IRS Audit Red Flags: The Dirty Dozen

Our clients often ask us how they can best avoid an audit. Audits can be stressful, time consuming, and altogether inconvenient. The best advice we can give is to 1) tell the truth, and 2) keep REALLY good records of all of your deductions.

There are specific items IRS agents look for when examining a taxpayer’s returns. A recent article from Kiplinger outlines the “IRS Audit Red Flags: The Dirty Dozen.”

Managing Your Tax Records

Ok, so your taxes are now filed. Woo hoo! This is a real cause for celebration. But what do you do now with your tax paperwork for this year? Use it to line your hamster cage?

The IRS has other ideas. Follow these tips from the IRS and you’ll be sure to keep the proper records:

1. Keep your tax records for three years (for you pack rats out there, longer is okay, too).

2. Documents related to capital transactions, such as a home purchase or sale, stock transactions, rental or business property, or retirement related assets, such as IRAs or 401ks, should be kept longer.

3. Documents may be kept in either paper or electronic form. The IRS suggests you keep any and all documents that may have an impact on your federal tax return.

4. Records you should keep include bills, credit card and other receipts, invoices, mileage logs, canceled, imaged or substitute checks, proofs of payment, and any other records to support deductions or credits you claim on your return.

5. For more info on what kinds of records to keep, see IRS Publication 552, Recordkeeping for Individuals, which can be found at http://www.irs.gov. We also have a handy Business Record Retention Schedule on our website, which you can find by clicking here. In this document we recommend how long to keep certain documents based on what category they fall under. (Please note: some documents should be kept permanently!)

If you are maintaining paper files of your tax documents, be sure to have a backup system in place in case you experience paper file loss. Your accountant may be able to offer you a paperless storage system or file backup solution to ensure you have quick, easy access to your tax documents in the future.

Delayed Tax Filing for Some Taxpayers

Three federal tax deductions were recently reinstated, thanks to tax law changes enacted a few weeks ago. Because of late Congressional action to enact these tax law changes, certain taxpayers will need to wait to file until mid- to late February.

IMPORTANT: the delay is for filing taxes, but you can begin preparing your taxes at any time. It is essential that taxpayers provide 2010 tax information to their preparers as soon as it is available. The sooner the returns are prepared, the faster your preparer will be able to file your returns when eligible.

Taxpayers will need to wait to file if they are within any of the following three categories:

• Taxpayers claiming itemized deductions on Schedule A. Itemized deductions include mortgage interest, charitable deductions, medical and dental expenses, and state and local taxes.
  
  
• Taxpayers claiming the Higher Education Tuition and Fees Deduction. This deduction for parents and students covers up to $4,000 of tuition and fees paid to a post-secondary institution. However, the IRS emphasizes that there will be no delays forthose claiming education credits, including the American Opportunity Tax Credit and Lifetime Learning Credit.
  
  
• Taxpayers claiming the Educator Expense Deduction. This deduction is for kindergarten through grade 12 educators with out-of-pocket classroom expenses of up to $250. The educator expense deduction is claimed on Form 1040, Line 23, and Form 1040A, Line 16.

The delay affects both paper and electronic filing of returns for those falling into one of the three above categories. The IRS emphasizes that electronic filing of returns is the fastest, best way for those affected by the delay to get their refund.

The New Tax Bill

The recently enacted “Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010” is a sweeping tax package that includes, among many other items, an extension of the Bush-era tax cuts for two years; estate tax relief; a two-year “patch” of the alternative minimum tax (AMT); a two-percentage-point cut in employee-paid payroll taxes and in self-employment tax for 2011; new incentives to invest in machinery and equipment; and a host of retroactively resuscitated and extended tax breaks for individuals and businesses. Here's a look at the key elements of the package:

• The current income tax rates will be retained for two years (2011 and 2012), with a top rate of 35% on ordinary income and 15% on qualified dividends and long-term capital gains.
• Employees and self-employed workers will receive a reduction of two percentage points in Social Security payroll tax in 2011, bringing the rate down from 6.2% to 4.2% for employees, and from 12.4% to 10.4% for the self-employed.
• A two-year AMT “patch” for 2010 and 2011 will keep the AMT exemption near current levels and allow personal credits to offset AMT. Without the patch, an estimated 21 million additional taxpayers would have owed AMT for 2010.
• Key tax credits for working families that were enacted or expanded in the American Recovery and Reinvestment Act of 2009 will be retained. Specifically, the new law extends the $1,000 child tax credit and maintains its expanded refundability for two years, extends rules expanding the earned income credit for larger families and married couples, and extends the higher education tax credit (the American Opportunity tax credit) and its partial refundability for two years.
• Businesses can write off 100% of their equipment and machinery purchases, effective for property placed in service after September 8, 2010 and through December 31, 2011. For property placed in service in 2012, the new law provides for 50% additional first-year depreciation.
• Many of the “traditional” tax extenders are extended for two years, retroactively to 2010 and through the end of 2011. Among many others, the extended provisions include the election to take an itemized deduction for state and local general sales taxes in lieu of the itemized deduction for state and local income taxes; the $250 above-the-line deduction for certain expenses of elementary and secondary school teachers; and the research credit.
• After a one-year hiatus, the estate tax will be reinstated for 2011 and 2012, with a top rate of 35%. The exemption amount will be $5 million per individual in 2011 and will be indexed to inflation in following years. Estates of people who died in 2010 can choose to follow either 2010's or 2011's rules.
• Omitted from the new law: Repeal of a controversial expansion of Form 1099 reporting requirements.
• Also not included: Extension of the Build America Bonds program, which permits state and localities to issue federally-subsidized municipal bonds.

We hope this information is helpful. If you would like more details about these provisions or any other aspect of the new law, please give us a call.

Using the HIRE Credit

On March 18, 2010, the federal government enacted the Hiring Incentives to Restore Employment (HIRE) Act, which provides two new tax benefits for employers who hire certain previously unemployed workers, also called qualified employees. The first benefit is payroll tax exemption, and the second is a retention bonus.

The payroll exemption provides employers with a waiver of the 6.2% social security tax on wages paid to qualifying employees from March 19, 2010 through December 31, 2010. The employee is still responsible for his/her share of social security and Medicare tax. Employees must be performing services in the employer's trade or business, so household employees are excluded from qualification.

The HIRE retention credit provides the lesser of $1000 or 6.2% of wages paid to a retained qualified employee during a 52 consecutive week period. The wages for the last 26 weeks must equal at least 80% of the wages for the first 26 weeks. The credit applies to workers hired after February 3, 2010 and before January 1, 2011.

A qualified employee is an individual who has been unemployed or employed for 40 hours or fewer during the 60 day period ending with the date their employment begins. Typically, the new employee must not be replacing another employee or be a family member of the employer. A qualified employee must sign an affidavit that they have not been employed for more than 40 hours during the 60 day period ending with the date they started employment. The 60 day period must be continuous. A previous employee who was rehired may be considered a qualified employee, as could a student or graduate, as long as they meet the underemployment requirements.

Employers may claim either or both HIRE credits on their quarterly tax return using form 941.

Form w-11 may be used for the employee affidavit. http://www.irs.gov/pub/irs-pdf/fw11.pdf

For frequently asked questions on the IRS website, visit: http://www.irs.gov/businesses/small/article/0,,id=220745,00.html

State Tax Amnesty

Michigan Governor Jennifer Granholm recently signed legislation allowing for state tax amnesty in 2011. The amnesty period begins on May 15, 2011 through June 30, 2011, and represents a huge opportunity for taxpayers. The piece of legislation applies to taxes due before December 31, 2009.

Taxpayers could have all criminal and civil penalties waived by filing for amnesty and paying all tax and interest owed related to the state income tax, the Michigan Business Tax (MBT), state sales tax, and many other categories covered by the Revenue Act. All taxes and interest must be paid by the end of the amnesty period in order for penalties to be waived. Situations such as failing to file a return, nonpayment of tax, or excessive claim of a refund may have resulted in penalties for taxpayers.

The Michigan Department of Treasury will be notifying eligible taxpayers no later than April 15, 2011. Amnesty filing forms are unavailable as of this post, but we expect the Treasury to include in their mailing either the physical forms or instructions on how to obtain the forms online.

The Self-Rental Tax Trap

The current economic environment has caused an upheaval in the real estate market, especially in the commercial property arena. Many business owners are taking advantage of this by renegotiating their leases or purchasing buildings for their operations.

A common practice among small, closely held corporations is that of self-rental. Under this arrangement, a business owner purchases a building either personally or through another entity and leases it back to their corporation. The Journal of Financial Service Professionals published an article by Thomas M. Brinker, Jr., CPA/PFS, ChFC, AEP in their September 2010 edition titled “The Self-Rental Dilemma: Is Net Rental Income or Loss Passive for Planning?” You can get more information on the journal and subscribe online at http://www.financialpro.org/pubs/journal_info.cfm.

The article points out how Section 469 of the tax code, which provides for self-rental rules, is highly complex and confusing. The possibility for a tax trap is high when considering self-rental given the complexity of the rules. It is important to consult with a professional when dealing with this type of scenario.

Self-rental income is passive, to the extent that it represents a separate venture into real estate. As a general rule, passive losses from one activity may offset income from other passive activities, subject to IRS limitations. Many business owners are under the impression that if they have rental income from property they are renting back to their corporation, that income can be offset by losses from other passive activities. This view is often incorrect.

Passive losses can only be used to offset passive income. If an owner “materially participates” (i.e., is a shareholder or works in the business) in the corporation that is renting the real estate, income from the real estate activity is considered non-passive. Any losses from other passive activities may be carried forward to offset future passive income, but aggregating losses to offset income from self-rental in which an owner materially participates is disallowed.

To confuse things a little more, the Section 469 does allow passive income to be offset by self rental losses, up to IRS limits, and excluding any excess loss (excess loss may be carried forward in future years to offset passive income). Tax planning in these scenarios is key because any income or losses from passive activities or self-rental can have a significant impact on your tax liability.

If you currently use self-rental as part of your tax strategy, consult a professional to ensure that your strategy and tax reporting are in compliance with Section 469.