
you are filing as an individual or on behalf of your small business, here are
some tips to help you prevent an audit. Despite the American Taxpayer
Relief Act of 2012 passed in January, the government is still tasked with how
to cut spending and reduce the deficit. As a result, Certified Public
Accountant David Wolfson, a partner in the accounting and consulting firm
Schulman Lobel Wolfson Zand Abruzzo Katzen & Blackman LLP, predicts that
the Internal Revenue Service (IRS) will be on the lookout for tax errors:
“There will always be more audits (deserved or not) in a down economy, as a
cash-strapped government seeks to raise funds.” Though the 2013 goal for
taxpayers may be how to legally reduce more of their tax burden in lieu of higher taxes, there’s a fine
line between legal tax maneuvers and suspicious claims that lead to a tax
audit. Here is expert insight into five common tax filing practices that might
invite you into the unpleasant world of tax audits.
1. Filing the old-fashioned way. While
completing your tax returns with a pen and hard copy tax form is perfectly
legal, Kathy Pickering, executive director of The Tax Institute at H&R Block (NYSE:HRB), cautions that handwritten returns raise a red flag to the
IRS. That’s because simple miscalculations and human errors, like putting the
wrong number in the wrong box, happen far more often than when
technology is used. According to Pickering, approximately 9.4 million
taxpayers made math errors on tax returns for the 2010 filing year, and more
than half of those resulted in a larger refund from the IRS. Remember that
filing electronically needn’t be expensive, and could actually expedite the
process of receiving a tax refund—especially if you’re among the earlier
filers. Beginning January 31, the IRS will open its Free File for taxpayers
with an adjusted gross income of less than $57,000. If your income
exceeds that amount, costs to prepare your tax filing are tax deductible,
whether you choose an accountant or online service that handles more than basic
calculations.
2. Trying to game the system. Taxpayers who
generate all their income from a salaried W-2 reported role generally have a
fairly straightforward tax filing process. But for less traditional workers,
like independent contractors with multiple income streams, employees who make
income from cash-based gratuities and odd jobs, and entrepreneurs, the process
of keeping track of where income was generated can be daunting. The headache
deepens if a client or vendor sends a 1099 or similar tax form after you’ve
already filed, leaving you with the burden of filing an amended and corrected
return. But, unless you want to hear from the IRS, keeping diligent records and
honestly reporting your income are the best ways to avoid an audit. Pickering
says almost 4 million taxpayers received notices saying that they
under-reported income in 2010, resulting in an increase in tax liability and
additional tax and penalties. Though what really triggers is an audit is a
mystery to some degree, Pickering explains that document-matching programs
allow the IRS to check income reported on tax returns against what is reported
on forms like a W-2, 1099-INT, 1099-DIV, and 1099-B. With such a program, the
IRS is able to compare taxpayers' deductions with others in the same income
bracket in order to assign a score to each return. Items used in the comparison
include things like mileage, charitable donations, and other deductions. If a
return includes such items that are not in proportion to income reported, it’s
an inconsistency. In turn, that return gets a “high score,” and could be
flagged for an audit.
3. Claiming a credit you don’t deserve. The Earned
Income Tax Credit (EITC) is designed to help lower to moderate income taxpayers
reduce tax burdens and possibly even get money back, if the EITC exceeds the
amount of taxes owed. But attempting to reduce your income by taking a slew of
deductions, or not claiming income that is subject to tax in order to qualify
for credit will cost you far more in the long run. Pickering says that EITC
audits made up more than 30% of all 2010 individual audits.
4. Misunderstanding rental income. Riding out the
housing market slump by renting your property? Rental property owners are
required to file a Schedule E, and it’s critical you understand the nuances
behind it. Wolfson explains that real estate rentals tend to reflect losses due
to depreciation write-offs, and that most of the time, those losses are limited
on an individual's tax return--unless he or she qualifies as a real estate
professional. He explains that many taxpayers take the losses on their
individual tax returns, and as a result, get audited. To limit audit risk,
Wolfson suggests either forming a Limited Liability Corporation (LLC) for
rental operations, or ensuring that you understand the IRS criteria around
participation: You must devote at least 500 hours toward the rental property in
order to take deductions on the property, or invest 750 hours to managing
the rental, to be considered a real estate professional.
5. Assuming your small business is too small for an
audit. Wolfson says that the IRS has always viewed Schedule C filers with
close scrutiny—especially those with gross incomes of more than $100,000, who
have a five times greater likelihood of being audited than those who do not
file a Schedule C. To mitigate audit risk, he advises such filers to
incorporate, and separate personal and business finances properly. Other
audit “red flags” for small business filers include income that varies greatly
from year to year, and having employees--including 1099 and freelance workers.
Even small businesses that don’t generate a lot of income aren’t exempt.
Pickering says businesses with a high volume of cash based transactions are at
a greater risk of audit, as are Schedule C filers with numerous years of
losses. When using a Schedule C to properly report all income, Pickering says to
deduct only the expenses entitled on the Schedule C, which includes costs
related to advertising, insurance, legal services, vehicle expenses, employee
wages and taxes, home office expenses, and depreciation. If you can’t
substantiate a business expense with backup documentation, you might be playing
with fire.
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