Beware: These Tax Return Red Flags Could Catch the Eye of the IRS

Tax time can be one of the most hated times of the year. Just preparing the forms is enough to be an irritant, and if you owe the government money there’s a good chance that you’re downright annoyed. But neither of those things compare to the feeling that accompanies an envelope bearing an IRS return address, alerting you to the fact that your taxes are about to be audited.

The truth is that audits are relatively rare in the United States. As much as people fear them, the IRS reports that between 2010 and 2018 only 0.6% of individual tax returns resulted in an audit. That may make you feel better, but statistically speaking that still means that more than 250,000 taxpayers had to go through the process. In many cases the audit process could have been avoided had the taxpayers simply known what we’re about to spell out for you – that there are specific triggers that send up IRS red flags and frequently lead to an audit process.

The red flags include:

Disparities Between Information on Tax Forms and Reported Income
Whether you’re a W-2 employee or self-employed, the IRS will compare the income information that you report on your tax forms with the W-2 and 1099 forms that are sent by those individuals and entities that have paid you. If the two don’t match, the IRS is going to want to know why.

Disparities Between Business Income and Business Expenses
Just as the IRS will respond when your tax form income and reported income don’t match, the same is true for businesses that report business expenses that don’t make sense. In some cases, they are looking for people who are trying to take business expense deductions for what is really a hobby rather than a business. Many times these disparities are the result of actual expenses incurred for which income went unreported. Though there is always the chance that the odd numbers are an accident, such as the result of duplication of employee and business expenses, that oversight can lead to the discomfort of an audit, so take the time to double and triple check before filing your tax forms.

Outsized Charitable Contributions
Our tax system awards charitable contributions with tax deductions, and though that has proven to be a powerful incentive for some, it has also served as a temptation. To counter this, the IRS has created an automated computer program that analyzes nearly every return to identify figures that seem outsized as compared to an individual’s income, as well as other factors that are commonly abused. The system assesses each return based on numerous factors and assigns a DIF, or Discriminate Function, score. If your return exceeds the IRS DIF score threshold, there’s a good chance you’re headed for an audit.

Disparities Between Lifestyle Expenses and Reported Income
As with other mismatches found on tax returns, the IRS is particularly sensitive to returns in which taxpayers take deductions for expenses reflective of a high income living and yet report income that is much more modest. Paying personal property taxes, real estate taxes and taking mortgage interest deductions for million-dollar lifestyles will raise a red flag if the income you’re reporting is not enough to support it.

When You Happen to Hit Right on the Income to Expense Ratio You Need to Qualify for the Earned Income Credit
To claim the Earned Income Credit — which can be as high as $6,660 for tax year 2020 — taxpayers’ income has to be below a certain level, and if you’re a business owner whose return includes a Schedule C to prove all offsetting expenses, there is a particular ratio that you need to achieve in order to qualify. In most cases a business will either be somewhere below the ratio or above the ratio: They’ll either qualify for a larger earned income credit or they won’t. If the number hits exactly at the level needed to qualify for the larger credit, the IRS is more likely to ask for a closer look to see if numbers on either side of the equation have been manipulated.

Disproportionate Itemized Deductions
If you qualify to itemize, then you’re entitled to take deductions for qualifying expenses. But in cases where itemized deductions seem disproportionately high, the IRS is likely to ask some questions. If the expenses are legitimate and you’re able to present documentation, you’ll be fine, but make sure that you hold onto all receipts, as there’s a good chance that you’ll be called in for an audit.

One important thing to remember: You may have been able to deduct unreimbursed employee business expenses in the past, but that stopped being true for federal income taxes after tax year 2017. Some states, including California, still permit those deductions on state taxes, so make sure that you maintain receipts for those returns as well.

Lapses in Reporting Cryptocurrency Transactions
Bitcoin and other virtual currency transactions have led to plenty of tax return headaches, as in the last several years approximately 10,000 taxpayers have failed to report gains or losses on this innovative currency. To address the issue, the IRS has taken to sending taxpayers letters providing a chance to take part in a voluntary disclosure program. The agency is clearly on the watch for and acting upon this particular red flag. In addition, the IRS has added a question to the 1040: “Did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?” Of course, if you answer no and later it is determined you did, then you have committed perjury since you sign your return under penalty of perjury.

Rental Property Expenses that Appear to be Inflated
One of the most common reasons for tax returns to be flagged is rental expenses that appear to be inflated. Taxpayers who prepare their own returns and who report deductions for rental income on their Schedule E need to ensure that they fully understand that some deductions are allowed and some need to be capitalized over time, as not knowing which is which could lead to a return being flagged. There are also special and rather complicated rules associated with renting a vacation home, room rentals and short-term rentals.

Two People Claiming the Same Dependent
It is not at all uncommon for families that split custody of a dependent as a result of separation or divorce to alternate the years in which they claim a dependent, but if mistakes – or fraud - are detected and both are claiming the same individual, that will be sure to trigger an audit. Proving custody will require documentation, including school records and birth certificates.

Not Understanding Which Filing Status to Use
Though the head of household filing status is extremely useful, it can also be confusing and lead to mistakes when filling out status, and especially regarding how dependents are treated. Though the Tax Cuts and Jobs Act of 2017 was supposed to simplify the tax form process, in this particular area it made things even more complicated by introducing a new $500 credit for ‘qualifying relatives’, which is defined by certain tests that may make people not related to the taxpayer eligible as a dependent while not making the taxpayer eligible for the head of household filing status.

Failure to Report Overseas Accounts
Whether it generates taxable income or not, if you are a U.S. citizen or U.S. resident with interest in, authority over, or signature authority on foreign financial accounts that exceed $10,000 at any time during the calendar year, you are required to report them to the U.S. Treasury Department under the Bank Secrecy Act. The appropriate form to be filed is the Report of Foreign Bank and Financial Accounts, or FBAR. Failing to disclose these accounts can have significant repercussions and are likely to be discovered as a result of disclosure requirements placed on foreign financial institutions.

In Case of Audit
The goal of providing this information is to fend off the possibility of red flags ever being raised on your tax filing. However, if one of those envelopes with the IRS return address appears in your mailbox, contact us immediately.

 

  101 Hits

Increased Business Meal Deductions for 2021 and 2022

If you recall, the Tax Cuts and Jobs Act (TCJA), effective beginning in 2018, eliminated the business-related deduction for entertainment, amusement or recreation expenses. However, it did retain a deduction for business meals when the expense is ordinary and necessary for carrying on the trade or business and is not lavish or extravagant, along with some other requirements noted below.

Under TCJA, the business-meal deduction continues to be 50% of the actual expense. Also remember that business meals must be documented, including the amount, business purpose, date, time, place and names of the guests as well as their business relationship with you.

Great News – For 2021 and 2022 only, the Taxpayer Certainty and Disaster Tax Relief Act of 2020 allows businesses to deduct 100% of business meal expenses under the following circumstances:

  • The food or beverages must be provided by a restaurant. The use of the word “by” (rather than “in”) a restaurant makes it clear that the new rule isn’t limited to meals eaten on the restaurant’s premises. Takeout and delivered meals provided by a restaurant are also fully deductible. 
  • The expense is an ordinary and necessary expense paid or incurred during the taxable year in carrying on any trade or business.* 
  • The expense is not lavish or extravagant under the circumstances.* 
  • The taxpayer or their employee is present at the furnishing of the food or beverages.* 
  • The food and beverages are provided to a current or potential business customer, client, consultant or similar business contact.* 

IRS regulations expand on the last requirement by explaining that to be deductible, the food or beverages must be provided to a “person with whom the taxpayer could reasonably expect to engage or deal in the active conduct of the taxpayer’s trade or business such as the taxpayer’s customer, client, supplier, employee, agent, partner, or professional adviser, whether established or prospective.”

Where food or beverages are provided at an entertainment activity, the food and beverage must be documented separately from the entertainment because entertainment is not deductible. Also, be cautious of the requirement that food or beverages be provided by a restaurant to be eligible for 100% deductibility pending IRS regulations defining what constitutes a restaurant.

*Meals and beverages not provided by a restaurant will be deductible but limited to a 50% deduction of the expense if otherwise meeting the qualifications of a business meal.

If you have questions about how this 100% meal deduction might apply to your business, please give our office a call.

  45 Hits

How Biden's Rescue Plan Might Impact Your Taxes

President Biden released his “American Rescue Plan” on January 14. It is a wish list of proposals he wants Congress to enact to address the COVID-19 pandemic and associated economic crisis. While some of the proposals are intended to be in effect for just one year, it isn’t too great a stretch of the imagination that these could later be extended or made permanent, as many of them have been on the Democrats’ agenda for some time. The anticipated cost of the American Rescue Plan, if all of the proposals are agreed to by Congress, is $1.9 trillion. None of Biden’s proposals are revenue raisers, and according to a January 15, 2021 Wall Street Journal report, he intends to use government borrowing to pay for his plan. Following are some of the tax-related proposals.

Stimulus (Economic Impact) Payments: Biden’s plan requests that Congress provide an additional stimulus payment of $1,400 to qualified lower income households. Combined with the $600 that Congress authorized in December legislation, this will bring the latest total direct assistance to $2,000 per person. The prior stimulus distributions included stipends for dependent children under the age of 17, whereas the proposed payments will be provided for all dependents regardless of age.

So far, the payments have counted as advances toward a 2020 Recovery Rebate Credit. This is so even for the second round of payments that didn’t reach recipients until early January 2021. Individuals will need to reconcile the payments they received and the credits they are entitled to on their 2020 returns. Whether the proposed additional payments will be considered part of the 2020 credit (which could delay some 2020 return filings) or as an advance toward a new 2021 credit will need to be clarified in the legislation.

Unemployment Compensation: This part of the plan requests that Congress provide a $400-per-week unemployment insurance supplement through September 2021, and extend the unemployment benefits to self-employed workers such as ride-share drivers and many grocery delivery workers, who do not typically qualify for regular unemployment compensation. Presumably, the $400-per-week enhancement would be in lieu of the $300-per-week benefit passed in the Consolidated Appropriations Act in December 2020. In any event, the unemployment benefits are taxable income for federal purposes; most states also tax this income, but a few do not.

Raise the minimum wage to $15 per hour.

Education Assistance: The CARES Act, passed in late March 2020, included a Higher Education Emergency Relief Fund that provides funding to institutions to provide emergency financial aid grants to students whose lives have been disrupted by the COVID-19 pandemic. Emergency financial aid grants to students are nontaxable and can be used for expenses related to the disruption of campus operations due to coronavirus (including eligible expenses under a student’s cost of attendance, such as food, housing, course materials, technology, health care, and child care). Biden’s proposal would increase funding for the Higher Education Emergency Relief Fund, including providing college and university students with up to an additional $1,700 in financial assistance from their institutions.

Families First Coronavirus Response Act: This part of the American Rescue Plan requests that Congress fund an extension of sick leave through September 30, 2021, which would provide over 14 weeks (up from 12) of paid sick and family and medical leave to help parents with additional caregiving responsibilities when a child or loved one’s school or care center is closed; for people who have or are caring for people with COVID-19 symptoms, or who are quarantining due to exposure; and for people needing to take time to get the vaccine. The maximum payment would be increased from $1,000 per week to $1,400 per week.

Under Biden’s plan, the exemptions for businesses with over 500 employees and those with fewer than 50 employees would be eliminated, making the program mandatory for all sizes of businesses. The government will reimburse employers with fewer than 500 employees for 100% of the cost.

Increase the Child Care Tax Credit: Currently, a nonrefundable tax credit is available to some taxpayers for the expenses they incur for the care of a child, spouse, or other dependent while the taxpayer is gainfully employed (or is seeking a job). The maximum expenses that can be used to determine the credit are $3,000 for one child and $6,000 for two or more children. The credit rate ranges from 20% to 35% depending on income (the higher the income, the lower the credit rate).

Biden’s plan requests Congress to authorize an increase in the child care credit and make it refundable for one year. The credit would be a full 50% of the expenses, with maximum expenses of $4,000 for one child under age 13 and $8,000 for two or more children. The credit would be phased out when income ranges from $125,000 to $400,000.

Child Tax Credit: For years 2018 through 2025, the child tax credit is a maximum of $2,000 per dependent child under the age of 17. In some cases, up to $1,400 of the credit is refundable. The credit phases out when the taxpayer’s modified adjusted gross income exceeds $200,000 ($400,000 for married joint filers). Biden is asking Congress, for a period of one year, to include children through age 17 in the credit and increase the Child Tax Credit to $3,000 ($3,600 for children under the age of 6).

Earned Income Tax Credit (EITC): Childless adults are eligible for a lesser earned income tax credit amount than if they had a qualifying child. Biden’s plan requests that Congress make a one-year increase in the EITC for childless adults from roughly $530 to $1,500 and increase these individuals’ income limit for the credit from roughly $16,000 to $21,000. Biden also would also like Congress to eliminate the age cap so that older workers without a qualifying child can claim the credit (currently, a childless individual cannot claim the credit after reaching age 65).

Healthcare Coverage: Individuals who purchase their health insurance through the government marketplace may be eligible for a premium tax credit, with an advance premium tax credit (APTC) used to reduce monthly premiums, and the advance and actual credits reconciled on their income tax return each year. Biden’s plan asks Congress to increase the premium tax credit so that workers will pay no more than 8.5% of their income for coverage.

Although not tax-related, other issues in the plan affecting individuals include:

Evictions and Foreclosures: President-Elect Biden is calling on Congress to extend the eviction and foreclosure moratoriums and continue applications for forbearance on federally guaranteed mortgages until September 30, 2021, as well as to provide funds for legal assistance for households facing eviction or foreclosure.

Homelessness: The plan requests that Congress provide $5 billion to help secure housing for the approximately 200,000 individuals and families.

Remember, these are only Biden’s proposed changes; quite often, what Congress ends up passing is not the same as the originally proposed legislation. If you need assistance or have questions related to other tax issues, please give our office a call.

  91 Hits

4 Questions Business Owners Should Consider During the 2020 Tax Season

As if 2020 wasn’t challenging enough, this season’s tax-filing is going to be even more complicated than usual. Though the CARES Act and the Paycheck Protection Program were put into place to help small businesses, the old adage about “no such thing as a free lunch” is proving true once again as business owners sit down to gather their documents and realize just how big an impact the changes will make on what they can and can’t deduct, on payroll tax, and many other elements of their filing. We encourage you to speak with our office as soon as possible so that you can get some insights into the specific effect on you and your business. Start by asking these questions and go from there.

I took a Paycheck Protection Program loan. How will it impact my taxes?

The PPP loans were attractive because they were forgivable if used for the intended purposes. Normally, under tax law, when debt is forgiven it becomes taxable income. However, by law the PPP loan forgiveness is also tax exempt, which means it is not taxable income. The IRS had taken the position that the business expenses paid for with the forgiven loan proceeds would not be deductible expenses for tax purposes. The passage of the COVID-Related Tax Relief Act in December 2020 has overridden the IRS’s interpretation in Rev Ruling 2020-27. Thus, the expenses are fully deductible even though the loan is forgiven. CAUTION: This may not be true for state tax purposes.

I deferred my payroll taxes. When are they due?

As part of the CARES Act, employers struggling with making payroll were offered a life raft in the form of a deferral of the employer’s portion of their employees’ Social Security payroll taxes. The deferral applied to the 6.2% Social Security tax on wages paid for the period from March 27, 2020 to the end of the year. If you are one of the many businesses that chose to take advantage of the deferral, you will need to pay the first half of what’s owed by December 31, 2021 with the balance due one year later on December 31, 2022.

How does the CARES Act impact how net operating losses are handled?

Back in 2017, the Tax Cuts and Jobs Act eliminated the net operating loss (NOL) carrybacks for most businesses, but under the CARES Act, NOL carrybacks are allowed for tax years 2018, 2019 and 2020 in the form of a five-year carryback That means that for each of the last three tax years you can carryback losses five years and any unused NOL is then carried forward until used up. You can also elect to forgo the carryback and carry the losses forward, whichever provides the best outcome for your business. The CARES Act also suspended the rule that the taxable income of the carryback or carryforward year can only be reduced by 80% as a result of the NOL. That suspension only applies to NOLs originating in 2018, 2019 and 2020.

I had employees working remotely in different states. Will that affect my taxes?

One of the biggest tax headaches introduced by the pandemic has been the effect of having employees working in different states. Though in most cases these temporary changes will not have an impact, it is important that you ask your accountant about your specific situation, as some states have introduced new tax regulations in order to recoup some of their tax losses.

Additionally, if your business is like many others and you are considering making remote work permanent, then any employees living and working in other states may put you in the position of having to pay those states’ business taxes as well as withhold state income tax on the employees’ wages.

Understanding the full impact of this past year may take a long time, but for right now, business owners need to address the challenge of preparing their taxes. Start speaking with our office as early as possible so that you have plenty of time to come up with a workable strategy.


If you have questions related to how charitable contributions might affect your tax return or how to document charitable contributions of any type, please call our office.

  43 Hits

Charitable Contributions Deduction Liberalized for 2021

As a means to stimulate charitable contributions during the COVID crisis, Congress made two notable changes for 2020—one allowing taxpayers that don’t itemize their deductions an above-the-line deduction for cash contributions of up to $300 and another for those itemizing their deductions to increase the maximum deduction for cash contributions to 100% of their adjusted gross income (AGI).

The recent COVID-related tax relief act, passed late in December, extends and enhances those liberalized charitable contribution deduction provisions. Here is a rundown on these charitable contribution tax benefits for 2021:

  • Charitable Contributions for Non-Itemizers – The Taxpayer Certainty and Disaster Tax Relief Act allows those who don’t itemize their deductions a deduction of up to $300 for cash contributions made during 2021. Married couples filing jointly are allowed a deduction of up to $600 for the cash contributions they make during 2021. This is an increase from 2020, when the contribution was limited to $300 regardless of filing status. However, contributions by non-itemizers to new or existing donor-advised funds or private foundations don’t qualify for either year.

    For 2021, the $300 or $600 amount is an add-on to a non-itemizer’s standard deduction. Claiming the deduction as part of the standard deduction for 2021 may not be quite as beneficial tax-wise for some taxpayers as was the deduction for 2020. This is because on 2020 returns the cash contributions, up to $300, are deducted in computing adjusted gross income, while on 2021 returns, the deduction will be taken after the AGI is figured. This distinction matters because many credits and other tax benefits are limited by the AGI amount.

    Apparently, Congress anticipates that non-itemizers will abuse this new deduction by taking the deduction without actually making a contribution. In a preemptive attempt to head off such behavior, Congress also increased the accuracy-related tax penalty from 20% to 50% on an underpayment of tax resulting when a non-itemizing taxpayer improperly claims the charitable contribution deduction. 

  • Cash Contributions for Itemizers – Under the CARES Act that was enacted in March 2020, the 60% deduction limit on cash contributions to most charities was suspended for 2020, thus allowing larger cash contributions during the COVID crisis—potentially up to 100% of the AGI. Under the Taxpayer Certainty and Disaster Tax Relief Act of 2020, the suspension of the 60% limit has been extended to 2021.

Cash contributions include those paid by cash, check, electronic funds transfer or credit card. Taxpayers cannot deduct a cash contribution, regardless of the amount, unless they can document the contribution in one of the following ways:

  1. A bank record that shows the name of the qualified organization, the date of the contribution, and the amount of the contribution. Bank records may include:
    a. A canceled check,
    b. A bank or credit union statement or
    c. A credit card statement. 
  2. A receipt (or a letter or other written communication) from the qualified organization showing the name of the organization and the date and amount of the contribution. 
  3. Payroll deduction records that include a pay stub showing the contribution and a pledge card showing the name of the charitable organization. If the employer withheld $250 or more from a single paycheck, the pledge card or other document must state that the organization does not provide goods or services in return for any contribution made to it by payroll deduction.

To claim a deduction for a contribution of $250 or more, the taxpayer must have a written acknowledgment of the contribution from the qualified organization that includes the following details:

  • The amount of cash contributed; 
  • Whether the qualified organization gave the taxpayer goods or services (other than certain token items and membership benefits) as a result of the contribution and a description and good-faith estimate of the value of any goods or services that were provided (other than intangible religious benefits); and 
  • A statement that the only benefit received was an intangible religious benefit, if that was the case.

Thus, for example, money dropped in a Christmas Kettle or tacked onto your purchase at a retail store would not be deductible because there is no documentation that the contribution was made.

If you have questions related to how charitable contributions might affect your tax return or how to document charitable contributions of any type, please call our office.

  71 Hits