Chances of Audit Continue to Drop – What you need to know
The IRS continues to use their audit department as a poster child to try to get more funding. The result can be seen in their declining audit rates. But do not be fooled. Here are the most recent IRS audit statistics for your review.
You can be audited the later date of either three years after the filing deadline of your tax return or when you actually filed your tax return. However, there are two main exceptions to this rule that can extend the risk of being audited;
|1||If the IRS audits a tax return and discovers an error of more than 25% of your claimed tax obligation they can go back six years.|
|2||If the IRS deems there is fraud involved, they can go back indefinitely.|
Every year the IRS publishes their examination statistics. Provided here are three years of published information to help you identify trends:
Audit Rate Statistics for INDIVIDUALS
|Fiscal Year Ending||2015||2011||2008|
|All Individual Tax Returns||.84%||1.11%||1.00%|
|No Income (AGI)||3.78%||3.42%||2.15%|
|Income under $25,000||1.01%||1.22%||.90%|
|$25,000 – 50,000||.50%||.73%||.72%|
|$50,000 – 75,000||.47%||.83%||.69%|
|$75,000 – 100,000||.49%||.82%||.69%|
|$100,000 – 200,000||.64%||1.00%||.98%|
|$200,000 – 500,000||1.54%||2.66%||1.92%|
|$500,000 – $1 million||3.81%||5.38%||2.98%|
|$1 million – $5 million||8.42%||11.80%||4.02%|
|$5 million – 10 million||19.44%||20.75%||6.47%|
|$10 million and over||34.69%||18.38%||9.77%|
|Note: These audit rates are stated as a percent of total tax returns with “total positive income” (TPI) as claimed on individual tax returns. In general the examinations are for tax returns filed in the previous calendar year.|
|Source: IRS Data Books|
- Despite complaints of fewer audits from the IRS, the audit rates are still up dramatically versus 2008 for those with incomes over $500,000. This is because the vast majority of income tax collected comes from these taxpayers.
- Upper income taxpayers could assume they will be audited every 3 to 5 years.
- Those with incomes over $10 million have seen their audit rate go up over 300% since 2008.
Note that the IRS also audits taxpayers with little to no taxable income. Much of this is due to the high incidence of error and fraud within the Earned Income Tax Credit.
Play it safe
Always retain your tax records and support documents for as long as they may be needed to substantiate claims on your tax return. Make sure you consider any state record retention requirements as you review when it is safe to destroy old records. Remember some records need to be retained indefinitely. This includes, at minimum, copies of original tax returns, legal documents, and real estate transactions.
Understanding Your Special K’s – 1099-Ks are now being subject to underreporting IRS audits
The IRS recently announced it is going to conduct automated audits of 1099-K filings against business income. This includes unicorporatated small businesses filing Schedule C with their Form 1040. How do you protect yourself from this audit risk?
For the first time, the IRS is reporting that it will be comparing filed 1099-Ks against income reported on business tax returns (including those reported on 1040 Schedule C tax returns). Knowing how this impacts you can save you an unwanted IRS correspondence audit.
A couple of years ago the IRS introduced the 1099-K. This new informational tax return is meant to capture sales activity of previously unreported credit card transactions from places like e-bay and Amazon. Credit card processors are now required to report these transactions to you and the government if you have 200 or more transactions and over $20,000 in billing activity.
What is happening now
The IRS is now going to be comparing these filed 1099-Ks with the income reported by those receiving the form. If their computer audit shows you have not reported income sufficient enough to cover the activity on the 1099-K you will receive a letter asking for an explanation.
What you need to know
- 1099-Ks could include more than income. Since your 1099-K comes from a credit card merchant processor, whatever is on that credit card transaction is included on the tax form. This means it can often include sales tax receipts that have been passed on to your state. If you only record the income portion of the 1099-K, you may run the risk of under-reporting your 1099-K causing an underreporting audit.
- Sole proprietors using a Schedule C do not have a place to report 1099-K activity. If you are a sole proprietor, your business activity is reported on a Schedule C. There is not a separate line to report 1099-K activity. Given this, the problem with sales tax previously mentioned can become even more complicated.
- Make sure you do not double count. Remember 1099-K is credit card transaction activity that may also be reported within other types of 1099 reporting. You must make sure that Gross Revenue on your tax return matches the revenue on your business books.
- Leverage the IRS matching knowledge. Knowing that the IRS is going to run an automated underreporting match using 1099-K information, here are some suggestions;
- Make sure your Gross Income (gross receipts) surpasses the amounts shown on all related 1099 transactions. Focus on your 1099-MISC and 1099-K activity.
- Reduce your gross 1099-K activity to account for non-revenue transactions on a separate line and note what the activity represents. Do not net out the non-revenue portion of 1099-K activity as this may cause a mismatch for the IRS comparison program.
- Double check your book income against your tax return and make sure you can tie them to each other. Pay special attention to ensure your 1099-K activity is not over-stating your revenue.
Should you receive a correspondence audit from the IRS concerning a 1099-K call for help. Remember, this process will be new for them as well as for you.
Determining the value of items on your tax return is always open to interpretation. You do not want that to happen to you during an audit as it can lead to additional tax and penalties. Here are some tips to help defend your Fair Market Value (FMV)
“Fair market value (FMV) is the price that property would sell for on the open market. It is the price that would be agreed on between a willing buyer and a willing seller, with neither being required to act, and both having reasonable knowledge of the relevant facts.”
Source: IRS Publication 561
This is the standard the IRS uses to determine if an item sold or donated by you is valued correctly for income tax purposes. It is also a definition that is so broad that it is wide open to interpretation. The difficulty here, is if the IRS decides your FMV opinion is wrong, you are not only subject to more tax, but penalties to boot. Here are some tips to help defend your FMV in case of an audit.
Understand when it is used
Fair Market Value or FMV is used whenever an item is bought, sold, or donated that has tax consequences. The most common examples are:
- Buying or selling your home or other real estate
- Buying or selling personal property
- Buying or selling business property
- Establishing values of other business assets like inventory
- Valuing charitable donations of personal goods and property like automobiles
- Valuing bartering of services
- Valuing transfer of business ownership
- Valuing the assets in an estate of a deceased taxpayer
Ideas to defend your FMV determination
Here are some suggestions to help you defend your FMV determinations.
Properly document donations. FMV of non-cash charitable donations is an area that can easily be challenged by the IRS. Ensure your donated items are in good or better condition. Properly document the items donated and keep copies of published valuations from charities like the Salvation Army. Don’t forget to ask for a receipt (confirmation) of your donations.
Donate capital items like automobiles to the correct places. You may use the FMV of a donated automobile but only if the charity you donate the item to will use it themselves, or will provide it to someone who will use it. Websites like Kelley blue book (kbb.com) can help establish the value of your vehicle when you donate it. Otherwise, the FMV of the donated vehicle will be limited to the amount the charity receives when they re-sell it.
Get an appraisal. If you sell a small business, collection, art, or capital asset make sure you have an independent appraisal of the property prior to selling it. While still open to interpretation by the IRS, this appraisal can be a solid basis for defending any differences between your valuation and the IRS.
Keep copies of similar items and transactions. This is especially important if you barter goods and services. If you have a copy of an advertisement for a similar item to the one you sold, it can readily support your FMV claim.
Take photos. The condition of an item is often a key determinate in establishing FMV. It is fair to assume an item has wear and tear when you sell or donate it. Visual documentation can be used to support your claimed amount.
Keep good records. Keep copies of invoices for major purchases. Retain bills for any improvements. Make sure your sale of property includes a dated bill of sale that clearly states transfer of ownership and amount paid for the item.
With proper planning, establishing the fair market value of an item sold or donated, can be done in a reasonably defendable way if ever challenged.
Every year thousands of taxpayers go through a ”gotcha” with the IRS. A large, unexpected tax bill. Here are five common causes of tax surprises from lost refunds to retirement plan mistakes.
Every year taxpayers are hit with tax surprises that could be avoided if they just knew the rules. Here are five big ones that are easy to avoid with some simple planning.
Mistake #1. Withholding too little. This results in a tax surprise when filing your income tax. Don’t be too hard on yourself if this happens to you. Social Security withholdings have changed each year and new tax laws in 2013 make it very difficult to withhold the proper amount from each paycheck.
The plan: Check your withholdings after filing each year’s taxes. Make adjustments as necessary by filing a new W-4 with your employer.
Mistake #2. Inadvertently withdrawing funds from retirement plans. Amounts taken out of pre-tax retirement plans like 401(k)s and IRA’s can create taxable income. The most common inadvertent withdrawal occurs when you roll over funds from one retirement plan to another. If done incorrectly all the rollover could be deemed taxable income.
The plan: Do not touch your retirement accounts if at all possible (Exception: when you reach age 70 ½ you may be subject to Required Minimum Distribution rules). If you do withdraw funds, ensure you have the proper withholdings taken out at time of withdrawal. Direct rollovers into your new plan are always a better alternative than receiving the withdrawal from the plan administrator and then conducting the transfer yourself.
Mistake #3. Not taking advantage of tax-deferred retirement programs. There are numerous opportunities to shelter income from tax through tax preferred retirement programs.
The plan: Review your retirement savings options and plan to contribute as much as possible to your plans. Pay special attention to plans that include an employee match component. This attention can reduce your taxable income each year.
Mistake #4. Direct deposit mix-ups. You may now have tax refunds directly deposited in up to three bank accounts. The problem: what if one of the account numbers is entered incorrectly? Unfortunately, unlike replacing a lost check, the IRS does not have a good means of correcting this type of error. There have been instances where taxpayers have lost their refund when this occurs.
The plan: Many taxpayers do not feel comfortable giving the IRS direct access to their bank account. If you are in this camp, the digital deposit problem is solved. If you use direct deposit, avoid depositing your refund into more than one account. Ideally have a second person double check the account number on your tax form prior to submitting the return.
Mistake #5. Not keeping correct documentation. You know you drove the miles, donated the items to charity, had the medical expense, and paid the daycare. How can the IRS be disallowing your valid deductions? Remember without correct documentation the IRS is quick to disallow them.
The plan: Set up good recordkeeping habits at the beginning of each year. Create both a digital and paper folder separated by income and expense type. Keep a mileage log and properly document your charitable contributions.
Often the #1 target of IRS audits, sole proprietors need to be prepared with good
records. Here are some tips.
Each year the IRS publishes their activities in a publication called the Data Book. And each year for the past number of years the number one target of audits are those tax returns with a Schedule C for small business activity. So how to prepare yourself for a possible audit? Here are some tips.
- Keep records separate. The quickest way to get a deduction for your business disallowed is to blend your personal bills with those from your business. Open a separate checking account and use a separate credit card for business expenses.
- Keep logs. Keep a logbook for business miles. Keep receipts for business meetings and meals. Include the date, time, subject, and who was present at the meeting.
- Ordinary and necessary. Two key words to use to qualify legitimate, deductible business expenses per the IRS are;
- Ordinary: an expense that is common and accepted in your industry.
- Necessary: an expense that is helpful and appropriate for your business.
- Business not hobby. A qualified business activity allows for direct deductibility of appropriate expenses, where-as hobby activity expenses are only allowed as a miscellaneous itemized deduction subject to passing a 2% adjusted gross income threshold. There are many facets here, but key among them is a profit motive and active participation in the activity to qualify your activity as a business.
Just because the IRS focuses their audit activities in this area does not mean you should be reluctant to take appropriate deductions. Just be prepared to defend your position with excellent records.
With a sigh you are relieved that yet another tax return has been sent off to the government. Another 12 months before you need to do this again. But before you close that tax file, there is still some work to do. If the IRS or state revenue department selects your return for review, you will need to be prepared. Here is what you need to know:
Record Keeping Tips
- Normally three years. Normally tax records should be kept for three years from the later of the tax filing due date, the date you filed your taxes, or the date you paid your tax in full.
- Some documents should be saved indefinitely. This includes things like:
- Your tax return
- Records related to a home purchase or sale
- Stock transactions
- Business/Rental records
- The IRS does not require any special record keeping system. You just need to keep all documents that can support information on your tax return.
- Here are common records worth retaining:
- Canceled checks
- Other proof of payment for claimed deductions
- Bank and credit card statements
- Mileage logs
- Receipts with time; place; and purpose noted
- Be mindful of other record retention requirements
- State record retention requirements are often 6 months to 1 year longer than Federal requirements
- Social Security records often need to be proofed to ensure they match your pay stubs
- Insurance, banking, and estate management may require other records
- Federal retention requirements become 6 years if your return understates your tax obligation by more than 25%, and the record retention period is indefinite if fraud is involved.
Keep a good system
So the build up of paperwork does not overwhelm your attic, at the end of the tax year rotate your records. Decide how many years of records must be retained. Then count back from your current tax return filing year and shred unneeded, older documentation. Create new empty files for the current tax year to save receipts for the coming year. Consider scanning records to keep digital copies. A final word of caution. If you are unsure whether to retain or shred, keep it unless you know the document can be replaced.
Very few banks return your cancelled checks. So what do you need to do if required by the IRS to prove your deductions? Often this means staying ahead of the game at year-end.
Year-end is a good time to ensure you have proper documentation to substantiate your tax deductions. This is important as many banks start deleting online documentation that is over one year old.
Two things have happened over the past ten years that have greatly reduced the ability to have a canceled check as proof when the auditor comes calling. The first is the advent of online bill paying services. The second is a regulation that was passed in 2003 commonly known as Check 21. With online bill paying, you pay a bill via an online banking service. Your only receipt is often just an entry in your checking account. With Check 21, the law allows banks to digitally capture the check and then destroy the paper copy without returning it to you. So what do you do if you need proof that you paid for a tax deductible item?
- Know your bank. Understand what your bank keeps and for how long. This includes digital statements and digital copies of checks (both front and back). Understand if there are any fees charged if you need to request copies of payments.
- Retain copies of all bank statements. Review your records to ensure you have copies of all monthly bank statements. This is often the starting point for an IRS agent that wants proof of payment, so it should be yours as well. These copies may be in either paper or digital format. Download online copies of your statements and place them in a password protected file.
- Collect copies of tax related proof of payment. Go through your statements and mark the payments that will, in all likelihood, be used as a tax deduction. Make sure you have copies of the front and back of each of these payments. If you do this work now, the copies are often still available online for no fee. Even online bill payments often have a digital copy that can be used.
- Get independent acknowledgements. If you have larger payments you should also make sure you have independent acknowledgement from the merchant or organization to substantiate the deduction. This is true for charitable contributions of $250 or more, and any business or medical expenses.
While having the traditional “proof” of an expenditure is now harder to come by, the IRS understands that approved technologies are changing the type of substantiation available for them to review. By being on top of this documentation at the end of each year, you can save yourself a lot of headaches should you ever need to prove your deductions.