Martin S. Kaplan, CPA
Martin S. Kaplan, CPA, New York City. He is a frequent guest speaker at insurance, banking and financial-planning seminars and author of What the IRS Doesn’t Want You to Know (Wiley).
The IRS has been stepping up efforts to make sure that taxpayers are paying up, especially as the federal budget deficit soars. About 40,000 more individual tax returns were audited in fiscal 2009 than in 2008 — and the number has more than doubled since 2000. For 2010, the tentative federal tax-enforcement budget is up nearly 10% from last year.
There’s no way to absolutely audit-proof a tax return. However, there are steps you can take to minimize the chances that the Internal Revenue Service will challenge yours, including ways to make sure that you don’t have any of the new potential red flags that the IRS is targeting. To reduce the chances of an IRS audit…
In the current economic climate, unreported income is a major concern of the IRS, especially if you are self-employed and report income on Schedule C of IRS Form 1040. The IRS estimates the annual “tax gap” between what taxpayers should pay and what they actually pay at $290 billion, and has said that underreported income accounts for 80% of this tax gap.
An agent may look beyond your W-2 forms and 1099 forms that report income. He/she may examine all of your checking and savings accounts from December of the year prior to the year that is under examination through January of the following year — 14 months in all. You may have to provide that information for your children’s bank accounts, too. The agent will be looking for deposits substantially in excess of the income you reported.
You’ll be asked to explain any deposits that were not classified as income, such as proceeds from a home-equity loan, account transfers, an inheritance and gifts.
What to do: Make sure that you report all of your taxable income. Go over all of your bank deposits as an IRS agent might, and see if you can account for all deposits in excess of the taxable income you report.
With income of $200,000 or less, you have about a 1% chance of being audited, according to the IRS. Audits of taxpayers in this income group rose only slightly from 2008 to 2009. With income of more than $200,000 up to $1 million, your chance of an audit triples to about 3%. Audits of such taxpayers rose by 11% from 2008 to 2009. And with income of more than $1 million, your chances of facing IRS scrutiny shoot up to more than 6%. Audits of seven-figure-income taxpayers rose by 30% from 2008 to 2009.
What to do: The higher your income, the more vigilant you must be about avoiding errors, omissions and questionable deductions. There also is more reason to hire a professional tax preparer. And there may be more reason to lower your taxable income by investing in tax-exempt bonds and other means.
Be cautious about reporting as a business any hobby that is only minimally profitable — an increasingly common practice that the IRS frowns upon because you are not allowed to deduct losses from a hobby (but you can deduct losses from a business).
A true business may lose money, of course. As long as you have records showing that you made a legitimate effort to create a real business, you can deduct the loss. This means running the activity in a businesslike manner — with a business plan, a separate business bank account, good records of income and expenses, etc.
If you report business expenses, including auto, travel and entertainment expenses, that are high relative to your income, that also could draw extra scrutiny from the IRS. Keep thorough records of income and expenses for your business.
Be aware that you do have to report all income from a hobby. The good news is that you can deduct expenses of the hobby to the extent of that income.
In addition to unreported income, IRS examiners often focus on deductions for a home office. Therefore, filing Form 8829 (Expenses for Business Use of Your Home) might attract IRS attention and trigger an audit.
What’s new: When a taxpayer who is audited has filed Form 8829, many IRS districts now are making it mandatory for a revenue agent to physically visit the taxpayer’s home by appointment. During the home visit, the agent will look around and take pictures to determine whether there really is a home office, whether it’s set up exclusively for business and how large a portion of the home is taken up by the office.
What to do: Consider restricting the square footage you report for a home office to less than 20% of the total space in your home. You might end up with a slightly lower tax deduction than you are technically entitled to, but you may reduce your exposure to an audit. You even may want to avoid declaring a home office at all.
The IRS appears to be taking a much closer look at cash and noncash charitable donations, especially ones that are very large relative to the taxpayer’s income. Giving 10% of your income to charity is far above the norm, which is around 2%. Thus, donating large amounts relative to your income may be a red flag to IRS examiners. Gifts of property, especially those valued at more than $5,000, often draw scrutiny.
All charitable deductions must be backed up by written verification now, such as a letter from the charity or a bank record of the gift, or, for cash donations under $250, a bank record recording the gift.
What to do: If you really donate substantial amounts and have supporting evidence, such as receipts… letters from the recipient organizations… and/or your bank statements, take the deductions. Avoid making cash donations — it’s better to use a check or credit card.
New laws in 2008 and 2009 created tax credits of up to $8,000 for many first-time home buyers and $6,500 for many repeat buyers.
However, the Treasury Department found that about one out of every 10 claims for the tax credit is faulty, for a total of more than $600 million in claims that will not be allowed. The IRS has frozen thousands of tax refunds and initiated more than 100,000 examinations of questionable claims.
Examples: More than 580 people under age 18 (including a four-year-old) claimed the credit, even though they are not eligible. The IRS suspects that some high-income parents (who were not eligible for the credit) had their low-income children claim the credit. Another, perhaps more innocent, mistake might be claiming the credit if your income was over the limit.
What to do: To avoid inviting an audit, be familiar with all of the requirements for the home buyer’s credit, and follow them to the letter. For details, go to www.HomeBuyerTaxCredit.com. Be sure to attach Form 5405 and proof of closing to your tax return.
During the housing boom, many people refinanced their homes with “cash-out” mortgages, pulling out home equity to use for living expenses. In 2009, the IRS announced that it will extend a regional project scrutinizing mortgage interest to a nationwide level by December 2011. The regional project found many people reporting large mortgage interest deductions in relation to their income — a potential audit red flag.
What to do: If you are reporting, say, $20,000 in mortgage interest payments but only $25,000 in income for 2009, you would be wise to attach a brief statement explaining how you can handle such a big mortgage — for example, that you are tapping your savings to pay the mortgage.
The IRS has announced that it expects to collect $8.5 billion in back taxes from Americans with foreign bank accounts over the next few years. The IRS is pressuring foreign banks to name names. For example, in 2009, the US and Switzerland reached an agreement requiring Swiss banks to provide account information if the IRS suspects any tax evasion by account holders.
What to do: If you own or have authority over a foreign financial account, you are required to file a Report of Foreign Bank and Financial Accounts (FBAR) to the IRS if the aggregate value of all your foreign accounts exceeds $10,000 at any time during the calendar year. Be sure to do it.
