Tag: taxation

Audit Featured Image

What to Expect from an IRS Audit

What every taxpayer should know regarding types of IRS audits and common issues that can trigger audit.

An audit is an investigation into a tax return of an individual, business, estate or trust.  The IRS uses this process to determine if the information provided in the tax return is correct. This article discusses three types of audits and several common audit triggers.

Types of IRS Audits

Correspondence Audit

This is the most common type of audit and also the easiest in terms of what is required and the length of time involved.  Usually the IRS will send a request for supporting documentation to prove deductions, exemptions, proof of dependents, proof of charitable donations or other documentation to corroborate a specific part of the return.  This is the least stressful form of audit for the taxpayer and usually sending in the requested paperwork is enough to satisfy the IRS.   It is strongly advised that you seek the help of an experienced tax attorney to prepare your reply to the IRS correspondence audit and to ensure the documentation you send is exactly what is needed.  As long as a response is made within the timeframe and the documentation enclosed satisfies the proof needed by the IRS, the audit is complete.  This type of audit is most commonly utilized for individual tax returns, where there are perhaps one or two simple issues the IRS wants you to substantiate.

 Office Audit

An invitation to appear at an IRS office to conduct an office audit is a serious matter.  It is important you do not attend the office audit without your tax attorney.  Being asked to an office audit means the IRS is counting on the possibility that you owe additional taxes.  It is essential that you seek the advice of an experienced tax attorney to accompany you to the IRS office audit to protect your rights and to use their knowledge and experience to assist you in finding ways to reduce or eliminate any additional taxes.

Field Audit

A field audit is the most serious form of audit and involves an IRS Auditor coming to your place of business to thoroughly audit your records.  If the IRS finds that your business has inaccurately reported income and evaded paying the correct tax, the consequences could result in heavy penalties, additional taxes and possible prison time.  It is of utmost importance to engage the services of an experienced tax attorney to be present while the IRS auditor is at your place of business.

Below is a summary of common audit triggers

Large amount of charitable donations

The IRS looks closely at the receipts and proof of your charitable donations.  If your charitable donations are more than 3% of your income, the IRS will scrutinize your documentation.  Make sure you have receipts, cancelled checks, and appraisals for all donations to substantiate your claim for deductions.

Failing to report part of your income

The IRS already knows what is on your W-2 and 1099s in terms of income.  If you do not report your income accurately on your tax return, this will likely trigger an audit.  You will receive a W-2 from your full-time job, but may also receive 1099s for freelance work you do on the side, as well as other forms of miscellaneous income, in all cases you must report all of your income from all sources.

Large losses on Schedule C, or many years of losses on Schedule C

If you are self-employed, and report your income on a Schedule C, you will report either a profit or a loss.  If your return shows a very large business loss on a Schedule C, or if you have a history of several years of losses on your Schedule C, this will likely attract IRS attention.

The reason behind this is that the IRS likes to see a profit at least two out of five years to consider a business legitimate.  If there are five years of losses reported on a Schedule C, the IRS will likely audit to see if ‘hobby’ would be a better description.  This is important because taxpayers are required to report any income earned from a hobby, but tax payers generally cannot deduct losses.

For example, a Professional Photographer with his own business, clients, advertisements, portfolio etc., can claim as a business expense the purchase of a camera.  Whereas, a doctor who enjoys taking photographs during his weekend hikes cannot claim a new camera as a business expense.

Claiming too many business expenses

In addition to the business/hobby issue just discussed, reporting too many losses can also cause the IRS to question how your business is staying solvent.  If you report many personal expenses through your business without it being a true necessary business expense (in order for your net profit to decrease and therefore your tax liability to decrease) the IRS will scrutinize your records during an audit.

Random Selection

Unfortunately, even if you do everything right, there is always a small (less than 1%) chance that your return will be randomly selected for an audit.

In Conclusion

If you do receive an audit notice from the IRS, it does not need to be the start of a stressful and difficult time for you and your family, or your business.  You will likely benefit from an experienced tax attorney’s advice and direction with the protection of the attorney client privilege.

Estate Tax Image

There is a Free Lunch – Rethinking Your Relationship With the Estate Tax System

Americans have been trained to fear the US Estate Tax system, sometimes called the death tax system.

However, now that a single person can transfer more than $5 million through the estate tax system without paying a tax, the time has come for us to change our way of thinking.  We need to change our thinking because the estate tax system includes a hidden gift that is now extremely valuable.

The gift is this:  Assets that pass through the estate tax system receive a new basis, which is the value of the asset on the date of death.  Given the number of assets that have increased in value over the course of the past 40-50 years, the new basis at death is frequently an increased “stepped up” basis.

To begin at the beginning, the tax basis of an asset is generally the price that a taxpayer paid for the asset.  The tax basis is important, because it is the measuring point for determining a taxpayer’s gain or loss on disposition of the asset.  So, if a taxpayer paid $1.00 for a share of stock, then sells it for $10.00, the taxpayer’s gain is $9.00, and the taxpayer has to report that gain and pay a tax on it.

The lesson is: The higher an asset’s basis, the better.

The problem is that basis increases generally are not free.  For example, if a person owns a rental property, he or she can increase basis by spending money on the property with the addition of a capital improvement.  The basis adjustment is the direct result of spending money.

Historically, the basis adjustment that is available through the estate tax system – like other basis adjustments – came with a price tag.  The property was subject to estate tax and it emerged from a painful taxation system with a new basis because it had generated a tax payable to the IRS.

Now, though the estate tax exemption is so high that people can use the estate tax system to acquire something that was inconceivable not so long ago: free basis.

The logic to free basis:

  1. The price of the basis adjustment at death has been the need to expose the asset to the estate tax system and the consequent need to pay an estate tax at high rates.
  2. Now, though, the estate tax exemption is so high that many people can expose their entire fortunes to the estate tax system without paying any tax, and many can do this without even filing an estate tax return.
  3. Since Congress did not change the basis adjustment rules when it changed the exemption amounts, the assets that go through the estate tax system painlessly (and perhaps without even filing a return) still receive a basis increase at no cost, which equals free basis.

The key underlying lesson to learn from the current situation is that – even if you cannot look at the US Estate Tax system as a friend – you can look at the system as a neighbor you need to learn to live with.

A few ideas to help you take advantage of free basis:

  1. Historically, parents have given assets that were likely to appreciate to children, so that the appreciation would not be exposed to the estate tax system at the parent’s death. However, when the gift was made, the parent’s basis would transfer to the child, and would not be stepped-up at the parent’s death.  This made sense when the estate tax system imposed a price.  Now that the system does not impose a price for most people, it makes sense for the parent to hold the asset until death so that it can be transferred to the child with a free basis increase.
  1. You probably have a natural aversion to taking money from your IRA, because you pay income tax on your withdrawals. However, if your aversion to taking money from your IRA were to cause you to sell an asset to pay tax at the capital gains rate, you might reconsider.  The assets in the IRA will not get a basis increase when you die.  The capital asset outside the IRA will get a basis increase.  Your situation might be improved by taking money from the IRA and leaving the capital asset on hand so that it can be eligible for free basis.
  1. Think twice before making annual exclusion gifts with anything but cash.
  1. Don’t get involved with family limited partnerships and fractional interest discounting unless you are rich enough to really need them.
  1. Recognize that a traditional A/B Trust may result in the loss of a stepped-up basis at the death of the second spouse. While an A/B Trust can still make good sense for family reasons (especially dealing with a blended family), you should be sure that the trust has been modified to provide a method for obtaining an increased basis. The attorneys in our firm are adept at accomplishing this without disrupting family dynamics.