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Avoid an Audit: 6 ‘Red Flags’ You Should Know
February 10, 2010
PROVIDED BY INVESTOPEDIA
by Glen Curtis
Wednesday, February 10, 2010
If history is any indicator, less than 1% of Americans will be audited by the Internal Revenue Service in the coming year. And while some of these audits are totally random, and there’s nothing that the individual taxpayer can do about them, many audits are actually instigated by the taxpayers themselves.
To that end, below is a list of “red flags” that can cause your return to be cherry picked by the IRS for review. Pay particular attention, as knowing what the flags are can keep you out of trouble.
1. Overestimating Donated Amounts
The IRS encourages individuals to donate things like clothes, food and even old automobiles to charities. It does this by offering a deduction in return for a donation. However, the problem with this system is that it is up to the taxpayer to determine the value of goods that are donated.
As a general rule, the IRS likes to see individuals value the items they donate at anywhere between 1% and 30% of the original purchase price (unless special circumstances exist). Unfortunately many, if not most, taxpayers either aren’t aware of this, or simply choose to ignore this fact.
There are several other tips that the taxpayer can use to ensure that he or she is valuing donated goods at a “fair” price. Aside from the 30% and under rule mentioned above, consider having an appraiser write a letter. (In fact, for individual items valued at $5,000 or more, an appraisal is required.). Another benchmark the IRS uses that could come in handy is the willing-buyer-willing-seller test.
This means that taxpayers should value their goods at a point or price where a willing seller (who is under no duress) would be able to sell his property to a willing buyer (who also is under no duress to purchase the item). Using such a benchmark will keep you out of trouble and prevent you from placing an excessive value on your dad’s old Frank Sinatra albums.
2. Math Errors
While this may sound simple, many returns are selected for audit due to basic math errors. So when filling out your tax return (or checking it after your accountant has completed the form) make sure that the columns add up. Also make sure that the total dollar value of capital gains and/or losses are properly calculated. Even a small error can raise eyebrows.
3. Failure to Sign the Return
A large percentage of folks simply forget to sign their tax returns. Don’t be a part of that number! Failure to sign the return will almost guarantee that it will receive additional scrutiny. The IRS will wonder what else you might have forgotten to include in the return.
4. Under-Reporting Income
Tempting as it might be to exclude income from your tax return, it is vital that you report all money that you received throughout the year from work and/or from the sale of an asset (such as a home) to the IRS. If you fail to report income and you are caught, you will be forced to pay back-taxes plus penalties and interest.
How can the IRS tell if you’ve reported everything? In some situations it can’t. After all, the system isn’t perfect. However, a common way some individuals get caught is that they accept cash for a service they’ve performed. If the customer or individual who paid that individual the cash gets audited, the IRS will see a large cash disbursement from his or her bank account. The IRS agent will then follow that lead and ask the individual what that cash layout was for. Inevitably, the trail leads right back to the individual who failed to report that money as income.
In short, it’s better to be safe than sorry. Make sure you report all of your income.
5. Home Office Deductions
Be careful with home office deductions. Excessive or unwarranted deductions can raise red flags. In addition, large deductions in proportion to your income can raise the ire of the IRS as well.
For example, if you earned $50,000 as an accountant (operating from home), home-office related deductions totaling $30,000 will raise more than a few eyebrows. Trying to write off the value of a new bedroom set as office equipment could also draw unwanted attention.
Deduct only items that were used in the course of your business.
6. Income Thresholds
There is nothing the individual taxpayer can do about this one, but if you earn more than $100,000 each year, your odds of being audited increase exponentially. In fact, some accountants put the odds of being audited at one in 72, compared to the one in 154 odds for people with lower incomes.
Other Sensitive Tax Areas
Partnership/Trust/Tax Shelter Risk
If you own shares in a limited partnership, control a trust or partake in any other tax shelter investments, you are more apt to be audited. While there may be no way to avoid such an audit, individuals that have a stake in such an entity should be aware that they have a target on their backs. They should also take even greater care to document deductions, donations and income.
Small Business Ownership
Small business owners are an easy target – particularly those with cash businesses. Bars, restaurants, car washes and hair salons are exceptionally big targets, not only because they deal in so much cash, but also because there is so much temptation to under-report income and tips earned.
Incidentally, other actions that go part and parcel with business ownership may draw unwanted IRS interest too, including putting family members on the payroll and over-estimating expenses.
In short, business owners must know that they can’t “push the envelope”. If they want to stay in business and avoid the scrutiny of an audit, it’s best to remain on the straight and narrow.
So why does the IRS seem to be cracking down more and more on individuals and small business owners these days? It’s simple. According to the IRS there is roughly an annual $300 billion gap between what Americans pay in taxes versus what they owe. That equates to about $2,680 per household. The Congress knows this too, and given the deficits the United States government has run up over the past 20 years, there is enormous pressure on legislators and the IRS to collect all tax funds.
Being Audited
What should you do if you are audited? Be honest with the auditor and respond to all inquiries as quickly as possible. Don’t be afraid to show all of your documentation. If possible, have a qualified accountant and/or tax attorney represent you.
Bottom Line
Audits have and will remain a part of the tax collection process for a long time to come, but that doesn’t mean that you have to be among the “lucky” few to be chosen. The key to avoiding an audit is to be honest, document your deductions, donations and income.
10 Astute Tax Moves in 2010
January 12, 2010
by Kay Bell
Provided by Bankrate
To put the struggling economy back on track, Congress has passed several new tax laws in recent years. The good news is some tax breaks will still be around in 2010 while new ones are in the works. Here are 10 tax moves that could help you lower your IRS bill in the New Year.
Tip 1: Buy a Home
The real estate market was a major economic drag, so lawmakers decided to jump-start it by offering first-time homebuyers a tax break. It seemed to work, so as 2009 wound down, Congress extended the first-time homebuyer credit and expanded it to folks looking to purchase move-up homes.
First-timers — individuals who haven’t owned a residence in the last three years — can claim up to $8,000. Current homeowners who’ve lived in their residence for five of the eight years before buying can get up to $6,500.
You must have a contract in place by April 30, 2010, and the deal closed by June 30 to qualify for the credit.
Even if your residential purchase is in 2010, you have the option to take the credit on your 2009 tax return or wait and claim it on your 2010 Form 1040. Run the numbers both ways to see which filing year will save you the most tax money.
Tip 2: Watch Out for Making Work Pay Complications
To get more money into taxpayers’ hands, the American Recovery and Reinvestment Act included a new tax break, the Making Work Pay credit. Rather than being a separate rebate check, this credit started showing up in worker paychecks last April. By the end of 2009, eligible employees received an extra $400.
Some workers, however, got more than they should have. This happened, for example, when a worker had two jobs. The new withholding rates meant that employee got $400 at each job, or twice the allowable credit amount. Similarly, a husband and wife who each had jobs could have received excess credit.
This filing season, taxpayers will have to fill out the new Schedule M to reconcile any credit overages. You might want to fill out the form early to see just what kind of tax damage you might face.
If you did encounter a Making Work Pay problem in 2009, consider adjusting your withholding early in 2010.
Now about that 2010 payout. Even if you don’t make any W-4 changes, you’ll see more tax withheld from your paychecks than was taken out after the Making Work Pay credit went into effect last year. When the credit took effect, the full $400 amount was paid out over just the last nine months of the year. But with the credit being paid out over all 12 months of 2010, this year’s per-paycheck bump will be smaller.
Tip 3: Convert Your Traditional IRA to a Roth
With the arrival of 2010, anyone can now convert a traditional IRA to a Roth retirement account. Before, shifting tax-deferred traditional IRA money into a tax-free Roth plan was not available to folks with adjusted gross income of $100,000 or more. That income limit has been removed.
If you decide this is the right retirement move for you, note that you will have to pay taxes on the previously untaxed amounts you convert. The good news is you can opt to pay half the conversion costs on your 2011 taxes, with the remainder in 2012.
Tip 4: Improve Your Home’s Energy Efficiency
Thanks to another portion of last year’s stimulus bill, the tax savings for energy-efficient home improvements were themselves improved.
Instead of a complicated patchwork of credit amounts, homeowners can claim up to 30 percent of the first $5,000 spent on qualifying residential energy upgrades, or up to $1,500 in tax credits. If you want to go even greener, for example by installing a solar home heating system, you could get even bigger tax credits.
The new credit format took effect last year, but is running through 2010. This might be the last year, though, so if you need to make home repairs, consider energy-efficient upgrades that could pay off at tax-filing time.
Tip 5: Hit the Road in a Hybrid
Gas prices stabilized over the last year, but there’s no guarantee they won’t once again nudge the $4 mark. If you’re concerned about it, consider a hybrid. Even better, these cars could pay off at tax time.
However, you have to shop carefully. The hybrid credit, which is available through 2010, was designed to phase out once an automaker sold 60,000 eligible vehicles. That happened years ago with popular Toyota and Honda hybrids. Other auto manufacturers, however, still offer an array of fuel-efficient cars, trucks and SUVs that could save you tax dollars.
Tip 6: Hire an Estate Tax Attorney
The estate tax died as scheduled in 2010, but look for a retroactive resurrection this year. Congress effectively has until September to approve a new law since estate tax returns aren’t due until nine months after a taxpayer dies. Most lawmakers agree that a tax should be in place. The question is: How much of an estate’s assets should be exempted? The congressional re-examination of the estate tax highlights how estate planning can be complex, confusing and costly. Don’t follow Congress’ bad example and put off dealing with your estate and potential tax ramifications. See an estate tax professional and get your affairs in order sooner rather than later so that your heirs, not the IRS, are your ultimate beneficiaries.
Tip 7: Remember That RMDs Are Back
Tax-deferred savings plans such as traditional IRAs or workplace 401(k)s are great ways to build a retirement nest egg. But the IRS won’t wait for its cut of the account earnings forever. Once you turn 70-1/2, tax law demands you start taking money out of these accounts via required minimum distributions, or RMDs.
In 2009, retirees didn’t have to worry about RMDs thanks to a one-year waiver granted by Congress. In 2010, RMDs are back, so make sure you take out the requisite money or you could pay a stiff penalty.
Tip 8: Cash in on Low Capital Gains Rates
The Bush administration tax cuts included reductions in capital gains tax rates based on taxpayer adjusted gross income. Currently, the highest rate is 15 percent for individuals in the 25 percent to 35 percent tax brackets. Taxpayers in the 10 percent and 15 percent tax brackets pay no capital gains.
That’s scheduled to change in 2011. The top rate will return to 20 percent; the zero rate will revert to 10 percent. There’s always a chance Congress could continue the current lower rates, but with the federal deficit, the top capital gains rate is likely to increase. If you are in a higher income bracket and could eventually face higher capital gains taxes, speak with your tax and investment advisers about whether cashing in now at the lower rates fits your portfolio plans.
Tip 9: Be Aware of Rising Income Tax Rates
Similarly, several other Bush administration tax cuts are set to expire at the end of 2010. As for income taxes, the top tax rate is scheduled to return to 39.6 percent from the current 35 percent and the 10 percent bracket would be eliminated.
Will this happen? Right now, it looks as if the 10 percent bracket is safe, but higher-income individuals might be facing increased taxes in 2011. If you could be affected, talk with your tax and financial advisers about what steps you can take to soften the tax blow.
There has been some talk that growing deficits could prompt rate hikes ahead of schedule. However, a still-sluggish economy and upcoming 2010 midterm elections make that less likely. So pay attention to Congress and to Bankrate for the latest on where personal income tax rates might go.
Tip 10: Keep an Eye on Health Care
President Barack Obama had hoped that health care reform would be resolved by now. But look for this debate to continue into the early part of 2010. If or when lawmakers reach an agreement, you’ll need to pay attention to what modifications might take effect.
Many changes, such as an increase in the amount of medical expenses necessary to deduct them, wouldn’t show up for several years. Others, however, are on a fast track. For example, the proposal to limit flexible spending account contributions to $2,500 a year would take effect in 2011. If that change comes to pass, you’ll need to account for it in 2010 as you make decisions about your company health care benefits.
Choose the Tax Form that Best Fits Your Needs
January 8, 2010
To file your 2009 individual tax return, you’ll have to decide which form to use…unless you e-file. If you file electronically, the software automatically selects the simplest and best form for you. Whether you use e-file or prepare on paper, using the simplest form will help avoid costly errors or processing delays. And remember, if you file electronically, it speeds up the processing of your tax return and the delivery of your refund.
Here are things to consider when deciding which IRS form to file.
Use the 1040EZ if:
- Your taxable income is below $100,000
- Your filing status is Single or Married Filing Jointly
- You and your spouse – if married — are under age 65 and not blind
- You are not claiming any dependents
- Your interest income is$1,500 or less
You are not claiming the additional standard deduction for real estate taxes, taxes on the purchase of a new motor vehicle, or disaster losses
Use the 1040A if:
- Your taxable income is below $100,000
- You have capital gain distributions
- You claim certain tax credits
- You claim deductions for IRA contributions, student loan interest, educator expenses or higher education tuition and fees
If you cannot use the 1040EZ or the 1040A, you’ll probably need to file using the 1040. You must use the 1040 if:
- Your taxable income is $100,000 or more
- You claim itemized deductions
- You are reporting self-employment income
- You are reporting income from sale of property
All IRS forms, instructions and information about e-file can be found on IRS.gov
Courtesy: IRS Newswire
How to Choose a Tax Preparer and Avoid Preparer Fraud
January 3, 2010
FS-2010-3, January 2010
(Jan. 5, 2009 – Corrected 2009 criminal investigation statistics.)
Taxpayers who decide they need assistance when preparing a tax return should choose a tax preparer with care and caution. Even if a return was prepared by an outside individual or firm, taxpayers should remember that they are legally responsible for what they file with the Internal Revenue Service.
Most return preparers are professional, honest and provide excellent service to their clients, but some engage in fraud and other illegal activities. Return preparer fraud involves the preparation and filing of false income tax returns by preparers who claim inflated personal or business expenses, false deductions, unallowable credits or excessive exemptions on returns prepared for their clients.
Preparers may, for example, manipulate income figures to fraudulently obtain tax credits, such as the Earned Income Tax Credit. In some situations, the client, or taxpayer, may not even know of the false expenses, deductions, exemptions and/or credits shown on his or her tax return.
However, when the IRS detects a fraudulent return, the taxpayer — not the return preparer — must pay the additional taxes and interest and may be subject to penalties.
The IRS Return Preparer Program focuses on enhancing compliance in the return-preparer community by investigating and referring criminal activity by return preparers to the Department of Justice for prosecution. The IRS can also assert appropriate civil penalties against unscrupulous return preparers.
Also to combat fraud, IRS Commissioner Doug Shulman recently made a series of recommendations with the twin goals of increasing taxpayer compliance and ensuring uniform and high ethical standards of conduct for tax preparers.
While most preparers provide honest service to their clients, the IRS urges taxpayers to be careful when choosing a preparer –– as careful as they would be choosing a doctor or lawyer. Even if someone else prepares a tax return, the taxpayer is ultimately responsible for all the information on the return. For that reason, taxpayers should never sign a blank tax form. And they should review the return before signing it and ask questions on entries they don’t understand.
Helpful Hints When Choosing a Return Preparer
- Be cautious of tax preparers who claim they can obtain larger refunds than other preparers.
- Avoid preparers who base their fee on a percentage of the refund.Use a reputable tax professional who signs the tax return and provides a copy.
- Consider whether the individual or firm will be around to answer questions about the preparation of the tax return months, or even years, after the return has been filed.
- Check the person’s credentials. Only attorneys, certified public accountants (CPAs) and enrolled agents can represent taxpayers before the IRS in all matters, including audits, collection and appeals. Other return preparers may only represent taxpayers for audits of returns they actually prepared.
- Find out if the preparer is affiliated with a professional organization that provides its members with continuing education and resources and holds them to a code of ethics.
Reputable preparers will ask to see receipts and will ask multiple questions to determine whether expenses, deductions and other items qualify. By doing so, they are trying to help their clients avoid penalties, interest or additional taxes that could result from an IRS examination.
Tax evasion is a risky crime, a felony, punishable by five years imprisonment and a $250,000 fine.
Courtesy: IRS Website/Newswire
IRS Warns Taxpayers of First-Time Homebuyer Credit
July 29, 2009
IR-2009-69, July 29, 2009 (Courtesy IRS Newswire)
WASHINGTON — The Internal Revenue Service today announced its first successful prosecution related to fraud involving the first-time homebuyer credit and warned taxpayers to beware of this type of scheme.
On Thursday July 23, 2009, a Jacksonville, Fla.-tax preparer, James Otto Price III, pled guilty to falsely claiming the first-time homebuyer credit on a client’s federal tax return. Price faces the possibility of up to three years in jail, a fine of as much as $250,000, or both.
To date, the IRS has executed seven search warrants and currently has 24 open criminal investigations in pursuit of potential instances of fraud involving the credit. The agency has a number of sophisticated computer screening tools to quickly identify returns that may contain fraudulent claims for the first-time homebuyer credit.
“We will vigorously pursue anyone who falsely tries to claim this or any other tax credit or deduction,” said Eileen Mayer, Chief, IRS Criminal Investigation. “The penalties for tax fraud are steep. Taxpayers should be wary of anyone who promises to get them a big refund.”
Whether a taxpayer prepares his or her own return or uses the services of a paid preparer, it is the taxpayer who is ultimately responsible for the accuracy of the return. Fraudulent returns may result not only in the required payment of back taxes but also in penalties and interest.
First-Time Homebuyer Credit
The First-Time Homebuyer Credit, originally passed in 2008 and modified in 2009, provides up to $8,000 for first-time homebuyers. The purchaser, however, must qualify as a first-time homebuyer, which for purposes of this credit means someone who has not owned a primary residence in the past three years. If the taxpayer is married, this requirement also applies to the taxpayer’s spouse. The home purchase must close before Dec. 1, 2009, to qualify, and the credit may not be claimed on the purchaser’s tax return until after the taxpayer closes and has purchased the home.
Different rules apply for homes bought in 2008.
Full details and instructions are available on the official IRS Web site: http://www.irs.gov
