The IRS audits for a good reason – They want everyone to pay their fair share. The IRS assigns a numeric score to every income tax return based on specific criteria. The higher the assigned score, the more likely you will be selected for audit. Here are some of the common items that may catch the IRS’ attention, and what to keep in mind:
SCHEDULE C BUSINESS DEDUCTIONS AND LOSSES
This is the form used when you operate a small business that is not a legal entity such as a corporation. It’s one of the most likely types of returns to be examined. People normally are in business to make money, so you are particularly at risk if you’ve reported losses for several years in a row. The IRS will first look at expenses that could be personal in nature, like automobile usage, meals and entertainment costs. Make sure you have a legitimate business purpose with a profit motive (riding horses and driving race cars – not such a good idea!) with detailed records of expenses and business miles. And keep a separate business checking account.
HOME OFFICE DEDUCTIONS
This could be part of Schedule C deductions, as well as employees who work mainly from home. Make sure the area is used regularly and exclusively for business. If you say that you are using 75% of your 3,000 square foot home occupied by 5 family members to run your small business – expect the IRS to come calling!
RENTAL LOSSES
Let’s say you own an apartment building or other rental properties. Are you involved in your rental property, or do you hire a management company to oversee leasing and day-to-day operations? This will make a big difference whether the IRS will treat your losses as:
- Active — generally deductible against earned income like wages; or
- Passive – losses can only offset other passive income
The IRS knows if you have a job with significant W-2 wages, it’s not likely that you’ll have time to actively manage these rentals. In order to qualify for what the IRS calls a “real estate professional”, you must meet 2 conditions:
- You spend more than 50% of your personal services materially participating in real property trades or businesses, and
- You spend more than 750 hours during the year materially participating in real property trades or businesses.
When it comes to real estate rental losses, it’s extremely important to keep good records of your time spent, as well as expenses.
CHARITABLE DONATIONS
Deducting amounts that are way out of line with your income will raise suspicion. $20,000 charitable contributions when you earn $50.000 from all sources? We don’t think so.
Keep dated receipts for cash gifts of $250 or more, as well non-cash donations. If you give away items like furniture or equipment worth more than $500, you will need to fill out Form 8283. Items valued at over $5,000 will also require a written appraisal.
Don’t get too carried away in determining values of donations. That $500 VCR you bought 10 years ago is probably not valued at $500 today.
Remember, you are entitled to claim valid deductions on your tax return. The best defense is to consult with your tax advisor and keep detailed records.
