5 Tax Mistakes That Could Get You Audited

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.

New York: Personal Income Tax: Wage and Withholding Guidance Issued for Taxpayers Affected by Hurricane Sandy

The New York Department of Taxation and Finance has issued personal income tax withholding and wage guidance for employers and individuals affected by Hurricane Sandy.

Employers

Employers whose 2012 withholding tax records were destroyed by Hurricane Sandy should make their best effort to recreate the records, or call 518-485-6654 to receive the latest information that the department has available on record. Employers should use that information to recreate the records to the best of their ability. Employers should also (1) Web File Form NYS-45 and select the Hurricane Sandy box, or file paper Form NYS-45 and write "Sandy" on the top of the completed form, and (2) provide their employees with good faith W-2 Wage and Tax Statement withholding estimates for the tax year.

The guidance for employers is available at http://www.tax.ny.gov/bus/wt/sandy.htm.

Individuals

If an individual’s employer cannot provide a W-2 Wage and Tax Statement, the individual may file his or her 2012 personal income tax return using wage and withholding information provided on the last pay stub received from the employer. An individual who does not have the last pay stub should call 518-485-6654 after February 1. The department will provide the latest information available on record. That information should be used to create a good faith wage and withholding estimate.

The guidance for individuals is available at http://www.tax.ny.gov/pit/file/sandy.htm.

Contact us at ExactCPA if you have any further questions.

As IRS Tax Filing Season Begins, There's Bad News For Honest Taxpayers

Janet Novack writes about tax and retirement policy and planning for Forbes and says:  With this year’s tax filing season set to begin in a week, there are ominous signs for honest folks who want to complete their 1040s and pay what they owe (not more or less) with a minimum of hassle.  Customer service at the Internal Revenue Service is dismal and deteriorating. (Only 68% of telephone callers who wanted to talk to a human at the IRS last tax filing season reached one, and then only after an average 17 minute wait.)  The epidemic of identity theft refund fraud hasn’t yet been contained.  Hope for a major reform that might simplify the tax code is waning. And last Friday a federal judge issued a permanent injunction blocking an IRS plan to regulate and enforce some minimum competency and continuing education requirements on hundreds of thousands of currently unregulated paid tax preparers.

“If the injunction stands, the taxpayers of the United States will be grievously harmed,” IRS National Taxpayer Advocate Nina E. Olson told Forbes. “The practical effect of not having some kind of consumer protection for taxpayers going to return preparers is enormous. And I say that seeing all the return preparer fraud, and the return preparer negligence, and the return preparer inadvertent mistakes that happen.” (Olson’s Congressionally created office acts as a watchdog for taxpayer rights, making policy recommendations and helping individual taxpayers deal with the IRS; it logged nearly 220,000 cases last year.)

In an interview Tuesday, Olson painted a depressing picture of how a variety of trends are coming together to create problems for taxpayers. “It’s this endless loop,’’ she said.  “You’ve got a complex tax law. People need to call to ask questions about things. And then they can’t get through and then they make mistakes, or they go to unscrupulous preparers, or preparers who aren’t educated, who make mistakes, and then you’re in this enforcement cycle.”

In the enforcement cycle, she adds, ordinary taxpayers get computer generated IRS letters demanding more money or documentation. When they call the IRS with questions related to these notices, they end up on hold. Then they mail their letters to the IRS explaining why they think the IRS’ proposed bill is wrong  or providing the requested documentation, and encounter yet another problem— the IRS is falling further behind on answering taxpayer correspondence.  According to Olson’s recent 2012 Annual Report To Congress, at the end of fiscal 2012, on Sept. 30^th, the IRS had more than a million pieces of correspondence from taxpayers waiting to be answered (up 188% from the inventory at the end of 2004), with nearly half of those letters more than 45 days old (up 316 percent from 2004.)

No, IRS workers aren’t suddenly slacking off.  In a statement last week, the IRS blamed a decline in some performance measures, including a drop in audit coverage and collections, on an 8% decline in its workforce since 2010, plus a doubling of the staff it has assigned to fight identity theft refund fraud. That’s where a fraudster (in some cases, a crooked tax preparer) uses stolen Social Security numbers to electronically file bogus returns seeking refunds. The IRS has gotten much better at screening for and preventing the payment of such fraudulent claims, Olson says, but the epidemic isn’t yet contained and the honest folks whose identities have been hijacked end up going through a lot of grief and waiting six months or more for their refunds. At the end of fiscal 2012,  the IRS had almost 650,000 identity theft cases in its inventory, Olson reports.

Now if you’ve never had your Social Security number stolen, and you’ve never gotten a letter from the IRS ‘demanding more money or documentation, you may not know what Olson is talking about. Nearly 60% of taxpayers pay a pro and the majority of those pros are, no doubt, competent and honest.  As for do-it-yourselfers, the IRS’ web site is pretty useful and tax software like Intuit’s TurboTax and H &R Block’s AtHome mask a lot of the tax code’s insane complexity. (That’s provided you don’t try to understand the calculations on your IRS Form 6251, Alternative Minimum Tax.)

But what if you have a question you want to ask a real human being? According to a recent report from Congress’ Government Accountability Office, the IRS had the “full time equivalent” of  about 13,500 customer service representatives answering taxpayer calls and mail in 2011 and 2012, down from 15,000 in 2010. So even though the IRS has added more automated features to handle some calls, the average wait for a human grew to 17 minutes last year, from 9.5 minutes in 2010 and just 4.6 minutes in 2007,  when 81% of callers got through to a human, before either becoming discouraged and hanging up or being cut off. (For the IRS, 81% is considered good service.)

These days, even the most knowledgeable taxpayers can find dealing with the IRS a pain. Just read the account here from Forbes Associate Editor and tax maven Ashlea Ebeling who got a computer generated Automated Under Reporter (CP 2000) notice demanding $3,242 in additional 2010 tax last year, spent  20 minutes on hold before giving up on speaking to a person at the IRS, wrote a letter explaining why the agency was wrong, and then waited two months for an IRS reply acknowledging she owed no extra tax on her CPA-prepared return. (Unlike most taxpayers, she wasn’t intimidated by the letter and knew enough to challenge it herself, so she didn’t have to pay her CPA extra to resolve the issue.) Think this can’t happen to you? It’s not that unusual. The IRS sends out nearly five million AUR notices, plus five million “math error” notices annually. In addition, 1.4 million individual returns were examined in FY 2012, with 1.1 million of those done in “correspondence” audits, in which taxpayers are asked to send in documentation to substantiate some item, such as their charitable deductions. (For context, about 140 million individual tax returns are filed each year.)

In Ebeling’s case, the IRS challenged numbers related to dependent care benefits and distributions from her Health Savings Account, illustrating yet another reason honest taxpayers’ hassles with the IRS are growing. Over the last two decades, Olson points out, Congress has been using the tax code to deliver ever more social welfare benefits. So there are dozens of different tax breaks—and in some cases big refundable tax credits– for the working poor, kids, child care, adoption, college tuition, retirement savings, high deductible health plans, and even green remodeling. The refundable credits are a magnet for fraud. Plus, most of these breaks  have tricky eligibility rules and substantiation requirements, leading to confusion and honest mistakes— by both taxpayers and the IRS.

Here’s just one example, from Olson’s latest report, of the strains on the tax system. Congress created the adoption credit on a temporary basis in 1997 and  then kept renewing and increasing it. In 2010, as part of ObamaCare, Congress made it into a fully refundable $13,170 credit for 2010 and 2011—meaning a stipend adoptive parents could receive even if they hadn’t paid any income taxes.  (The fiscal cliff tax deal made the adoption credit permanent, at a maximum of $12,650 for 2012 and $12,970 for 2013, but eliminated refundability.) 

Understandably, with $13,170 checks being written by the Treasury, the IRS wanted to be vigilant. It audited 69% of the 2011 tax returns seeking the adoption credit, forcing taxpayers to wait months for their refunds. Many of the audited taxpayers had missing or potentially invalid paperwork.  Yet when all was said and the done, the IRS disallowed only $11 million of $668 million in 2011 adoption credit claims, Olson reports.  A lot of grief for parents and the IRS.

Now here’s where the unregulated tax preparers come in: After the expansion of the refundable earned income tax credit in the 1990s, Olson notes, folks who knew nothing about the tax law (and in some cases were happy to break the law) started hanging out their shingles as preparers and using tax software to process returns seeking EITC refunds. Yet because of all the complications surrounding the EITC and other tax benefits,  tax preparers really need to know  the tax law, just as the IRS must be able to promptly answer its phones and explain that law.  Sounds sort of obvious.

Tax efficient investments to offset higher rates

Linda Stern for Reuters writes:   Experienced money managers like to say you shouldn't "let the tax tail wag the investment dog," meaning you shouldn't let concerns about the tax effects of an investment drive your buy and sell decisions.  That is probably good advice, but still -- in this post "fiscal cliff" era of higher income tax rates and new healthcare reform-driven investment taxes, it makes sense to at least look at the tax impact of your savings choices.

"A good financial planner should be looking at how tax-efficient your investments are," says David Blanchett, head of retirement research for Morningstar Investment Management. He points out that the difference between having a $1,000 gain taxed at the long-term capital gains rate of 20 percent versus the income tax rate of 35 percent would save the investor $150. And that example doesn't even use the top income tax rate or note that other new provisions could hit investment income as well.

Upper-income households at several different levels face higher tax burdens this year. Individuals with adjusted gross income over $200,000 ($250,000 for joint-filing couples) will face a 2.8 percent Medicare surtax on investment income. Singles who earn over $400,000 (joint filers over $450,000) will face a new top marginal tax bracket of 39.6 percent. Those same people will see their tax rates on dividends and long-term capital gains go up to 20 percent from 15 percent. And limits on itemized deductions and personal exemptions will start to kick in on incomes over $250,000.

That all points to at least considering the wagging tail before you buy the dog. In addition to being taxed itself, income from investments could push investors into higher tax brackets, so minimizing taxable income could be an especially good idea for investors on the cusp of higher brackets. And some tax-smart investments actually perform better than their tax-ignoring counterparts.

Take tax-efficient mutual funds, for example. These funds are actively managed to minimize the taxable income they produce. Their managers sell losing securities, match up losses and gains, hold stocks at least a year so that their gains count as long-term, choose stocks that don't produce a lot of taxable dividends, and try to keep taxable transactions low. That's particularly important for mutual funds, because they are required to distribute dividends and capital gains to shareholders annually. So, even shareholders who keep a fund for decades will usually receive taxable contributions annually along the way.

These tax-managed mutual funds have a pretty good record of outperforming their non-tax-managed competitors on an after-tax basis, according to new research from Lipper, a Thomson Reuters company.  Lipper analyst Tom Roseen compared the after-tax performance of every major tax-managed mutual fund with the average after-tax performance of its whole category. "Tax-managed funds, on average, did a fine job," he said. For example, over the 10 years ended December 31, 2012, the tax-managed large cap core stock funds returned an annual average of 5.82 percent after taxes. The entire category (which includes hundreds more funds) returned 5.71 percent after taxes.

"In only six classifications of 20 did they not outperform their category average, and that is a pretty strong statement," Roseen said.  But both Roseen and Blanchett stressed that not every fund is a winner, and there are other ways to minimize the tax hit on investments. Here's how to approach that.

-- Be picky. Look at a fund's total return and its tax efficiency. Consider how it performs after expenses. Lipper offers performance and tax-efficiency ratings for funds at www.reuters.com/finance/funds. Morningstar (www.morningstar.com) has a measure called "tax cost ratio" -- the amount of a fund's annualized return that is lost to taxes paid on distributions.

-- Look at less managed alternatives. An active fund manager who's keeping one eye on the tax bill can produce solid low-tax returns, but you will have to pay for him. An exchange traded index fund (ETF) can be very competitive on performance, tax hit and bottom line cost, for a variety of reasons. Index funds tend to be low-turnover so they generate a low tax hit. ETFs don't have to buy and sell stocks to accommodate buying and selling shareholders (as mutual funds do) so they can hold onto their portfolios even longer. And, as low-trading, unmanaged index funds, ETFs keep expenses rock bottom.  Will an active manager beat an ETF by enough to justify her fees? Sometimes yes, and sometimes no. That's a question of investment philosophy that chartered financial analysts can spend their entire careers trying to answer, so it's OK to answer for yourself.

-- Run your own fund. It's not for everyone, but at least two online brokerage firms specialize in putting together pre-set portfolios for investors who would rather own pieces of individual stocks instead of a fund. You can use them to get the diversity of a mutual fund without the complicated tax structure and extra layer of management fees.  That sounds complex, but at Motif Investing Inc (www.motifinveseting.com) and Foliofn Investments Inc (www.folioinvesting.com) you can buy a fixed portfolio for a low fee. Because investors end up owning fractional shares of individual stocks, there are no capital gains distributed annually, as there would be from a mutual fund. Both sites let you manage the portfolios for maximum tax advantage by selling individual stocks to lock in losses.

-- Placement matters, too. Tuck those high income-producing investments inside your tax-advantaged 401(k) or Roth IRA. Use your taxable account for the low-tax-hit choices like ETFs, tax-managed mutual funds, and portfolios of individual stocks, or pieces of them.
(Linda Stern is a Reuters columnist. The opinions expressed are her own.  Linda Stern can be reached at linda.stern@thomsonreuters.com; She tweets at www.twitter.com/lindastern .; Read more of her work at blogs.reuters.com/linda-stern.