According to the recent Kiplinger Tax Analysis, the Internal Revenue Service (IRS) is struggling with its enforcement efforts as the agency’s funding has been significantly reduced over the past several years. Some interesting statistics included:
The odds may seem very low for the return to be picked for a review; however, taxpayers should look at the following factors (selected by Kiplinger’s Personal Finance Magazine) that could increase further scrutiny by the IRS and potentially result in a full-blown examination of your income tax return:
i. Taxpayers with incomes of $200,000 or higher had an average audit rate of 3.26%
ii. Taxpayers with incomes of $1mil or higher had an average audit rate of 11.11%
i. Hobby Losses – don’t confuse a hobby with a business. The activity must be conducted with the intent of making a profit; the law presumes you have a business if the activity at a minimum generates profit three out of five years. Also make sure that you have proper documentation for all of the expenses. If, however, you determine that the activity is actually a hobby, report any income and deduct any expenses only up to the level of income; the law prohibits writing off losses from a hobby.
ii. Home Office – you must use the space exclusively and regularly as your principal place of business (this area of the home should not be used as a family room in the evenings or a guest bedroom).
iii. Business Use of a Vehicle – claiming 100% business use of a vehicle is another red flag for the IRS and will get challenged; make sure you keep detailed mileage logs so that the deduction will not get disallowed.
iv. Meals, Travel, and Entertainment – to qualify for the deduction, you must keep detailed records for each expense amount including: the place, people attending, business purpose and the nature of the discussion/meeting. Taking excessive deduction will draw additional attention from the IRS, so make sure you have proper documentation.
v. Day-Trading Losses – many taxpayers who trade in stocks and other securities take an aggressive position of a “trader” rather than investor and report trading losses and expenses on Schedule C. The IRS is selecting those returns to determine if the taxpayers actually qualify as bona fide traders.
Claiming a higher than average deduction or loss on your income tax return may draw an unnecessary attention from the IRS; however, if you have proper documentation, you have nothing to worry about.
For more information about potential audit red flags, please contact your Aronson tax advisor or Anatoli Pilchtchikov at 301.231.6200.
About the Author: Anatoli Pilchtchikov is a manager in Aronson’s Personal Financial Services Group, where he specializes in tax compliance and consulting for high net worth individuals and their families, corporate executives and business owners. He manages his clients’ overall tax liabilities through proactive planning during the year and preparation of tax returns and projections.
Ask These Questions to Gauge Experience and Knowledge
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The 2011 IRS Data Book, a compilation of statistical data and IRS activities, is out. You can read the whole book here: http://www.irs.gov/pub/irs-soi/11databk.pdf or just skip to page 22 of the publication for the important stuff.
In summary, the average audit rate for individual tax returns is 1.1%. But what’s in your return can push you above the average. At the high end, those making more than $1 million have an audit instance of 12.5%. At the other end, returns for those making under $200,000 and without any business or rental activities have