Should You Be Worried About an IRS Audit?

Now that you’ve likely filed your 2018 tax return, one troubling afterthought may come to mind: Could I get audited? The mere notion strikes fear into most people’s hearts. And for good reason — under a worst-case scenario, an audit could take up lots of your time, create an enormous amount of stress and leave you with a hefty bill from the federal government in unpaid tax, penalties and interest.

Now let’s take a deep breath. An audit can also be a rather routine process that results in zero additional liability or even a refund. What’s more, the IRS is performing audits much less frequently than it used to.

Basically, the higher your income and more complex your return, the greater the likelihood that it will be audited. The IRS uses something called a Discriminant Inventory Function (DIF) score to rate the potential for change in a return, based on past IRS experience with similar returns. The agency also uses an Unreported Income Discriminant Index Formula (UIDIF) score to rate each tax return’s potential to indicate unreported income.

If you happen to be a business owner, the IRS may subject your return to intensified scrutiny in years it decides to target a category that your company falls into. Examples might include sole proprietorships with many cash transactions or companies that rely heavily on independent contractors.

By and large, the answer to the question posed in our headline is: Probably not. The best way to prevent a targeted audit or prepare for one you can’t avoid is to get sound guidance from a CPA before filing your return every year.

Send Your Kids To Day Camp and You May Get a Tax Break

Among the many great challenges of parenthood is what to do with your kids when school lets out. Do you keep them at home and try to captivate their attention yourself or with the help of sitters? Or do you send them off to the wide variety of day camps now in operation? There’s no one-size-fits-all answer, but if you choose the latter option, you might qualify for a tax break!


Dollar-for-Dollar Savings

Day camp — but, to be clear, not overnight camp — is a qualified expense under the child and dependent care tax credit, which is worth 20% of qualifying expenses (more if your adjusted gross income is less than $43,000), subject to a cap. For 2019, the maximum expenses allowed for the credit are $3,000 for one qualifying child and $6,000 for two or more.

Remember that tax credits are particularly valuable because they reduce your tax liability dollar-for-dollar — $1 of tax credit saves you $1 of taxes. This differs from deductions, which simply reduce the amount of income subject to tax. For example, if you’re in the 24% tax bracket, $1 of deduction saves you only $0.24 of taxes. So, it’s important to take maximum advantage of the tax credits available to you.

Qualifying for the Credit

A qualifying child is generally a dependent under age 13. (There’s no age limit if the dependent child is unable physically or mentally to care for him- or herself.) Special rules apply if the child’s parents are divorced or separated or if the parents live apart.

Eligible costs for care must be work-related. This means that the child care is needed so that you can work or, if you’re currently unemployed, look for work.

If you participate in an employer-sponsored child and dependent care Flexible Spending Account (FSA), also sometimes referred to as a Dependent Care Assistance Program, you can’t use expenses paid from or reimbursed by the FSA to claim the credit.

Determining Eligibility

Additional rules apply to the child and dependent care credit. If you’re not sure whether you’re eligible, contact us. We can assist you in determining your eligibility for this credit and other tax breaks for parents.

Deducting Business Losses for Pass-Through Entities

It’s not uncommon for businesses to sometimes generate tax losses. But the tax law limits deductible losses in some situations. And the Tax Cuts and Jobs Act (TCJA) further restricts the amount of losses that sole proprietors, partners, S corporation shareholders and, typically, limited liability company (LLC) members can now deduct. If your company operates under one of these business structures, it’s important to bear all these limitations in mind as the year rolls along.


Before and After

Under pre-TCJA law, an individual taxpayer’s business losses could usually be fully deducted in the tax year when they arose unless the passive activity loss (PAL) rules or some other provision of tax law limited that favorable outcome. Another restriction was if the business loss was so large that it exceeded taxable income from other sources, creating a net operating loss (NOL).

The TCJA temporarily changes the rules for deducting an individual taxpayer’s business losses. If your pass-through business generates a tax loss for a tax year beginning in 2018 through 2025, you can’t deduct an “excess business loss” in the current year.

An excess business loss is the excess of your aggregate business deductions for the tax year over the sum of your aggregate business income and gains for the tax year, plus $250,000 ($500,000 if you’re a married taxpayer filing jointly). The excess business loss is carried forward to the following tax year and can be deducted under the rules for NOLs.

What it Means

For business losses passed through to individuals from S corporations, partnerships and LLCs treated as partnerships for tax purposes, the new excess business loss limitation rules apply at the owner level. In other words, each owner’s allocable share of business income, gain, deduction or loss is passed through to the owner and reported on the owner’s personal federal income tax return for the owner’s tax year that includes the end of the entity’s tax year.

Keep in mind that the new loss limitation rules kick in after applying the PAL rules. So, if the PAL rules disallow your business or rental activity loss, you don’t get to the new loss limitation rules.

Practical Impact

The rationale underlying the new loss limitation rules is to restrict the ability of individual taxpayers to use current-year business losses to offset income from other sources, such as salary, self-employment income, interest, dividends and capital gains.

The practical impact is that your allowable current-year business losses can’t offset more than $250,000 of income from such other sources (or more than $500,000 for joint filers). The requirement that excess business losses be carried forward as an NOL forces you to wait at least one year to get any tax benefit from those excess losses.

Potential Effect

If you’re expecting your business to generate a tax loss in 2019, we can help you determine whether you’ll be affected by the new loss limitation rules.

Innocent Spouse Rules Offer Protection Under Some Circumstances

Must one spouse pay the tax resulting from a fabrication or omission by another spouse on a jointly filed tax return? It depends. If the spouse qualifies, he or she may be able to avoid personal tax liability under the “innocent spouse” rules.


Joint Filing Status

Generally, married taxpayers benefit overall by filing a joint tax return on the federal level. This is particularly the case when one spouse earns significantly more than the other. Filing jointly may also help the couple maximize certain income tax deductions and credits.

But joint filing status comes with a catch. Each spouse is “jointly and severally” responsible for any tax, interest and penalties attributable to the return. And this liability continues to apply even if the couple gets a divorce or one spouse dies. In other words, the IRS may try to collect the full amount due from one spouse, even if all the income reported on the joint return was earned by the other spouse.

Basic Rules

However, the tax law provides tax relief for an “innocent spouse.” Under these rules, one spouse may not be liable for any unpaid tax and penalties, despite having signed the joint return.

To determine eligibility for relief, the IRS imposes a set of common requirements. The spouses must have filed a joint return that has an understatement of tax, and that understatement must be attributable to one spouse’s erroneous items. For this purpose, “erroneous items” are defined as any deduction, credit or tax basis incorrectly stated on the return, as well as any income not reported.

From there, the other (“innocent”) spouse must establish that, at the time the joint return was signed, he or she didn’t know — or have reason to know — there was an understatement of tax. Finally, to qualify, the IRS needs to find that it would be unfair to hold one spouse liable for the understatement after considering all the facts and circumstances.

Additional Notes

For many years, innocent spouse relief had to be requested within two years after the IRS first began its collection activity against a taxpayer. But, in 2011, the IRS announced that it would no longer apply the two-year limit on collection activities.

In addition, by law, when one spouse applies for innocent spouse relief, the IRS must contact the other spouse or former spouse. There are no exceptions even for victims of spousal abuse or domestic violence.

Help Available

Historically, courts haven’t been particularly generous about upholding claims under the innocent spouse rules. State laws can also complicate matters. If you’re wondering whether you’d qualify for relief, please contact us for help.

 

Sidebar: What does the IRS consider?

The IRS considers “all facts and circumstances” in determining whether it would be inequitable to hold an “innocent” spouse liable for taxes due on a jointly filed tax return. One factor that may increase the likelihood of relief is that the taxes owed are clearly attributable to one spouse or an ex-spouse who filled out the errant return.

If one spouse was deserted during the marriage, or suffered abuse, it may also improve the chances that innocent spouse relief will be granted. In some cases, the IRS may examine the couple’s situation to determine whether the spouse applying for relief knew about the erroneous items.

Second Quarter Deadlines are Looming

It’s hard to believe that second quarter tax deadlines are already in our midst. Mark your calendars for the following due dates…

April 15 — Besides being the last day to file (or extend) your 2018 personal return and pay any tax that’s due, 2019 first quarter estimated tax payments for individuals, trusts and calendar-year corporations are due today. Also due are 2018 returns for trusts and calendar-year estates and C corporations, FinCEN Form 114 (“Report of Foreign Bank and Financial Accounts” — though an automatic extension applies to October 15), and any final contribution you plan to make to an IRA or Education Savings Account for 2018. SEP and Keogh plan contributions are also due today if your return is not being extended.

May 15 — Original due date for exempt organization returns (Form 990).

June 17 — Second quarter estimated tax payments for individuals, trusts, and calendar-year corporations are due.

Are Income Taxes Taking a Bite Out of Your Trusts?

If your estate plan includes one or more trusts, review them before you file your tax return. Or, if you’ve already filed it, look carefully at how your trusts were affected. Income taxes often take an unexpected bite out of these asset-protection vehicles.


3 Ways to Soften the Blow

For trusts, there are income thresholds that may trigger the top income tax rate of 37%, the top long-term capital gains rate of 20%, and the net investment income tax of 3.8%. Here are three ways to soften the blow:

  1. Use grantor trusts. An intentionally defective grantor trust (IDGT) is designed so that you, the grantor, are treated as the trust’s owner for income tax purposes — even though your contributions to the trust are considered “completed gifts” for estate- and gift-tax purposes. The trust’s income is taxed to you, so the trust itself avoids taxation. This allows trust assets to grow tax-free, leaving more for your beneficiaries. And it reduces the size of your estate. Further, as the owner, you can sell assets to the trust or engage in other transactions without tax consequences. Keep in mind that, if your personal income exceeds the applicable thresholds for your filing status, using an IDGT won’t avoid the tax rates described above. Still, the other benefits of these trusts make them attractive.
  2. Change your investment strategy. Despite the advantages of grantor trusts, nongrantor trusts are sometimes desirable or necessary. At some point, for example, you may decide to convert a grantor trust to a nongrantor trust to relieve yourself of the burden of paying the trust’s taxes. Also, grantor trusts become nongrantor trusts after the grantor’s death. One strategy for easing the tax burden on nongrantor trusts is for the trustee to shift investments into tax-exempt or tax-deferred investments.
  3. Distribute income. Generally, nongrantor trusts are subject to tax only to the extent they accumulate taxable income. When a trust makes distributions to a beneficiary, it passes along ordinary income (and, in some cases, capital gains), which are taxed at the beneficiary’s marginal rate. Thus, one strategy for minimizing taxes on trust income is to distribute the income (assuming the trust isn’t already required to distribute income) to beneficiaries in lower tax brackets. The trustee might also consider distributing appreciated assets, rather than cash, to take advantage of a beneficiary’s lower capital gains rate. Of course, doing so may conflict with a trust’s purposes.

Opportunities to Reduce

If you’re concerned about income taxes on your trusts, contact us. We can review your estate plan to assess the tax exposure of your trusts, as well as to uncover opportunities to reduce your family’s tax burden.

Business vs. Hobby: The Tax Rules Have Changes

If you generate income from a passion such as cooking, woodworking, raising animals — or anything else — beware of the tax implications. They’ll vary depending on whether the activity is treated as a hobby or a business.

The bottom line: The income generated by your activity is taxable. But different rules apply to how income and related expenses are reported.

Factors to Consider

The IRS has identified several factors that should be considered when making the hobby vs. business distinction. The greater the extent to which these factors apply, the more likely your activity will be deemed a business.

For starters, in the event of an audit, the IRS will examine the time and effort you devote to the activity and whether you depend on income from the activity for your livelihood. Also, the IRS will likely view it as a business if any losses you’ve incurred are because of circumstances beyond your control, or they took place in what could be defined as the start-up phase of a company.

Profitability — past, present and future — is also important. If you change your operational methods to improve profitability, and you can expect future profits from the appreciation of assets used in the activity, the IRS is more likely to view it as a business. The agency may also consider whether you’ve previously made a profit in similar activities. Also, the intent to make a profit is a key factor.

The IRS always stresses that the final determination will be based on all the relevant facts and circumstances related to your activity.

Changes Under the TCJA

Under previous tax law, if the activity was deemed a hobby, you could still generally deduct ordinary and necessary expenses associated with it. But you had to deduct hobby expenses as miscellaneous itemized deduction items, so they could be written off only to the extent they exceeded 2% of adjusted gross income (AGI).

All of this has changed under the Tax Cuts and Jobs Act (TCJA). Beginning with the 2018 tax year and running through 2025, the TCJA eliminates write-offs for miscellaneous itemized deduction items previously subject to the 2% of AGI threshold.

Thus, if the activity is a hobby, you won’t be able to deduct expenses associated with it. However, you must still report all income from it. If, instead, the activity is considered a business, you can deduct the expenses associated with it. If the business activity results in a loss, you can deduct the loss from your other income in the same tax year, within certain limits.

An Issue to Address

Worried the IRS might recharacterize your business as a hobby? We can help you address this issue on your 2018 return or assist you in perhaps filing an amended return, if appropriate.

Running Your Personal Finances Like a Business

Most individuals don’t regard themselves as businesses, trying to turn a profit and beat the competition. But, occasionally, it may help to look at your financial situation this way to determine where you might cut expenses and boost cash flow. Here are some tips.

Lay Out Your Financials

Where an executive might reach for financial statements to get a read on the company’s standing, you can create or update a net worth statement. Essentially a monetary scorecard, a net worth statement helps you determine where you stand financially and whether you’re on track to meet your goals.

You can calculate your net worth by adding all your assets, including cash and cash equivalents, brokerage account balances, retirement funds, real estate and other fixed assets and personal property. Then subtract your liabilities, including mortgages, personal loans, credit card balances and taxes due.

The result provides some important clues about where your money is going and how you might be able to trim spending and increase savings. Are you overrelying on credit cards with high interest rates? Could you cut back on food or entertainment costs?

Practice Risk Management

To maintain their companies’ financial health, business executives also practice risk management. You can do the same by first assessing compensation and benefits elections. A major life change — such as a marriage or birth — may require an update to your W-4 withholding allowances with your employer.

Unexpected medical costs can be a huge risk. Review your health insurance to ensure it’s providing the best value. Now might not be an ideal time to switch to a spouse’s plan but, if it’s a better deal, perhaps make a note to do so when you can. Also, if you have a Health Savings Account or Flexible Spending Account, make sure you’re using it to your full advantage.

Think about other insurance, too. Perhaps your home has increased in value, necessitating a corresponding increase in your homeowner’s coverage. Or maybe you no longer have enough life insurance to protect your growing family. Talk to your insurance professional to determine the right amount of coverage.

Finally, check your credit report. If you wait until something is obviously wrong, it may be too late to prevent significant damage. Federal law requires the three major credit reporting agencies to provide you with one free report per year.

Think About Retirement

Business owners must think about succession planning. But even if you don’t own a company, you should think about life after employment.

If your employer allows you to adjust your retirement plan contributions during the year, consider boosting them to take full advantage of tax-deferred compounding and, if available, employer matching. Similarly, if you plan to make an IRA contribution this year, do so as early as possible to give your assets more time to grow.

Also review your estate plan and, if necessary, update it. Financial priorities change over time, so make sure the beneficiary designations for your retirement accounts and insurance policies still match your wishes. Check your will or living trust to ensure no changes are necessary. And, if you’re looking to reduce the value of your taxable estate, remember that you can make $15,000 ($30,000 for married couples) in annual exclusion gifts per recipient this year without using up any lifetime exemption.

Get Rolling

Some might say that the beginning of the year is the most important time for financial planning. Others might say it’s year end, when you start preparing to file your tax return. In truth, the whole year is important. And right now, with the arrival of spring and the year well under way, is a perfect time to adjust objectives set a few months ago — and really get rolling. Contact us for help.

Copyright © 2019

Beware of Seasonal Scammers

It’s a common story that we see far too often. Seasonal tax preparers looking to take advantage of taxpayers with promises of big refunds and overblown tax credits. Those most frequently targeted are the elderly, low-income taxpayers, non-English speakers, or some who may not have a filing requirement. They commonly advertise with word-of-mouth (boasting big referral dollars), flyers, and even small community events.

The most important thing to remember is that while these scammers may face legal recourse as well, the taxpayer is legally responsible for what is filed in their name, even if it’s prepared by someone else. This can come as a shock to some victims who are penalized due to a falsified return.

How to avoid being a victim of these scammers

  • Check their credentials. Whether they are a CPA, EA, or even an attorney, there are online records through the IRS and many state associations detailing the information of reputable, trustworthy preparers.
  • Review your return. Tax preparers who are honest do not keep the return private from the client. It’s standard practice among reputable CPA firms to supply a copy of the return to the client and walk them through their return. If your preparer does not allow you to review what has been filed in your name, it may be a red flag.
  • Make sure the refund is deposited into your account. Some scammers direct your refund to be deposited into their personal or business account and then deduct their “fee” before paying the victim of their fraud. Don’t let this happen to you. Make sure your refund is directly deposited into your account to not be charged outrageous fees by these scammers.
  • Do your research. Ask your friends, family, do online searching, whatever is needed to find a local, reputable tax preparer. Ask questions at your initial consultation about their background, local history, and filing processes. Don’t be shy about interviewing your prospective preparer, as they will obtain very sensitive financial information from you and should be properly vetted.

 

There May Be Unclaimed Property With Your Name On It

It may sound too good to be true, but there may be valuable unclaimed property out there with your name on it. The term generally refers to financial assets being held for owners who haven’t been found. Just a few examples include uncashed dividend and payroll checks; unclaimed tax refunds; and insurance payments, refunds or policies with cash value.

If you’re interested in looking, there are search databases maintained by the state or states where you live and work, as well as states where you (or a deceased relative) previously lived and worked. Unclaimed property is sent to the state of the owner’s last known address.

Most states participate in MissingMoney.com, a free, national unclaimed property database. For states that don’t participate, you can find links to every state’s unclaimed property database on unclaimed.org, the website of the National Association of Unclaimed Property Administrators. You can also use this site to find links to relevant federal programs.

If you discover unclaimed property in your name, follow the instructions on the website where you found it. Typically, you’ll need to provide proof of ownership or, in the case of a deceased owner, a death certificate and proof that you’re entitled to the assets (such as a will).

Finally, be wary of companies that offer to locate and obtain property for a fee. Some of these offers are scams. But even if they’re legitimate, in most cases you can find and claim assets yourself for free or by paying a nominal handling fee.