While the government has cracked down in recent years on wealthy Americans stashing millions in offshore accounts, tax pros say it isn’t just the high rollers who might merit a double take from the IRS.
The total number of audits conducted over the mail for people earning more than $200,000 increased by 13% in 2012 from the year before, to 109,318, according to the IRS. Some taxpayers can get flagged for an audit if they make mistakes that cause the agency to question whether they’re reporting all of their income — from forgetting to report even small amounts of income to paying taxes for your babysitter.
To be sure, you can typically stay in the clear if you report your income honestly and maintain proper documentation, tax pros say. And overall, the probability of being audited is still low — the IRS audited less than 1% of taxpayers last year. Still, there are a few steps taxpayers can take to help keep their chances to a bare minimum.
List all of your income
Not reporting all the income listed on 1099 forms, says Robert Wood, a tax attorney in San Francisco, invites an audit from the IRS. The IRS has matching software that can help it catch any income that was reported under your Social Security number but that wasn’t listed on your tax return. That includes investment income, payments for freelance work, and interest earned on a bank account. “They will match it no matter how small it is,” says Wood. Being flagged for underreported income could open the door for the IRS to scrutinize other parts of your return, including deductions and credits claimed, says Bill Smith, managing director of CBIZ MHM’s National Tax Office, a consulting firm that helps individuals and businesses with their taxes. You could also be charged late-payment penalties on any taxes owed, says Smith.
Don’t mix business with pleasure
The IRS keeps a close eye on income and deductions reported by self-employed taxpayers since much of the tax gap — the difference between the amount of tax owed and what’s actually paid — is due to misreporting on the Schedule C, the tax form self-employed workers use to report income. If you are self-employed and going to claim business deductions for travel expenses, keep a log of trips made to visit clients so that you can distinguish personal travel costs from those incurred for work. And while the IRS recently introduced a simpler method for claiming the home-office deduction, taxpayers still need to show that the space is used exclusively and often for work, in accordance with IRS rules. “You can’t have a family room that doubles as your office,” says Benson Goldstein, senior technical manager on the tax staff for the American Institute of Certified Public Accountants. See: Coming soon: A simpler home-office tax deduction.
Be careful when claiming a hobby loss
The recent tax court ruling against former NFL linebacker Bill Romanowski affirming that he and his wife owe $4.75 million in back taxes from deductions related to horse-breeding expenses brings attention to a key requirement many taxpayers may forget when they try to claim losses on a hobby: Taxpayers need to show they’re going into the hobby with the intention of making a profit. If they keep striking out, they should show that they are changing their methods to improve their chances of making money, or at least show that the activity has made a profit in the past, according to IRS rules. “Your behavior has to be in line with somebody who is trying to make a go of it,” says Anthony Parent, a tax resolution attorney with IRS Medic. Otherwise, the IRS may suspect you’re investing in the hobby solely with the purpose of creating a loss that could be used to deduct taxes owed, he says.
Pay your nanny taxes
People hired to do work around the house, such as a nannies and gardeners, need to be reported properly to the IRS, and families may need to pay Social Security and Medicare taxes and withhold the worker’s share of those taxes just like any other employer, experts say. The rules apply to any one household worker paid at least $1,800 this year. Parents, children, spouses and employees under the age of 18 don’t count. Not doing so could lead to thousands of dollars in back taxes and penalties, and families could be charged with tax evasion, says Stephanie Breedlove, a partner at Breedlove and Associates, a firm that helps families handle payroll taxes and labor law. Families have a greater chance of being audited if they incorrectly list a household worker on the payroll of a small business they own, says Breedlove. While that may seem like a simpler way to pay the appropriate taxes for the worker, taxpayers could be exaggerating the number of small-business credits and deductions they’re entitled to, says Breedlove.
Double check your math
The IRS caught more than 6 million math errors on tax returns in 2010, according to the most recent data available. Taxpayers commonly make mistakes on how big their deductions are, how much they owe and how large their refunds should be, tax pros say. Filing electronically may help people catch some of these errors, but experts say taxpayers should pause to make sure they’re claiming the appropriate amount of deductions. The IRS may flag your return if the deductions you claim seem out of line for your income, says Goldstein. It also helps to use exact numbers, since rounding may give the IRS reason to request more documentation, experts say. See: 8 most common tax blunders.
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