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What are My Chances of Being Targeted for an IRS Audit?

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:

  • 2012 audit rate for individuals was the 0.96% – approximately 1 out of 100 filed returns (lowest since 2005)
  • 2013 audit rate for individuals is projected to be at 0.80%

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:

  1. Large Gross Income – According to the IRS statistics, even though the overall individual rate is below 1%:

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%

  1. Failure to properly report all taxable income – The IRS receives copies of all forms 1099s and W-2s; a mismatch is easily detected by the IRS computers and a subsequent notice will be issued.
  2. Large Charitable deductions – The IRS is aware of the average charitable donation for taxpayers in various income categories (ex., taxpayers with Adjusted Gross Income in $100k-$200k range reported, on average, $3,939 charitable deduction). If your deduction is disproportionately larger, it raises a red flag. Also note that, for noncash donations in excess of $500, a form 8283 must be included with your tax return and, for noncash donations in excess of $5,000, an appraisal is required.
  3. Schedule C – Considered by some as a goldmine for IRS agents, as history shows that most understating of income and overstating of deductions is done by those who are self-employed.

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.

  1. Rental Losses – The IRS launched a “real estate professional“ audit project several years ago that targets taxpayers with real estate losses who claim to be real estate professionals. As a general rule, in order to qualify as a real estate professional, you must spend more than 50% of the working hours and 750 or more hours each year materially participating in a capacity of a real estate developer, broker, landlord, etc. If however, you hold a full-time job (outside of real estate) most likely you will not qualify as a real estate professional and the losses from your rental activity will be either limited to current year income or suspended to future years.

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.


Important Considerations When Choosing a Benefit Plan Auditor

choosing-a-benefit-plan-auditorAsk These Questions to Gauge Experience and Knowledge

Choosing a qualified benefit plan auditor can be a challenging process for construction companies and contractors. Selecting an inexperienced auditor or one with a less than stellar track record can have lasting ramifications on your plan. There are several factors to consider when evaluating potential auditors:

  • The firm’s experience with auditing benefit plans.  To perform an audit in accordance with the standards, tests need to be performed that are unique to benefit plans.  The firm you select should be committed to the training of its staff, not just in audit skills, but in understanding how benefit plans operate and the regulatory requirements to which plans are subject.   The firm should audit more than just a few plans a year in order to provide you with the most efficient and effective audit.  Teaching an audit team how an employee benefit plan works can be very frustrating

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Tax Tip: Proof of Gross Income

During the course of a tax audit, the agent will add up all bank deposits, back out identifiable non-tax items (such as account transfers) and compare that total to the gross income reported on the tax return. The excess of deposits over reported income is deemed to be unreported taxable income unless proven otherwise. Frequently, taxpayers find themselves trying to explain undocumented deposits. A loan from a friend, a gift from a relative, and other clearly nontaxable deposits will be included in the taxpayer’s income unless proof of

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Transfer Pricing – General Principles, Penalties and Contemporaneous Documentation

General Principles – Transfer pricing is relevant for U.S. companies with foreign subsidiaries or foreign parent companies that engage in certain intercompany transactions.  U.S. transfer pricing rules require that intercompany pricing between a U.S. company and a foreign affiliate must be based on an ‘arm’s length’ price that would be charged in a similar transaction with an unrelated third party.  The arm’s length principle is typically applied to intercompany transactions in which goods, services or property are sold between a U.S. company and a foreign affiliate.  The transfer pricing rules also can apply to

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What are your chances of being selected for an IRS tax audit?

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

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