How To Avoid Audit Triggers On Form 1040 Schedules A, C, And E

How To Avoid Audit Triggers On Form 1040 Schedules A, C, And E

The IRS makes no secret of the fact that it commonly examines items reported (or not reported) on Form 1040 Schedules A, C, and E. Practitioners may have received one or more of the IRS warning letters sent to practitioners who prepare a large volume of these important schedules. These letters generally direct practitioners to ask more questions of their clients and be more circumspect with the information they receive. But the wary practitioner can go further to circumvent potential audit issues by taking note of specific potential pitfalls, such as documentation requirements, changes in tax law, or tax form revisions. This article summarizes some of the major audit issues covered by Claudia Hill, E.A. M.B.A., TaxMam, Inc., during her February 7, 2014 CCH webinar “Schedule A, C & E: Audit Hot Buttons.”

Schedule A, Itemized Deductions

Medical and Dental expenses, Line 3. The tax law has changed so that taxpayers who were under age 65 at the end of 2013 may only itemize a deduction for unreimbursed medical expenses that exceed 10 percent of their adjusted gross income (AGI). However, if a taxpayer or his or her spouse was 65 or older at the end of 2013, the lower 7.5 percent threshold still applies. In 2017, however, the AGI threshold increases to 10 percent for all taxpayers without exception.

Auditor Note

“The IRS knows how old you are, so make sure the taxpayer’s birth date is entered into your tax preparation software,” Hill said. She advised practitioners to double check whether the birth date field was required, and if not to change their office practice to require its entry.

Home mortgage interest, Lines 10 and 11. Both lines are for reporting home mortgage interest paid during 2013 and reported on Form 1098. However, line 10 is for interest and points reported to the taxpayer; whereas line 11 is for home mortgage interest paid by the taxpayer, but reported to someone else.

This situation might arise in a situation where a mortgage was partially financed by the taxpayer’s family member, but the taxpayer paid the interest, Hill explained. “Failure to put the number on the correct line can generate a CP 2000 letter,” she said. Practitioners should train the clients to bring the actual mortgage interest documents to the office so the practitioner can cross-check the name of the person listed on a Form 1098.

Mortgage insurance premiums, Line 13. Although taxpayers may deduct amounts paid during 2013 for mortgage insurance premiums, this deduction is no longer effective for 2014 and beyond. Practitioners should prepare their clients for the fact that, absent Congressional action, this deduction is now unavailable for 2014 and future tax years.

Gifts to charity made by cash or check, Line 16. Cash contributions under $250 must still be substantiated by a bank record, receipt or other written communication from the qualified donee organization that verifies the transaction took place, Hill said. That means that cash donations of change thrown into a bell ringer’s collection bowl or money placed in a church collection plate without a contemporaneous record would not be deductible.

For any cash or property contribution of $250 or more, a taxpayer must obtain and keep a contemporaneous written acknowledgment from the qualified organization indicating the amount of the donation, a description of any property contributed, and a statement reporting any goods or services received as a result of the contribution. If no goods or services were received, the statement must say as much.

Auditor Note

Practitioners should take particular care to ensure that the acknowledgment is contemporaneous, meaning the receipt was obtained prior to filing the tax return, Hill said. Furthermore, in the event of an audit, if a taxpayer cannot find an acknowledgment, the taxpayer must have the charity reproduce a copy of the original contemporaneous written acknowledgment. It would be insufficient to have the charity produce a new one, even if it reported all the same information, since the law requires taxpayers be holding the receipt at the time their return is filed.

Gifts to charity other than by cash or check, Line 17. Noncash gifts of $500 or more must be accompanied by Form 8283, Noncash Charitable Contributions. With the exception of donations of publicly traded securities, for which a taxpayer may rely on the valuation given by regulated securities markets like the NASDAQ, taxpayers must obtain a qualified appraisal.

Auditor Note

The rules for qualified appraisals are stringently applied. For example, in the case Mohamed v. Commissioner, TCM 2012-152, Dec. 59,074(M), the taxpayer was a certified real estate appraiser. However, when he appraised his own donation of property to the Charitable Remainder Unitrust that he and his wife had established, the Tax Court disallowed the deduction. When in preparation for the trial, the taxpayer obtained a new qualified appraisal, the Tax Court still denied the deduction. The appraisal had been made only as the audit began, and was not contemporaneous with the gift.

Casualty and theft losses, Line 20. Theft losses reported on Schedule A are calculated using Form 4684, Casualties and Thefts. The IRS has added a new Section C to the new 2013 Form 4684 for taxpayers to claim a theft loss deduction from a Ponzi-type investment scheme. Section C replaces Appendix A in Rev. Proc. 2009-20.

Other miscellaneous deductions, Line 28. The IRS instructions for Schedule A list several types of itemized deductions that are not subject to the 2 percent AGI threshold and that must be reported on line 28. Hill stated that this list, however, was not exhaustive. Once in a while a practitioner might find another deduction that could be included on Line 28. If the practitioner’s tax software does not allow the deduction to be added, the return must be filed on paper, she explained.

Schedule C, Profit or Loss From Business

Payments requiring Form 1099s, Line I. Tax preparation software often has default settings regarding the checkbox line asking whether a taxpayer made any payments in 2013 that would require a Form 1099 to be filed. Sometimes the software checks “Yes,” other times “No,” and other times left the box blank. “You do not want to leave this blank,” Hill cautioned. Know how your software works, she emphasized.

Auditor Note

Taxpayers should not assume that they do not need to issue a Form 1099 to a service provider, Hill said. For example, a piano teacher who has paid a piano tuner more than $600 is required to file a Form 1099.

Gross Receipts or sales, Line 1—Form 1099-K, Payment Card and Third Party Network Transactions. The IRS has announced that it will audit the underreporting of Form 1099-K income. In the case of a Schedule C filer, such income must be reported on Line 1, even though the individual line reserved for Form 1099-K income has disappeared from the 2013 Schedule C.

Auditor Note

Practitioners should be prepared for instances where payments reported as income to taxpayers on the Form 1099-K do not actually match the amount the taxpayer counted as gross receipts in its books. For example, a Form 1099-K might report a total amount of a credit card transaction that includes state sales tax or transaction fees that the proprietor did not actually receive as income.

Home office deduction—Simplified method, Line 30. New for 2013 is the simplified method by which taxpayers calculate a deduction for business use of their home. The simplified method introduces relaxed reporting requirements by allowing a deduction of $5 per square foot of home used for business (up to 300 square feet). However, the actual expenses could be greater than the standard deduction. Also, the simplified method does not allow a deduction for depreciation or a loss carryover.

Schedule E, Supplemental Income and Loss

Passive activity loss limitations, Line 22. In general, losses from rental real estate activities are considered passive, andCode Sec. 469 provides that they can be deducted only to the extent of a taxpayer’s passive income. Two exceptions exist: (1) the taxpayer is a real estate professional, or (2) they actively participate in the rental real estate activity and their income is under $100,000.

Auditor Note

The second exception can result in a maximum $25,000 deduction for qualifying taxpayers. The deduction is reduced by $.50 on the dollar for taxpayers with AGI between $100,000 and $150,000.

Rental real estate professional. “Who is a rental real estate professional? The government will not commit on this point,” Hill said. However, in general, a taxpayer is a real estate professional if (1) he or she spends more than 750 hours in a year performing services in one or more real property trades or businesses in which he or she materially participates; and (2) the taxpayer spent more time providing personal services in the real property business in which he or she materially participates than in a non-real property trade or business.

Auditor Note

What constitutes “material participation” is further defined under another set of requirements. The result of the complicated PAL rules is that many inexperienced taxpayers improperly claim they are real estate professionals and deduct passive losses that may later be disallowed on audit.

Form 8960, Net Investment Income Tax—Individuals, Estates, and Trusts. The 3.8 percent net investment income surtax applies to certain investment income of individuals, estates and trusts that have income above the statutory threshold amounts. This can include rental real estate income, unless the rental real estate income was derived from the operation of a trade or business in which the taxpayer materially participates.

Auditor Note

Hill predicted that this area could generate much significant controversy over what constitutes a real estate trade or business. She did clarify, however, that even if a taxpayer does qualify as a real estate professional, his or her participation in rental real estate activity does not necessarily constitute a trade or business for purposes of the net investment income tax.

Reference: PTE §39,020.15