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Archive for Audits

Increase Your Tax Deductions—Switching from the IRS Mileage Rate to Actual Expenses

By Kim M. Larsen EA CTFS
Friday, February 27th, 2015

Do you feel like you’re not getting as much as you should from your business vehicle mileage deductions? For some business owners, gas and maintenance for a vehicle can be significant business expenses. If you’re not already using the actual expense method to calculate your mileage deduction, that may be your ticket to getting more from your vehicle expenses.

Usually, you’ll make a decision once regarding whether to use the IRS mileage rate for your deductions or to use the actual-expense method. If you choose the IRS mileage rate, you also lose out on MACRS depreciation.[1] However, you’re not locked into your choice forever. You have two different options for switching to claiming actual expenses.

Option 1: Amending Your Tax Return

If you realize fairly quickly that you’ve made the wrong decision in choosing to use the IRS mileage rate, you can act quickly and change your decision. That means you’ll have to file an amendment to your tax return before its original due date (if you filed extensions, the deadline includes the extensions).[2]

This option is fairly easy to enact. You’ll file the amendment, electing actual mileage expenses, Section 179 deductions, and MACRS depreciation. But, you have to act fast. This method essentially replaces the election on your original tax return.

Option 2: Straight-Line Depreciation

If you’ve already missed out on your chance to amend your return, you do have other options. You could still switch to the actual-expense method with MACRS depreciation, but you’ll have to get permission from the IRS commissioner . . . if you enjoy wasting time and money with the possibility of rejection.[3] Let’s be smart here; the commissioner is not a good option.

Instead, you can opt for straight-line depreciation for the remainder of your vehicle’s useful life.[4] This allows you to make the actual expense deductions. For calculating the straight-line depreciation, you’ll need the following information on your vehicle:[5]

  • Its Adjusted Basis—This is typically the original cost of the vehicle minus depreciation. When you use the IRS mileage rate, depreciation is included in it (22 cents per mile in 2014 and 24 cents per mile in 2015).[6] If you pay $30,000 for your car and drive it 5,000 miles for business (with no personal miles), you would calculate your depreciation at 5,000 miles x $0.22, which equals $1,100. Your adjusted basis is $28,900 ($30,000 – $1,100).
  • Its Estimated Remaining Useful Life—You don’t need to think too hard about this. It’s simply how long you expect to keep the vehicle.[7] We’ll call it 5 years for our example.
  • An Estimate of Its Salvage Value when the Useful Life Ends—To get a salvage value, you should use a respected pricing source, such as Kelly Blue Book. In our example, the value is what you estimate you could sell the vehicle for in 5 years (the remaining useful life). Let’s say this number is $4,000. Don’t forget to document where you get this number from!

Now, when you switch to actual mileage expenses, the IRS gives you a bonus on the salvage value if you plan to keep the vehicle for more than three years. Our example vehicle meets that requirement, which means you can reduce the salvage value by $3,000 (10 percent of the basis). If 10 percent of the basis exceeds the salvage value, that’s no problem. You’ll simply claim a salvage value of zero.

An Additional Consideration

When claiming actual expenses, you’ll have to pay attention to the luxury vehicle depreciation limits. These apply to passenger vehicles, and the limits differ between cars, vans, and trucks. You’ll need to find the amounts for the year you placed your vehicle in service.

For 2014 the limits for cars placed in service that year are:

The limits for vans and trucks are:

Note: These are amounts for used vehicles only. If your leased or purchased a new vehicle, use the tables in Rev. Proc. 2014-21 . Regardless of the type of vehicle or whether it is new or used, you must reduce the limit by your personal use. So, if you use your car for 80 percent business and 20 percent personal purposes, your first year limit is $2,528. If these limits affect your depreciation, you can simply claim the rest of the depreciation in a later year—you do not lose it.

Some vehicles are exempt from the luxury limits. Your truck, van, crossover, or SUV may be exempt if it 1) is classified as a truck by the Department of Transportation, and 2) has a gross vehicle weight rating over 6,000 pounds. Note that some passenger trucks are not classified as a “truck” by this definition.

If you don’t like the choice you made for your mileage deductions, you can fix it. If you catch it early, you’ll still get all the additional benefits that come with the actual-expense method (Section 179 expensing and bonus depreciation). However, if you make the switch later, you can still get some benefit from actual expense deductions with straight-line depreciation. What you need to know is that the choice to switch is available to you.

  1. Rev. Proc. 2010-51; IRC Section 168(f)(1) ↑
  2. Reg. Section 301.9100-2(d) ↑
  3. Rev. Proc. 2011-14, Appendix 6.02 ↑
  4. Rev. Proc. 2010-51 ↑
  5. IRS Pub. 534, Depreciating Property Placed in Service Before 1987, (Rev. Nov. 1995), p. 7 ↑
  6. Notice 2014-79; http://www.irs.gov/2014-Standard-Mileage-Rates-for-Business,-Medical-and-Moving-Announced ↑
  7. IRS Pub. 534, Depreciating Property Placed in Service Before 1987, (Rev. Nov. 1995), p. 7 ↑
Categories : Audits, Business Expenses, Cars, Trucks & SUVs, Depreciation, Listed Property, Tax Planning

Do You Own Multiple Businesses? Consider this Tax Advice for Passive Losses

By Kim M. Larsen EA CTFS
Friday, February 27th, 2015

Any time one of your businesses experiences a loss, you want to be able to claim those losses on your tax return. Unfortunately, the passive loss rules can stand in the way of these deductions, unless you plan ahead. In case you don’t already know the passive loss rules, here’s a breakdown of the requirements for deducting passive losses:

  1. You must participate materially in the business that has losses in order to deduct those losses (or if you group the business with another, you must actually participate in the group); or
  2. If you do not participate materially in the business, you must have other sources of passive income that you can deduct the losses against.

Grouping to Claim Passive Losses

Here’s a likely scenario. A medical doctor owns a medical practice, and she would like to open a physical therapy business, but she does not plan to actually work at the new business. Someone else will handle management of this business, and employees will provide the services. The doctor understands that the business will likely lose money for the first couple of years.

However, the doctor does not have any other source of passive income; her only other business is the medical practice in which she actively participates. Therefore, she has to figure out some other way to avoid passive loss rules and claim her deductions. Aside from deducting the losses from other passive income, she could also wait to deduct the losses in total when she gets rid of her entire interest in this passive business.[1] But, she doesn’t want to do that—she wants the deductions now because she doesn’t plan on selling this business for quite some time.

As you can see from the above points, one option for getting around passive loss rules is to form a group from the multiple businesses you own. So, in order to deduct those losses, she groups her new physical therapy business with her medical practice. “Wait a minute,” you may say. Even if she groups these two businesses together, doesn’t the physical therapy business still have only passive income?

It turns out that in order to meet the material participation requirements, you can group your business together to form suitable economic units.[2] That means the businesses and business activities within the grouping must make sense together based on these factors (quoted from IRS Publication 925):[3]

  1. The similarities and differences in the types of trades or businesses,
  2. The extent of common control,
  3. The extent of common ownership,
  4. The geographical location, and
  5. The interdependencies between or among activities.

Note that each business may conduct multiple sets of activities, and any entity structure may group its businesses or activities into one.[4] Even if you are the sole owner of three business that conduct four separate business activities, you can group all of these into one. Your material participation in the grouping then allows passive loss deductions for any of the business activities.

If you want to take advantage of such a common ownership grouping, you’ll need to make the election on your tax return and attach a disclosure statement.[5] Additionally, you’ll need to attach a statement with your tax return for any year that you add another activity to an existing group or regroup a grouping that was inappropriate. If you group inappropriately and don’t follow the requirements, you could end up losing your deductions because the activities will be treated separately.

Your disclosure statements should include the names, addresses, and employer identification numbers for each of the businesses being grouped together. Once you’ve made the election to group, you’re good to go with claiming deductions on an activity’s passive losses, so long as you meet the material participation requirements for the group. What that typically means is you have to participate in the combined businesses for at least 500 hours per year. Going back to our doctor, if she works at the medical practice for 1,968 hours in the course of a year and never does any work at the physical therapy business, she has met the 500-hour test for the entire group.

Not everyone has two business interests that make sense together as an economic unit. If you, like the doctor, are considering opening a second business, but your second business operates in a completely different way from the first, you may not be able to take advantage of grouping. When that’s the case, you should ask yourself, “Is it even worth it to start a business I cannot deduct losses for?” Remember, your tax deductions can make a big difference in your yearly profit.

Basically, you want to make sure the plans you make for your business ventures are the best choices for your bottom-line. Grouping elections are easy to make for the single-owner business, and the rules apply to real estate rentals, as well. So, if you have taxable income you’d like to offset, grouping may be a solution for your business.

  1. IRC Section 469 ↑
  2. Reg. Sections 1.469-4(a); 1.469-5T(a)(1) ↑
  3. Reg. Section 1.469-4(c)(2). ↑
  4. Passive Activity Loss Audit Technique Guide (ATG), Training 3149-115 (02-2005), Catalog Number 83479V, p. 4-2. ↑
  5. Rev. Proc. 2010-13 ↑
Categories : Audits, Business Expenses, Passive Income & Losses, Receipts, Records, Tax Planning

When Investments Go Wrong: IRS Safe Harbors for Ponzi Scheme Losses

By Kim M. Larsen EA CTFS
Friday, February 27th, 2015

It’s been several years since Bernie Madoff confessed to taking billions of dollars from investors in his fake asset management division. But, Ponzi schemes existed well before Madoff pulled off his extravagant plot, and you will always come across people who think they can skirt the law (and ethics in general). Sometimes, these “opportunities” seem like legitimate investments until you start looking at the statements. So, what do you do if you’ve been caught in a Ponzi scheme?

First, know that you do have some protection. You “invested” your money, so you can’t just get it all back unfortunately. You live and you learn. However, you are eligible to claim tax-deductible losses on that money. The problem is that you’ll have a heck of a time proving your Ponzi scheme losses in the year of the loss, which could really hurt your finances.[1] Luckily, the safe harbor laws grant additional protection. Legislation passed in 2009 allows losses from a Ponzi scheme to be carried back 5 years on your taxes, as long as you are eligible[2].

So, what do you do when you find yourself victim to investment fraud?

Using Tax Law Safe Harbors

First, you should know that you are not required to use the Ponzi scheme tax relief safe harbor. But, you’d be silly not to. If you don’t invoke the safe harbor rules, your losses will be deducted using the general rules for theft loss, which means jumping through more hoops and possibly being audited. Yes, you read that correctly. Regarding taxpayers who choose not to use the safe harbor, the IRS has stated:

Returns claiming theft-loss deductions from fraudulent investment arrangements are subject to examination by the [IRS].[3]

That means being audited.

When the IRS actually threatens you with an audit, you should probably take it seriously. And, what about those general theft rules? If you forego the safe harbors, you’ll be required to prove:[4]

  • The loss actually was theft;
  • You claimed this loss on your taxes the year you found out about it (which can be difficult to prove);
  • You have the exact dollar amounts lost, with documentation; and
  • You cannot reasonably expect to recover the loss through reimbursements in the year you found out about the theft and claimed the deductions.

All in all, it’s just easier to follow the safe harbor rules. In fact, you’ll have a much nicer time of it with the IRS if you do.[5] Here’s how it will work when you use the Ponzi scheme tax relief safe harbor laws:

  • You will be able to deduct the fraudulent scheme as a theft loss.
  • You will be able to deduct the loss the year the scheme was found out (i.e. when the perpetrator was indicted, or when the perpetrator either admits guilt or has their assets frozen following a federal or state criminal complaint).
  • Your losses will be calculated with the safe-harbor formula.

Using the safe harbor rules, you have less evidence to provide, and the deduction process is simpler for you to complete. You should know that the IRS often disagrees with deductions for theft loss. Safe harbor rules prevent that.

How Safe Harbor Amounts are Calculated

Before you can take advantage of the safe harbor, you’ll need to show that you are in compliance with its requirements by providing statements of the following (under penalty of perjury):[6]

  • The name of the Ponzi scheme perpetrator;
  • Confirmation that you have written documentation to back up your deduction amounts;
  • Your declaration of status as a Ponzi scheme victim and qualified defrauded investor; and
  • Confirmation that you will abide by all terms of declaration.

This information will need to be attached to your tax return.[7] Also, in this statement, you will show your loss deduction calculations for the discovery year, as follows:[8]

  1. The starting number is your original investment.
  2. Add all of your subsequent investment amounts.
  3. Add any money that was supposedly reinvested on your behalf and that you claimed on your tax returns as income (but for which you received no cash payments from the perpetrator).
  4. Subtract any withdrawals you made from the investment fund. The resultant number is your qualified investment.
  5. Next, determine whether you are a Ponzi victim with possible third-party recovery.
  6. Determine your net qualified investment. If you do have possible third-party recovery, you will multiple the qualified investment amount from step 4 by 75 percent. If you do not have possible third-party recovery, multiply the qualified investment amount by 95 percent.
  7. List any money you actually recovered from the Ponzi scheme (through any source) in the year you are making a deduction.
  8. List the totals for any agreements that protect you from the loss, including insurance policies, contracts, and amounts you are entitled to by the Securities Investor Protection Corporation (SIPC).
  9. Add together your total recoveries from step 7 and step 8.
  10. Finally, you will subtract the answer in step 9 from the answer in step 6 in order to get your gross theft-loss deduction.

It’s all pretty straightforward. As long as you kept all of your statements, and financial and insurance documents, you’ll have everything you need. In subsequent years, you’ll make adjustments for an additional recovery income or for increased losses in the case that your reasonably estimated recovery claims were too low.[9]

Typically, personal theft is subject to certain reductions before it can be claimed as a tax deduction.[10] First, the amount is reduced by a flat $100. Then, you reduce the remaining amount by 10 percent of your AGI. Fortunately, Ponzi scheme victims are not subject to these reductions; individuals can claim the full deductible amount, and businesses can claim the full business casualty loss amount.

Why the IRS Wants You to Follow Safe Harbor Rules

Do you really benefit from using the safe harbor calculations for your deductions? Let’s look at what you agree to give the IRS:

  • You will only deduct the amounts calculated in their formula (in the year the scheme was discovered);
  • For taxable years that precede the year of discovery, you will not amend or file tax returns that re-characterize or exclude income;
  • You will not claim Section 1341 benefits for your Ponzi scheme loss (restoration of an amount under the claim of right doctrine); and
  • You will not use the mitigation provisions of Sections 1311–1314 or the doctrine of equitable recoupment.

The IRS has made a strong statement against claiming the rights and provisions in that last bullet point.[11] It’s always a gamble going against the IRS in a situation that will likely end up in court. You could win the case, but will it be worth the time, money, and effort to challenge it?

Prevention

By being educated in financial matters and paying attention to your personal and business finances, you can avoid Ponzi schemes. For one thing, you should never, ever give someone else complete control of your money. The best advice is to always know exactly what you are investing in and not making financial decisions that you don’t understand—even if everyone else is doing it. The government also has some guarantees set up to help people avoid losses: Federal Deposit Insurance Corporation (FDIC) and the Securities Investor Protection Corporation (SIPC).

Aside from avoiding fraudulent investments and being aware of government protections, you have a couple of other options for reducing your risk. One way is to have insurance on your investments. Making the investments yourself (rather than having someone else handle it) is the another way to avoid investment fraud losses. If you feel nervous about making these decisions on your own, know that you have resources from the Internet, news publications, financial magazines, and television, and just because someone says they are a financial expert doesn’t necessarily mean they know more than you do.

Even if you do hire an investment advisor to help you make decisions, you should always maintain control of your funds yourself. Never let an advisor have direct access to your money. You can reduce your chances of needing these safe harbor rules in the future if you ask questions about your portfolio and always know what is happening with your money.

  1. Rev. Proc. 2009-20, Section 2.03 ↑
  2. IRC Section 172(b)(1)(H) ↑
  3. Rev. Proc. 2009-20, Section 8.03 ↑
  4. Rev. Proc. 2009-20, Section 8.01 ↑
  5. Rev. Proc. 2009-20, Section 5.01 ↑
  6. Rev. Proc. 2009-20, Appendix A, Part III ↑
  7. Rev. Proc. 2009-20, Section 6.01 ↑
  8. Rev. Proc. 2009-20, Appendix A, Part II ↑
  9. Rev. Proc. 2009-20, Section 5.03; Rev. Rul. 2009-9, Law and Analysis, Issue 3, Year of Deduction ↑
  10. http://www.irs.gov/pub/irs-pdf/p547.pdf ↑
  11. Rev. Rul. 2009-9 ↑
Categories : Audits, Casualty Losses, Investments, Records, Tax Planning

Make Your Records Rock Solid to Avoid Audit

By Kim M. Larsen EA CTFS
Sunday, February 8th, 2015

This article isn’t about any particular way to save money on your taxes. However, it will make a huge difference in your taxes no matter what strategy you use for your tax return. Even the absolute best tax methods can leave you at the mercy of an auditor when you don’t properly document and keep records. Sure, you may think it’s a hassle, but is putting in a few hours up-front on an organized record-keeping system worth thousands, even tens of thousands, of dollars in tax savings? You bet!

The Rules of Record Keeping

Here’s the fact—the IRS is never just going to take your word for it that you spent X number of dollars on justifiable and legal business expenses that are now tax-deductible on your return. Sorry, no documentation, no deduction.

So, with that in mind, here’s the first rule you need to know.

Rule #1 Always keep your accounts separate. In fact, you should have separate checking accounts for:

  • Each spouse,
  • Each corporation,
  • Each Schedule C business you report, and
  • Your rental properties (you may even want a few separate accounts for these if they are very different kinds of rentals).

How about an example of why this is so important. Let’s say you own a sole proprietorship, and you cover your spouse under a Section 105 medical reimbursement plan. If you’re using one checking account jointly for your household and your business, you would have to write the reimbursement check to yourself—and that negates your Section 105 plan.

That’s exactly how Darwin Albers lost out on deductions for his 105 plan.[1] Keep your business and personal accounts separate—just do it.

Rule #2 Earnings go to the account belonging to the business that earns the money. Do not take payments in your personal name. If you do, they cannot be assigned to your corporation. The person or entity that earns any given income is taxed for said income.[2] If you follow the rule above, then it’s easy not to mix personal receipts into your business account and vice versa. Although it’s possible to argue with the IRS that some receipts in a given account are not taxable, it’s not worth the frustration and wasted time.

Rule #3 Keep track of your deductible expenses each day. Don’t wait until two weeks from the purchase to write down your expenses (or save them in your file). For one thing, it increases the chance that you may miss something. For another, the IRS requires that deductible expenses are recorded within one week. The idea of doing daily record keeping may make you want to just toss your files over your shoulder (don’t—you’ll hate reorganizing them up later), but it really is good practice. After all, how hard is it to save a receipt and make a note about why you spent the amount?

Rule #4 Keep a log for each set of expenses. For most deductions, you need evidence that proves your business use or business purpose for the expense. Want to deduct vehicle expenses? Keep a log to track daily mileage. Want to deductions on your rental properties? You’d better keep track of how you materially participate in your real estate or how you qualify for status as a real estate professional. Planning to make deductions for your home office? Again, you need a log, this time to keep track of how many hours you spend working in that office. You’ll have to consistently spend more than 10 hours per week working from your home office in order to claim it on your tax return.[3] By keeping track on a daily basis, you can take advantage of the sampling method of calculating your deductions in some cases (such as vehicle mileage); this method allows you to take a sample from a three month period rather than calculating the exact sums.[4]

Rule #5 Keep track of travel and entertainment costs. For travel expenses, you have to prove (with documentation) where you were each day and why. Your business entertainment costs also need proper documentation, including what you spent money on, how much, when, and where the expense occurred. Your receipt will cover all of those, but you’ll additionally need to note who you entertained and why (i.e. the benefit to your business).

In the case that you operate your business as a corporation, you’ll have to turn the expenses in to your company. You can do this by paying with a corporate credit card, or you can have the corporation reimburse you for the expenses. Making sure the company pays is important; otherwise you’ll only get employee-business deductions for those expenses.

What to Remember

No matter what kind of business costs you incur, you need to remember these two primary pieces of information: 1) prove what you bought and 2) prove that you, in fact, paid for it. As mentioned above, a receipt or paid invoice covers the first part of this. In order to prove payment, you can use a credit card receipt or statement, canceled check, or bank statement (for electronic transfers). Note: An item is considered paid for when you charge it to your credit card, regardless of when you pay the amount to your card.[5]

Don’t pay with cash. It makes things more difficult for you. If you pay with cash, an auditor will want to know where the cash came from, how you can show cash trail and tie it to the payment, whether you can prove an ATM withdrawal, and most importantly, did you really pay for something in cash or are you just making up a deduction? Paying with pretty much any other method is much less of a hassle.

A Note on Petty Cash

Petty cash works for some small businesses. If it’s what you’re accustomed to and you haven’t had any problems, then by all means continue using the system. However, many small business owners end up kicking themselves in the pants with a petty cash system. You’ll likely find it easier to use a reimbursement system.

With the reimbursement system, your company simply writes you a check for the expense when you provide documentation for it (a receipt or expense report, for instance). Because you have to present documentation for reimbursement, you’re less likely to get caught without evidence for your spending, as you could with petty cash.

Statutes of Limitations and How Long to Keep Records

The IRS has statutes of limitations on when either you or it can make changes to a tax return (this is not just the period during which they can audit you). Here are the time frames given in IRS publications:[6]

  • No limit if you did not file a return
  • No limit if you filed a fraudulent return
  • Three years after filing if you filed on time (or with extensions), you did not understate your income by 25 percent or greater, and you did not file fraudulently
  • Six years after filing if you filed on time (or with extensions) but you understated your income by greater than 25 percent
  • If you filed an amended return or already made changes to the original return (like a quick refund claim), either three years after filing or two years after paying the tax
  • Seven years from filing for a claim filed for a bad-debt deduction or loss from worthless securities

If you have employees, you need to save your employment tax records for four years after whichever date comes later, the date payroll taxes were paid or the date they were due.

Because these statutes of limitations also indicate how long the IRS can audit your return, you need to ensure that you hang on to all of your records until the risk of audit has passed. This could mean keeping records for a period of multiple years. In the case of assets, like office equipment and office buildings, the records are relevant throughout the asset’s entire depreciable class life. As long as you are still depreciating an asset, it will be in that year’s tax return. When using Section 179 to expense an asset, you also have a potential recapture throughout the depreciable class life.

Here’s an example. You buy a desk for $1,500 and depreciate it over the MACRS life of seven years. This depreciation actually takes eight years, so you need the original purchase receipt in year eight in order to prove your deduction. Additionally, you will need to retain that purchase record for three years after that when the statute of limitations expires (for a total of eleven years). It works the same with Section 179, except that you also have recapture exposure during those eight years of depreciation.

Would you like an easy way to keep track of this? Just make a permanent file for any assets with a life greater than one year. This way, you don’t need to keep track of class lives or time frames on the statutes of limitations.

And, here’s another quick tip for keeping those records organized:

Simplify your file system by devoting separate drawers for each tax year. In those drawers, you’ll put any information on assets, income, and other information applicable to your return. This method is for assets other than those you keep in your permanent file. The first drawer will be where you put all documents as you acquire them throughout the year. The next drawer is last year’s tax documents. The drawer after that contains documents from three years ago, and so on until you reach the year at which your statute of limitations expires. Each year, you move the drawers down one level and dump the one at the bottom of the line. You can also use this method for any employee tax files.

You see? It really isn’t all that difficult to keep your records straight. You’ll be thankful you did when it comes time to prepare your return.

  1. Darwin J. Albers v Commr., TC Memo 2007-144. ↑
  2. United States v Basye, 410 U.S. 441, 449, 451 (1973); Lucas v Earl, 281 U.S. 111 (1930). ↑
  3. John W. and Regina R. Z. Green v Commr., 78 TC 428 (1982), reversed on other grounds, 707 F2d 404 (CA9, 1983). ↑
  4. IRS Reg. Section 1.274-5T(c)(3)(ii)(C), Example 1. ↑
  5. E.g., Rev. Rul. 78-38; Rev. Rul. 78-39. ↑
  6. IRS Pub., 583, Starting a Business and Keeping Records (Rev. January 2007), Record Keeping. ↑
Categories : Audits, Business Expenses, Cars, Trucks & SUVs, Depreciation, Entertainment, Receipts, Records, Tax Planning, Travel

The Relationship between Your Salary and Your Taxes

By Kim M. Larsen EA CTFS
Tuesday, February 3rd, 2015

It’s no secret that the more money you earn from your S corporation, the higher your tax bracket. But, have you actually run the numbers to see what damage—if any—your current salary is actually doing? If not, it’s time you did. As a business owner, you can’t leave financial matters to chance.

A big, fat salary may look nice, but it could actually be losing you money. By capping your own income at the proper amount, you can save yourself thousands of dollars in taxes. The old adage, “A penny saved, a penny earned” certainly applies when it comes to dealing with tax brackets.

Calculating the Right Number

Some may think the solution is to dramatically reduce your salary, but watch out for that tactic! If you set your salary too low, this can also arouse the suspicion of the IRS and elicit an audit. Did you know that if you set your salary unusually low, you could end up paying not only back taxes, but also penalties and interest? Luckily, this article is your guide to getting the amount right—for the most advantage and least audit risk.

The IRS actually has guidelines to setting reasonable salaries for S corporation owners. Keep in mind these are just guidelines created by the IRS—not tax law—but playing by IRS rules goes a long way towards reducing your chances of audit. The good news for you is that a few recent court cases help taxpayers like you to understand how these guidelines are held up (and how you can justify your salary).

Salary Case Examples

First, let’s look at how reducing your salary lowers your payroll taxes. For a sole proprietor earning $100,000 in business income for the year, $14,130 will be paid in self-employment taxes.[1] However, if you form an S corporation and give yourself a salary of $50,000, you pay only $7,650 of payroll taxes between yourself and your corporation combined.[2] That’s nearly $6,500 in tax savings! The remaining $50,000 can be considered a distribution, and those are not subject to payroll taxes.[3]

To see how all this is viewed by the IRS, let’s examine the results of precedent cases:

  • The S Corporation Accountant—David Watson operated his accounting business as an S corporation.[4] His corporation also happened to be a 25 percent partner in an accounting firm. For several years, the firm paid Watson’s corporation more than $200,000. Watson’s self-appointed salary, however, was only $24,000. As you can guess, this is far below the average salary for an accountant.

In fact, the IRS determined that for the area of the country where Watson did business, a reasonable salary was more like $91,044. They came to this conclusion using the Management of Accounting Practice survey conducted by the American Institute of Certified Public Accountants, which listed compensation. For an accountant with no investment interest, average salary was $70,000.

However, Watson did have investment interest. Considering that owners billed at rates 33% higher than directors, the IRS’s valuation expert then increased the reasonable amount by 33% and decreased that amount to reflect fringe benefits that were not taxed—coming up with the $91,044.

In the end, the court sided with the IRS expert and Watson’s salary was adjusted to the more reasonable number. He still took the majority of his income payroll tax-free as distributions (giving him bigger savings than he would have as a sole proprietor), but he got hit with $23,431.23 in payroll taxes owed, penalties, and interest.

  • The Real Estate Professional—Sean McAlary entered the real estate business before the housing crash.[5] His success allowed him $240,000 in distributions from his S corporation in 2006. The mistake he made was taking absolutely no salary—$0—despite being entitled to $24,000, according to corporate minutes.

Using methods similar to those above, the IRS valuation expert determined a reasonable salary of $100,755. Using the California Occupational Employment Statistics Survey, the expert found real estate brokers’ median wage to be $48.44 per hour. That wage was then multiplied by a 40-hour work week and again by 52 weeks. This was despite evidence that McAlary actually worked longer hours and rarely took days off. The court adjusted this finding slightly, and McAlary’s salary for tax purposes was considered to be $83,200, still making distributions a majority of his income.

  • The Glass Blocks Manufacturer—Frederick Blodgett produced glass blocks to be used in homes and other real estate. Unfortunately, the construction industry in his area had a bad year in 2006, and his company felt the fall.[6] So, in the following two years, he ended up loaning his S corporation $55,000. The corporation’s net income for each of the two years was $877 and $8,950.

For 2007 and 2008, Blodgett drew no salary from his corporation. Instead, he took what he described as a mix of distributions and loan repayment, in a total of $30,000 per year. His plan was not viewed his way by the court. The “loans” were deemed capital contributions, making 100 percent of his corporation’s payments to him distributions.

It was decided by the IRS, and held up by the court, that the $30,000 per year distributions would be assigned as Blodgett’s salary. Rather than doing calculations like those in the above cases, the IRS simply stated that someone in Blodgett’s field would make at least that much. The decision gave Blodgett’s business a net loss for the year.

Applying the Lessons

You can see a few tips from these examples. First of all, when setting your salary, consider what other professionals in your field make in your area. Being self-employed, you may not always be able to match yourself to a single profession with compensation statistics. In that case, choose a best match that you can reasonably back up.

Of course, you are also a business owner, so after comparing wages, you’ll need to adjust for several factors. Decrease your wage to account for:

  • Your business’s profit relative to similar businesses in your area (if your profits are smaller);
  • The number of hours you work (if you work less than full-time); and
  • Factors that contribute to your corporation’s success outside of your own personal efforts (for instance, unusually good market conditions for a particular year).

If you’re able to reduce your salary by a reasonable amount because of one of these circumstances, be sure to document your reasoning in the corporate minutes. The lower salary will give you big savings on payroll taxes, as long as it remains reasonable.

As a final note, you do not have to take a salary if your S corporation is not making a profit.[7] Just be prepared by understanding that taking distributions in a year you don’t take a salary is a major red flag to the IRS. If you don’t take a salary in a particular year, try to eliminate or at least minimize the distributions you take.

Reducing your salary is a legal tax strategy for S corporation owners. As long as you don’t take it to the extreme, the technique is an easy way to keep more of your cash. So, research comparable salaries in your area, adjust it downward if you can do so justifiably, and always document your strategy.

  1. Assuming a 15.3 percent self-employment tax rate is applied to 92.35 percent of the income. See Schedule SE for rate details. ↑
  2. $50,000 x 15.3 percent. ↑
  3. Rev. Rul. 59-221. ↑
  4. Watson v US, 668 F.3d 1008 (8th Cir.). ↑
  5. Sean McAlary Ltd, Inc., TC Summary Opinion 2013-62. ↑
  6. Glass Blocks Unlimited, TC Memo 2013-180. ↑
  7. See Davis, d/b/a Mile High Calcium, Inc. v US, 74 AFTR 2d 94-5618. ↑
Categories : Audits, Corporations, Payroll, Tax Planning

If You Have an IRS Audit Coming Up, Make Sure You Have the Tax Law on Your Side

By Kim M. Larsen EA CTFS
Wednesday, January 28th, 2015

When you have to go toe-to-toe with the IRS, make sure you keep the fight clean. The only way to succeed when arguing your case with an auditor is to follow the IRS’s own procedures. And, the primary way to do that is—you guessed it—keeping proper documentation. With this article, you’ll better understand where tax authority is derived, what rules the IRS must stick to, and what rules the IRS accepts.

Remember Who You’re Dealing With

As you prepare to make your case by checking the appropriate tax rules, remember that the auditor will be your primary audience. You want to build evidence that convinces the IRS. Although it’s possible that your audit could go to court, most do not. It is likely that the auditing process will stay with the IRS, so prepare yourself for that likely scenario.

A good place to start is with the IRS forms themselves, as well as guides, instructions, and other IRS publications. These are not a source of “substantial authority”,[1] but you can begin your research with them in order to get an overview of the particular tax issue you’re looking at. Just be sure you don’t end your research with these documents because they don’t always give the full story. When using these as part of your argument, however, you can be assured knowing that the IRS is unlikely to go against its own advice, even from a non-technical document.

Another type of non-technical documentation is internal IRS guides. These are made for employees, but copies are available to the public. Some examples include the Internal Revenue Manual, chief counsel advice, and audit manuals. They will give you an idea of how the auditor may be evaluating your situation.

Although both public and internal guides are easy to read compared to technical documents, you don’t have much support if you depend solely on them. To support your tax strategy more effectively, you’ll need a document with greater authority.

In order to make your best case, you should remember the following tax-document hierarchy:

  1. Statues and Regulations. Both the IRS and the courts can be persuaded by appropriate statutes and regulations.
  2. Case Law. Prior case law is often the next most convincing proof with the court.
  3. IRS Documents. For the IRS, the next best source is IRS documents, but some are better than others.

It is important to remember that tax laws change all the time. No matter how good you think your authority document is, it does little to help you if a more recent law has been enacted. New statutes even supersede prior Supreme Court rulings. When you need to back up your tax return during an audit, always make sure you check for any updates in the laws.

Here are some specific examples of good authority documents:

  • Tax Codes—Statutes in the tax code are always the best authority with the IRS. If possible, find the particular statute (i.e. tax code provision) that specifically addresses your situation. Throughout the process, keeping your argument focused on that provision. As mentioned above, tax statutes are the highest authority in these situations, so if the relevant law does not uphold your case, then don’t try to use a next best authority. Instead, attempt to settle with as little payment due from you as possible. The time that another source of authority comes in handy is when the language in the pertinent tax code is too general (as it often is), and you need additional support for your tax strategy.
  • Treasury Regulations—Regulations have almost the same weight as statutes, but the statute takes precedence in the case of any differences between the two.[2] Regulations fall into one of three categories: 1) final, 2) temporary, or 3) proposed. When Congress passes a new statute, the Treasury drafts temporary regulations that are valid for three years. After that, they expire. However, for the period they are valid, temporary regulations are equal in authority to final regulations.[3] In addition, older temporary regulations never expired, and you may find some that are still being used. Proposed regulations carry less weight than the other two types. Their strength is in persuading the IRS because they represent its official position, but they don’t mean as much in court.

A note on out-of-date regulations: Treasury regulations are not updated every time the tax code changes. Because of this, it’s not uncommon to find regulations intended for a law that no longer exists or exists in a newer version. But, that doesn’t necessarily mean the IRS has stopped using the regulation. Even the courts may treat these as relevant law! The only way to know if a regulation is still in use is to research cases, legal treatises, and IRS documents.

Strategy for Talking to the IRS

At the start of your audit, you’re going to be discussing the issues with auditors and agents. These are the typical IRS worker bees. They are knowledgeable about what they do but will be mainly concerned with IRS documents. They probably won’t delve into statutes or court cases. If your case advances, you will then deal with the supervisors and officers, who bring in the tax code and regulations (and possibly court cases). Just remember that at all levels, IRS employees put emphasis on IRS documents.

One of the best sources to build your argument with is an official pronouncement from the IRS. These are sent out in the Internal Revenue Bulletin, which is “the authoritative instrument of the Commissioner of Internal Revenue for announcing official rulings and procedures.”[4] All of these bulletin pronouncements are binding for the IRS, so you have a good case if one of the pronouncements supports your audit strategy. The problem is that they can be confusing to read. You’ll want to make sure you’re clear on what the actual IRS position is.

Here are several types of official pronouncements that provide good backing (the highest on the list are the best sources):

  • Revenue Ruling—These are the IRS’s own examples of how they apply their rules to particular sets of facts.
  • Revenue Procedure—These are IRS instructions on how to use their documents. Revenue procedures also include updates to monetary amounts to adjust for inflation.
  • Acquiescence or Non-Acquiescence—A good item to have if you plan to use a court case as evidence, these are statements of IRS agreement or disagreement with a particular court ruling.
  • Notices and Announcements—Providing the least authority (but still useful) are notices and announcements, which indicate the IRS’s official position regarding present issues.

Non-binding documents can also be useful. If you’re uncertain about a tax strategy you plan to use, you can request a private letter ruling (PLR) from the IRS prior to filing your tax return.[5] This allows you to get the okay for your strategy before filing, thus avoiding tax penalties. You will have to pay for the PLR. Technical advice memoranda (TAM)[6], which can be initiated either by the IRS or by you, are also an option and have the same level of authority as a PLR.

If you receive a PLR or TAM, you’ll see a disclaimer at the bottom that states “This ruling is directed only to the taxpayer who requested it. Section 6110(k)(3) provides that it may not be used or cited as precedent.” This is the IRS’s way of telling you that this is only their opinion on the law and that you should not rely on it. Regardless, these rulings (though not binding) are important guidance. Since it comes from the IRS, it is directly useful in dealing with auditors or agents. Furthermore, these documents can be useful in court if no better authority exists for the issue in dispute.

Speaking of court, when do prior court rulings come into play with the IRS? Here are two reasons you’ll want to include them in your research, even if your audit does not go to trial

  1. Lawyers are well-known for including as many words as possible, and their evidence is thorough. From case law, you can often find all of the regulations, statutes, and forms or other documents needed to support your own argument. Go ahead and pluck those citations right out of the case documents!
  2. If your audit goes to appeals (the highest level of review at the IRS), appeals officers will consider court cases when making their decision.

What If Your Case Goes to Court?

In the event that your case does go to court, your previous research for the auditing process will help immensely. For the most part, you’ll need all of the same types of documentation. The biggest difference is that prior court cases will now be a higher authority than IRS documents. Statutes and regulations will still be your best sources of documentation.

Be aware that your case will not necessarily go to tax court. Federal tax cases can also be taken to:

  • A federal district court,
  • A court of appeals,
  • The court of federal claims, or
  • The Supreme Court (but this is rare).

What is important when choosing the right cases as support for your tax strategy is to choose those that come from the same court your hearing is at, or those from a court of higher authority. Since the tax court specializes in tax law, it is the most cited source. Make sure you know how much authority your particular example case carries. The cases from tax court will be cited as follows:

  • T.C. or TC—This is a regular tax court decision, and the only kind that counts as official precedent.
  • T.C. Memo, TC Memo, or T.C.M.—The tax court memorandum can help your case, but they carry less authority.
  • T.C. Summary Opinion or TC Summary Opinion—Documents labeled summary opinions are not particularly helpful. They carry little authority and do not count as precedent.

It is possible to take your tax dispute to an appeals court after the initial hearing. Keep in mind that different judges make different judgments. That means what a judge in another jurisdiction decides may not be the same as the conclusion the judge in your circuit (i.e. region) comes to. In most circumstances, the tax court will rule in accordance with the circuit where your tax issue originated,[7] but the job of judges is to interpret the laws, and interpretation varies. Tread carefully by being as prepared as possible.

  1. Reg. Section 1.6662-4(d)(3)(iii). ↑
  2. Mayo Foundation v U.S., 131 S.Ct. 704. ↑
  3. IRC Section 7805(e). ↑
  4. This is in the introduction of all bulletins. See a list at http://apps.irs.gov/app/picklist/list/internalRevenueBulletins.html. ↑
  5. Rev. Proc. 2013-1. ↑
  6. Reg. Section 601.105(e)(iii). ↑
  7. Golsen v Commr., 54 T.C. 742. ↑
Categories : Audits, Business Expenses, Precedent, Receipts, Records

What the Statute of Limitations Means for Your Tax Records

By Kim M. Larsen EA CTFS
Monday, January 26th, 2015

When you went into business, chances are you weren’t imagining grand evenings filled with paperwork. Maybe you thought tax records were a thing you would think about once a year and have your accountant deal with. But, the truth is, as you progress in business, you come to realize that record-keeping for your taxes needs regular maintenance. In fact, even after you breathe a sigh of relief once that return has been double-checked and sent off to the IRS, you may need to make a change to the document.

That’s where the statute of limitations comes in. It refers to the periods of time during which both you and the IRS may make changes to your tax return (not just audits). Those time frames are clearly delineated in IRS publications[1].

Here they are:

  • No limit if you did not file a return
  • No limit if you filed a fraudulent return
  • Three years after filing if you filed on time (or with extensions), you did not understate your income by 25 percent or greater, and you did not file fraudulently
  • Six years after filing if you filed on time (or with extensions) but you understated your income by greater than 25 percent
  • If you filed an amended return or already made changes to the original return (like a quick refund claim), either three years after filing or two years after paying the tax
  • Seven years from filing for a claim filed for a bad-debt deduction or loss from worthless securities

Keeping Appropriate Records

Aside from letting you know how long you have to make changes to a return, the statute of limitations also lets you know how long the IRS has to audit your return. If an audit occurs, you are going to need all of your tax records to prove your deductions. What does this mean for your record keeping habits? Hang on to those records until any chance of audit has passed.

The following are a few guidelines for making sure you hold on to the appropriate records long enough:

  • Employment Tax Records—If you have employees, you need to save your employment tax records for four years after whichever date comes later, the date payroll taxes were paid or the date they were due. An easy way to do this is simply to keep six separate drawers in your filing cabinet for each tax year. Every year, discard the sixth drawer when it’s statute of limitations expires.
  • Records for Assets—You have certain assets that are pertinent to your tax return for as long as they remain in the depreciable category. Examples of such assets include your office building, computers, desks, and even your car. If you are depreciating those assets, they will be on your tax return. Otherwise, if you are using Section 179 to expense the assets, you may be able to recapture the depreciable class life.

For example, let’s say you purchased a desk for $1,500 and depreciate it over the seven year Modified Accelerated Cost Recovery System (MACRS) life, which takes eight years. You’ll still have to prove depreciation in the eighth year. So, you need the record of the original purchase in the eighth year and through the eleventh year to meet the three year statute of limitations (the time during which this purchase is subject to auditing). The example works the same if you used Section 179. Any assets with more than a one year class life should be kept in a separate, permanent file so they don’t get tossed out with files whose statutes of limitations have expired.

Record Keeping Tips

As mentioned in the section on employment tax records, you can simplify your file system by devoting separate drawers for each tax year. In those drawers, you’ll put any information on assets, income, and other information applicable to your return. The first drawer will be where you put all documents as you acquire them throughout the year. The next drawer is last year’s tax documents. The drawer after that contains documents from three years ago, and so on until you reach the year at which your statute of limitations expires.

In order to use this method, it’s important that you file your taxes on time or file an extension so you know for sure your specific time frames. At the end of each year, the last drawer gets dumped and you move the other drawers down, starting a new drawer for the current year. It’s really simple once you put the system in place. Record-keeping may seem tedious, but remember, it shows you where your business has been and where it’s going, like a runner trying to improve their time. You can’t improve the numbers if you don’t know what they are.

  1. IRS Pub. 583, Starting a Business and Keeping Records (Rev. December 2011), Dated Feb. 17, 2012, p 12. ↑
Categories : Audits, Business Expenses, Capital Gains, Payroll, Receipts, Records, Tax Planning

Are You a “Dealer” or “Investor” for Tax Purposes?

By Kim M. Larsen EA CTFS
Monday, January 26th, 2015

Tax law is forever classifying people and making structures that either create benefits or disadvantages on your tax return. Part of getting the most from your return is about understanding the definitions of the IRS. Two that seem very similar, but have distinctly different consequences on your taxes, are real estate dealer and real estate investor.

What’s the Downside of Each?

We’ll start by discussing the disadvantages. That’s right—there is no golden choice when trying to figure out if you classify as a dealer or an investor. In either case, there will be some disadvantages.

As a real estate dealer:

  • Your profits are taxed at both the ordinary income rates (up to 35 percent) AND the self-employment rates (up to 14.13 percent).[1]
  • You may not depreciate property that you are holding with the intention of selling.
  • You may not use the tax-favored installment method to report dispositions of your property.
  • And, you may not use the Section 1031 exchange to defer taxes on properties you hold as a dealer.

As a real estate investor:

  • You are subject to the net capital losses limit of $3,000 (applied after gains are offset against losses).
  • You must treat selling expenses as a reduction in sales proceeds, which means those expenses produce benefits at the capital-gains tax rates only.

Admittedly, the dealer gets the lesser deal when it comes to disadvantages. The investor does get to depreciate property, is allowed to sell using the tax-favored installment method, and may choose to use a Section 1031 exchange, thereby deferring taxes on a disposition.

What about the Up Side?

Every coin has a heads and a tails. And, it’s the same with tax designations. Both dealers and investors gain some advantages from their respective positions.

Advantages for real estate dealers include:

  • You are treated as a business and may treat most expenses as ordinary business deductions (advertising, commissions, legal fees, real estate sales, etc.).
  • Your property sale losses are not limited capital loss cap of $3,000 that limits investor properties.
  • Your losses are deducted as ordinary losses.
  • You get to deduct the entire loss (either immediately or using the net operating loss rules to deduct it over time—these rules allow you to carry back your losses up to five years and forward up to twenty years).

Advantages for real estate investors include:

  • Your sales profits are taxed at 15 percent or less, a tax-favored capital gains rate.
  • You are not subject to the self-employment tax.

Practical Application

So, what does all this mean for you and your business? Let’s run through some example numbers. For the example, we’ll say you have a $90,000 profit from a property sale. Based on the tax rates mentioned above, your taxes as a dealer could be as high as $36,370.[2] Your taxes as an investor might be as high as $13, 500.

You can clearly see that having your properties qualify as investment sales generates a considerable tax savings—potentially $22,870!

However, depending upon your business structure and activities, it may not be possible to define all of your property sales as investment sales. No problem. The IRS has no qualms with an individual taxpayer acting as part dealer and part investor. You read that right; you can balance the pros and cons of each situation. It’s simply a matter of taking each property on a case-by-case basis.[3]

Not so fast. You may think the IRS is giving you some kind of free gift by allowing this pick and choose method, but it’s not quite as unstructured as all that. You will be required to make a clear distinction in your record books. You didn’t think the IRS was going to let you off without documentation, did you? And, this means you must decide before-hand which route you’re going with each property sale. You cannot simply go back over your sales at tax time and assign designations. You will have to establish what your intent was with the sale—dealer sale or investment sale.

Tips on Documentation

Good documentation of your purpose and activities helps you to establish your case with the IRS. You should determine, and make note of, your intent for the property throughout the process:

  • When you purchase the property;
  • During your ownership; and
  • At the time you sell it.

If you keep records throughout the process (not just at the time of sale) it gives your case credibility. It’s important to keep in mind, however, that if your return is challenged in court, they will likely examine the sale when they rule on whether you acted as a real estate dealer or real estate investor on a particular property.[4] None of this means that your purpose may not change between the time you buy a property and sell it, but at least you will be prepared to understand and plan for such a scenario.

The All Important Point-of-Sale

Important: The point-of-sale is the most critical part of the process in determining your investor or dealer status. It’s often the deciding factor in IRS decisions. Although a single piece of real estate can have features of both dealer and investor property, it can only be treated as one or the other. Take a look at the characteristics of each from a tax standpoint.

  • Real Estate Dealer—First off, dealer property is held with the intention of being to customers in the ordinary fashion of business or trade.[5] If you buy and sell many properties throughout the year, you are likely a dealer regarding those properties.[6] Unfortunately, the IRS has not established any set number for determining dealer status, so it’s all about making your case. In fact, number is only one factor, and in previous rulings:
  1. A company earned dealer status with only one sale because it had already agreed on sale to a third party prior to purchasing the property itself;[7]
  2. A taxpayer, Mr. Goldberg, did not earn dealer status even with 90 home sales in a year.[8] In his case, the homes were built for rentals and used as such prior to the time of sale.

However, in the majority of cases, more sales equal dealer properties. In addition to the influence of the number of properties sold, real estate that you subdivide also has an increased chance of achieving dealer status,[9] except under Section 1237.[10] Removing a lien can also make a property more salable under the ordinary processes of business[11] (recall that dealer property is sold in the ordinary course of business).

Several other traits indicate a dealer business transaction over investment actions. They include active marketing and sales activities,[12] property held for a short period of time (indicating the intention to turn over the property for profit),[13] generally making your living as a dealer,[14] regularly buying and selling real estate for your own account,[15] and buying property with the proceeds from another property.[16]

  • Real Estate Investor—In contrast to dealer property, investor property is held with the intention of producing rental income[17] or appreciating in value. This means that investor properties are typically held for longer periods of time[18] and are not often sold, unlike the quick turnover of a dealer property.[19] Other situations in which a court may rule your property is an investor property include acquiring the real estate by inheritance,[20] dissolution of a trust,[21] or a mortgage foreclosure.[22] It’s even possible for you to make improvements to such property prior to selling it and still retain investor status.[23] [24] Just don’t put the proceeds into more real estate or subdivide the property[25] if you want to maintain that status.

If you don’t make clear in your documentation which type of property sale you are making, the IRS will make the decision based on their interpretation, and that is not the best situation for you! So, look at those characteristics above again. Since you’re going to know at the outset what your purpose is with each property, you can make sure to include as many of the appropriate features as possible well before the sale.

  1. The usual self-employment tax rate times the Schedule SE adjustment. ↑
  2. Assuming the real estate profits were your only income. ↑
  3. Tollis v Commr., T.C. Memo 1993-63. ↑
  4. Sanders v U.S., 740 F2d 886. ↑
  5. IRC Section 1221(a)(1). ↑
  6. Sanders v U.S., 740 F2d 886; Suburban Realty Co. v U.S., 615 F2d 171. ↑
  7. S & H, Inc., v Commr., 78 T.C. 234. ↑
  8. S & H, Inc., v Commr., 78 T.C. 234. ↑
  9. Revenue Ruling 57-565 ↑
  10. IRC Section 1237. ↑
  11. Miller v Commr., T.C. Memo 1962-198. ↑
  12. Hancock v Commr., T.C. Memo 1999-336. ↑
  13. Stanley, Inc. v Schuster, aff’d per curiam 421 F2d 1360, 70-1 USTC paragraph 9276 (6th Cir.), cert den 400 US 822 (1970); 295 F. Supp. 812 (S.D. Ohio 1969). ↑
  14. Suburban Realty Co. v U.S., 615 F2d 171. ↑
  15. Armstrong v Commr., 41 T.C.M. 524, T.C. Memo 1980-548. ↑
  16. Mathews v Commr., 315 F2d 101. ↑
  17. Planned Communities, Inc., v Commr., 41 T.C.M. 552. ↑
  18. Nash v Commr., 60 T.C. 503, acq. 1974-2 CB 3. ↑
  19. Rymer v Commr., T.C. Memo 1986-534. ↑
  20. Estate of Mundy v Commr., 36 T.C. 703. ↑
  21. U.S. v Rosbrook, 318 F2d 316, 63-2 USTC paragraph 9500 (9th Cir. 1963). ↑
  22. Cebrian v U.S., 181 F Supp 412, 420 (Ct Cl 1960). ↑
  23. Yunker v Commr., 256 F2d 130, 1 AFTR2d 1559 (6th Cir. 1958). ↑
  24. Metz v Commr., 14 T.C.M. 1166. ↑
  25. U.S. v Winthrop, 417 F2d 905, 69-2 USTC paragraph 9686 (5th Cir. 1969). ↑
Categories : Audits, Business Expenses, Capital Gains, Depreciation, Exchanges, Investments, Land, Leases, Passive Income & Losses, Receipts, Records, Rental Properties, Self-employment Tax, Tax Planning

Don’t Be a Target for the IRS

By Kim M. Larsen EA CTFS
Saturday, January 24th, 2015

If there’s one thing the IRS is most known and feared for, it’s the audit. It’s well-known by now that the IRS has had its eye on tax-exempt conservative groups, but what you may not realize is that they’ve now expanded that extra attention to entrepreneurs, owners of small businesses, and high income earners. This is atypical of their past trends, since they had previously focused efforts on watching large corporations. However, the number of revenue agents in the IRS has risen by more than 5,000 people in the last few years.

Who’s at Risk?

This expansion in auditing-capability primarily hits the upper-middle class and affluent individuals. Without raising taxes, this move has allowed the IRS to greatly increase total tax collections because more audits are performed and more revenue officers are available to collect unpaid taxes from citizens. Grumble if you will, but the decision-makers are probably pretty happy with their investment in extra workers. Estimates show that the IRS has an 18 to 1 return rate on each dollar invested in audits and collections.

Are you feeling confident that your business is too small to come under scrutiny? Think again. The IRS conducted a study involving 46,000 taxpayers, and the results indicate a $345 billion tax gap. Guess what else the study revealed—about two-thirds of that gap came from entrepreneurs, small business owners, professionals, and investors. The IRS has grown its means to act on suspicious tax returns, and it’s looking straight at you. That’s right; it’s moving about 30 percent of its auditors away from large corporations and using that workforce to scout out smaller prey.

What IRS Expansion Means for Your Tax Return

An audit can cost you a lot of money in professional fees, back taxes, interest, and penalties, so it makes sense to audit-proof your return now. Don’t assume that you make too little for the IRS to be concerned with you. Although the top earners have the highest audit risk (those earning more than $1 million have seen a dramatic increase in audit rates recently), even individuals making $200,000 are experiencing the effects of increased tax surveillance. Your risk of audit may not be as high as the 1 in 8 chance that millionaires now face, but it is trickling down to businesspeople with more modest incomes.

In order to understand why you may be audited, it helps to understand the process used by the IRS. It has several different methods for selecting returns for audit, and one that has been in use for decades is called the discriminant index factor (DIF). Basically, a mathematical formula is used to score a return, often based on the ratio of income to deductions. The process breaks down like this:

  • You send in your tax return, and the systems at Martinsburg West Virginia National Computer Center run the numbers.
  • Your return gets a DIF score. The higher the score, the bigger the chance that additional taxes may be able to be collected from you.
  • IRS employees audit the returns with the highest score first (i.e. the returns that will bring in the most additional revenue).

The formula for DIF scores is regularly updated using an analysis of intensive audits, the Taxpayer Compliance Measurement Program (TCMP). It’s conducted every few years. For a TCMP audit, every single piece of information on the return is analyzed. For people reporting business receipts on their personal income tax return (Schedule C and Schedule F), gross business income is used to determine DIF score, not net business income. Red flags that generate a high DIF result may lead to your receiving a letter of inquiry, or even the dreaded examination of your tax return.

Avoiding the Audit

After computer DIF scores are assigned to the returns, IRS employees then select which returns will be audited. This process usually starts later than June. A computer formula may assign you a high DIF, but in the end it is up to classifiers working in the district offices to determine whether your return raises red flags. So, even if a high DIF result brings your return under scrutiny, you can follow some simple rules to keep down your chances of being selected for audit.

Take a look at some basic tips for making your return less likely to be audited:

  • Balance Your Deductions—Risk of being scrutinized increases with the more deductions you take compared to the size of your income. Time your deductible expenses right so that they are fairly even on a year to year basis.
  • Always Respond to Inquiries—If the IRS sends you a letter regarding missing schedules, send a response! Failing to answer makes you much more likely to be examined.
  • Remember Form 8283—When you make a non-cash charitable contribution, you must include this form.
  • File Your AMT—The alternative minimum tax is separate from regular taxes. You’ll need to use Form 6251 and send it in with your 1040.
  • Document Your Casualty Losses—Casualty losses are already a red flag for the IRS. You definitely deserve any deductions you are entitled to for such losses, but be sure to document all information about the date of loss, cost, and any insurance payments you received. And, include this information with the return, not when they’ve flagged you for auditing.
  • Report Any 1099 Income—If a client of yours reports a 1099 to the IRS, you’d better make sure you report it on your tax return. When you don’t, it’s considered a matching issue, and you will be contacted about it. In the case that you are contacted about a mismatch issue, respond to the IRS immediately to prevent an escalation of the situation.
  • Use an Entity Structure—Filing a high number of gross receipts for your small business drastically increases your return’s chance of being examined. However, when you switch from reporting these on a Schedule C to reporting them as a corporation, partnership, or LLC, you significantly reduce that risk. Not only does using an entity structure lower your chance of being audited, it also decreases your taxes. It’s an excellent option to consider if you are functioning as a proprietorship or independent contractor.
  • File On Time—This one should go without saying, but turning in your tax return by deadline (including extensions) can help you to avoid examination.
  • File a Paper Return—Filing electronically may seem easy, but there’s a reason the IRS encourages taxpayers to use this method. An electronic return can go right into their DIF scoring system and be ready for analysis immediately. Rumor has it that only about half of all paper returns even get scored in the DIF system. Most taxpayers are required to use the electronic filing system. However, you can opt out by attaching IRS Form 8948 to your paper return.
  • Watch Out for the Big Three—IRS agents are coming down hard on deductions for travel, automobiles, and entertainment expenses. The secret to having these deductions approved is documentation, documentation, documentation. Quick and dirty tip: The IRS requires 5 pieces of documented evidence, but all you really need is your receipt! It covers 1) date of the expense, 2) where the expense occurred, and 3) amount of the expense. Then, you simply write on the back of the receipt 4) the business purpose for the expense and 5) your relationship to the person or group you entertained. Simple! Just don’t forget the receipt—the IRS does not count credit card statements as receipts. For automobile deductions, you’ll also need to keep a mileage log.

Electronic filing has made auditing easier (and a bigger priority) for the IRS. Now that they need fewer employees sifting through paper files, they have allocated a larger portion of their workforce towards audits and collections. With this increased strength, they have turned their eyes toward smaller entities, but you can audit-proof your return by providing accurate documentation and following these tips. Don’t let the IRS intimidate you into forgoing deductions you have a right to!

Categories : Audits, Business Expenses, Cars, Trucks & SUVs, Casualty Losses, Corporations, Entertainment, Tax Planning, Travel

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