Taxpayers should be aware of increased audits — Bloomberg News recently reported about the increasing number of audits conducted on high-net worth individuals. While overall audits have decreased, the IRS is focusing their time where they feel they can get the most bang for their buck. Historically known for utilizing more complex tax strategies, it’s important that high-net worth taxpayers make sure their support documents are readily available to backup potentially aggressive claims.
A representative of Deloitte has listed the IRS’s “favorite issues” of focus. The list includes:
Additionally, the IRS is distributing mass notices that address specific issues. For example, taxpayers claiming large charitable deductions should expect an automated notice requesting support. The best practice for addressing any notices or audit requests that come up is to respond promptly and with thorough support. Should you find yourself on the receiving end of an audit, please reach out to your accountant for support.
For questions or more information, please contact Aronson’s Jennifer Moss at Jmoss@aronsonllc.com.
What you need to know about Bipartisan Budget Agreement of 2015 …
In December, President Obama signed the Bipartisan Budget Agreement of 2015 into law. Contained therein is a significant revision of the outcome of partnership audits. “Partnership” refers to any entity taxed as a partnership even if it is classified as something else for legal purposes. The new rules take effect for partnership years beginning on or after January 1, 2018, though a partnership can elect to be subject to these rules for any partnership year beginning on or after November 3, 2015.
Previous rules stated a partnership adjustment flowed through to each partner’s tax return for their years involved, and each partner would be assessed the resulting tax based on their own situation.
The new rules impose any tax at the partnership level, and it is the partnership that will be liable for the taxes due. The tax is assessed on the tax return for the year the audit is completed, not for the reviewed year (year under audit). The tax is based on the net change to partnership income multiplied by the highest individual or corporate income tax rate. The most significant impact is that partners in the partnership in the year the audit is completed are the ones who effectively bear the cost of any tax assessment, even those partners who may not have been in the partnership for the reviewed years.
Moreover, such treatment for current partners can be avoided if the partnership makes a “push-out” election to provide to the IRS and to each partner (who was a partner in the reviewed year) an adjusted K-1 showing the partner’s share of the exam-related adjustments. This election must be completed within 45 days of the final partnership adjustment notice date. Affected partners would then be required to incorporate that K-1 into their own tax return in the year the K-1 is received. The effect of the push-out election is to insulate partners who were not in the partnership for a reviewed year from being unfairly saddled with a tax adjustment.
Partnerships with 100 or fewer partners and with no partner that is other than an individual, corporation, or estate of a deceased partner, can opt out of these new rules and continue to have any audit adjustments reflected on the partner’s tax return. The opt-out is an annual election and must be made on each timely filed partnership return. Thus, this is not an election that can be made at the time of the exam.
Given the complexity of these new rules, reviewing your partnership agreement or Limited Liability Company (LLC) operating agreement and modifying as necessary may be a worthwhile endeavor. While most existing agreements address what happens in the case of an audit, this new law may make current provisions obsolete, leaving an entity with no agreed-upon procedures to follow.
Some questions to consider as you navigate this new legislation are:
Should the partnership …
… file opt-out elections with each tax return?
… restrict the entrance of partners (including transfers of interest) to those who would not otherwise preclude the opt-out election?
… make a push-out election in the event of an adverse audit finding?
… provide for how a partnership level assessment will be shared in the absence of an opt-out or push-out election?
Other considerations should be made on an individual basis.
For further information or to discuss your specific situation; please contact Aronson Tax Controversy Practice Lead Larry Rubin, CPA, at 301-222-8212.
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.
Is your employee benefit plan participant count causing you to become dangerously close to needing an audit? Have you just received your compliance testing results from your record-keeper and realized that your benefit plan requires an audit this year? Your first response may be to panic (because who doesn’t panic at the word “audit”?). Then you find out that your plan will be subject to a limited-scope audit rather than a full-scope audit. Whew! Luckily, your custodian provides certified trust statements, eliminating the need for the auditor to perform investment valuation and investment purchase and sales testing. So, what else could the auditors really test in a benefit plan? The reality may surprise you!
While a limited-scope audit may scale back the scope of the audit and reduce the amount of testing to be performed during fieldwork, the audit procedures are not reduced as significantly as you might expect. A limited-scope audit still requires a substantial amount of testing to be performed. Fieldwork will consist of an in-charge auditor and one or two staff accountants who will test contributions, distributions, notes receivable from participants and expenses paid from the plan. These tests of plan transactions are outlined in the AICPA Audit & Accounting Guide for Employee Benefit Plans and will be performed regardless of the scope of the audit.
The only procedures that are reduced in a limited scope audit are the testing of investment valuation, investment income and investment activity. Not performing this testing only saves a few hours, especially when the investments held are readily marketable. Also, even though investments might not be tested in a limited-scope audit, the auditor still needs to review and evaluate the extensive footnote disclosures on investments that are required in the financial statements. Also be aware that the audit file and the financial statements are all subject to the same amount of first partner and quality control review regardless of whether the audit is a full or limited-scope audit.
While a limited-scope audit does reduce the overall time and procedures for a benefit plan audit, it may not reduce them as much as a plan sponsor would expect. Be aware that a limited scope audit is a real audit, and plan sponsors should expect their personnel, payroll and plan records to be scrutinized.
For more information on the difference between full scope and limited scope audits and how you can be better prepared for either scenario, contact Aronson’s Employee Benefit Plan Services Group at 301.231.6200.
The IRS released a Transfer Pricing Audit Roadmap on February 18, 2014. The Roadmap, which was issued through the IRS Transfer Pricing Operations of the Large Business and International (LB&I) division, was developed to provide audit techniques and tools for transfer pricing examinations. The Roadmap is designed as a comprehensive toolkit based on an audit timeline.
Transfer pricing involves an area of U.S. federal taxation which requires payments in certain intercompany transactions to be based on an arm’s length standard. The arm’s length standard is applied to determine whether intercompany pricing is consistent with pricing that would be prevalent in a transaction between unrelated parties. Section 482 of the U.S. Internal Revenue Code is the provision of U.S. federal taxation law that governs transfer pricing. Under I.R.C. Section 482, the IRS has the authority to reallocate income, expense, deductions, credits and allowances to clearly reflect income or to prevent the evasion of taxes. Section 482 applies to intercompany payments between commonly controlled entities. The regulations under Section 482 provide that the best method must be applied in determining the transfer price that is the most reliable measure of the arm’s length standard.
The IRS typically targets U.S. taxpayers for transfer pricing audits based on information disclosed on foreign reporting forms filed with the U.S. federal tax return. U.S. taxpayers who file the Form 5471, 8865 or 8858 to report ownership of a foreign company are subject to a high level of scrutiny concerning intercompany payments reported on such forms. The Transfer Pricing Audit Roadmap identifies these forms and other forms such as the Forms 5472 and 926 as the starting point when the IRS reviews a U.S. federal tax return for controlled transactions.
There are specific phases of a transfer pricing audit that are outlined in the Roadmap. The Planning Phase includes the pre-examination analysis, the opening conference, taxpayer orientations, and the preparation of the initial risk analysis and the examination plan. The Pre-Examination Analysis includes the review of the taxpayer’s contemporaneous transfer pricing documentation. The Planning Phase is a process that may continue for up to six months. The Execution Phase, which may continue for up to 14 months, includes fact finding and information gathering followed by issue development with economic analysis and a preliminary report with findings. The Resolution Phase includes issue presentation, issue resolution and case closing. The Resolution Phase is a process that may continue for up to six months.
Overall, the Audit Roadmap is a definitive indication that transfer pricing audits with the IRS are typically a lengthy process. Therefore, it is important to substantiate intercompany transfer pricing with the appropriate policy, methodology and documentation.
Please contact your Aronson LLC tax advisor, Alison N. Dougherty, International Tax Services, at 301.231.6290 for more information.