Who is afraid of the big bad…

Tax filing season is in full force and many of my clients express a healthy fear of the IRS. Any agency that has the legal power to tax and take ALL of your money should be respected. However the chance of the IRS showing up at your door is slim(apologies to Wesley Snipes and Lauryn Hill).

Now as the IRS wades through the reported 5 million letters received during the government shutdown and is rumored to start issuing funds 22nd of this month, you should be aware that there will be delays on any reviews for the 2018 tax year. Clients whose returns stray far away from the norm or have “large, unusual or questionable items” can always be singled out for an audit(look out of the return fee tied to refund guy). So, if you decide to take that big unsubstantiated deduction don’t be surprised by a letter come fall of 2020. But overall, as the statistics bear out, the IRS likes to audit clients with certain characteristics.

To start, individuals get audited far more than business and specialty taxpayers. In 2017, the IRS reported a 1 in 184 (0.542%) chance of being audited for all taxpayers. For taxpayers filing individual returns, the likelihood of audit is 1 in 161 (0.623%). Corporations (1120, 1120-S) and partnerships are audited less than individuals — with an audit rate of 1 in 224 (0.445%). In 2017, the IRS audited only 1 in every 568 (0.176%) employment tax returns (Forms 940/941).

Individual Taxpayers who file Schedule C’s or the Earned Income Credit are most likely to get audited. The IRS generally focuses its efforts on those traditionally to be more non-compliant: small businesses, international clients, high-wealth clients, and possible Earned Income Tax Credit fraud schemes. Traditional wage earners who have only W-2 incomes face much less scrutiny.

You are much more likely to get a notice for underreporting of income with what is called a CP2000 form. So if you have had multiple jobs or are unsure about a freelance position that may have warranted a 1099 always be sure to contact the employer and/or request a wage and income transcript from the IRS to verify all income to avoid a penalty for a failure to report.

In an effort to defeat any audit we all will need to be aware and compliant to the guidelines the IRS gives on what can be deducted and how you prove it. Here are some tips for you small business owners that gives guidance on these items.

Deduct It!

A trade or business is defined in code section 162. Code section 162 discusses expenses that are incurred in a trade or business, expenses that are ordinary and necessary in a trade or business.

To qualify for a deduction, the expense must be: 1. Paid or incurred during the taxable year; 2. Paid or incurred for carrying on a trade or business; 3. Ordinary; and 4. Necessary.(Your nice clothes may be “necessary” for you to look good but not to the IRS for you to conduct business ☹)

Cash basis taxpayers generally deduct expenses only when paid, while an accrual basis taxpayer may deduct expenses under the “all events test” when: (1) all events have occurred that determine the fact of the liability; (2) the amount of the liability can be determined with reasonable accuracy; and (3) economic performance has occurred.

In general, an expense is “ordinary” if it is considered normal, usual, or customary in the context of the particular business out of which it arose. An expense is “necessary” if it is appropriate and helpful to the operation of the taxpayer’s trade or business. The determination of whether an expenditure satisfies the requirements for deductibility under Code section 162 is a question of fact. However it is up to the taxpayer to prove the validity of any expenses. To prove the validity the taxpayer would be required to show: (1) the date of the expenditure; (2) the amount of the expenditure; and (3) the business purpose of the expenditure. If the deduction is related to the use of property (i.e., depreciation), the taxpayer must also document the amount of the business use of such property and the total use of the property for the tax year.

To meet the “adequate records” requirements of Code section 274(d), a taxpayer must maintain an account book, diary, log, statement of expense, trip sheets, or similar record and documentary evidence which, in combination, are sufficient In General to establish each element of an expenditure or business use of property. It is not necessary to record information in an account book, diary, log, statement of expense, trip sheet, or similar record which duplicates information reflected on a receipt so long as the taxpayer-kept account book and third-party’s receipt complement each other in an orderly manner.

Hopefully this hasn’t put you to sleep. But the key takeaway of the story is, keep good records and receipts, don’t intermingle personal and business transactions and keep information for at least 3 years. Remember the IRS does not call or email they only send mail those would be scams otherwise. And lastly if you break any of the tax law make sure to do it wisely (just making sure you are still paying attention). If you would like more information on any of these items feel free to contact us directly. Have hump day!

Author: Terrance Hutchins

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