The IRS Is Cracking Down on More Taxpayers

Martin S. Kaplan, CPA

The IRS has been stepping up efforts to make sure that taxpayers are

paying up, especially as the federal budget deficit soars. About

40,000 more individual tax returns were audited in fiscal 2009 than in

2008 — and the number has more than doubled since 2000. For 2010, the

tentative federal tax-enforcement budget is up nearly 10% from last

year.

There’s no way to absolutely audit-proof a tax return. However, there

are steps you can take to minimize the chances that the Internal

Revenue Service will challenge yours, including ways to make sure that

you don’t have any of the new potential red flags that the IRS is

targeting. To reduce the chances of an IRS audit…

REPORT ALL YOUR INCOME

In the current economic climate, unreported income is a major concern

of the IRS, especially if you are self-employed and report income on

Schedule C of IRS Form 1040. The IRS estimates the annual “tax gap”

between what taxpayers should pay and what they actually pay at $290

billion, and has said that under-reported income accounts for 80% of

this tax gap.

An agent may look beyond your W-2 forms and 1099 forms that report

income. He/she may examine all of your checking and savings accounts

from December of the year prior to the year that is under examination

through January of the following year — 14 months in all. You may

have to provide that information for your children’s bank accounts,

too. The agent will be looking for deposits substantially in excess of

the income you reported.

You’ll be asked to explain any deposits that were not classified as

income, such as proceeds from a home-equity loan, account transfers,

an inheritance and gifts.

What to do: Make sure that you report all of your taxable income. Go

over all of your bank deposits as an IRS agent might, and see if you

can account for all deposits in excess of the taxable income you

report.

MORE INCOME = MORE VIGILANCE

With income of $200,000 or less, you have about a 1% chance of being

audited, according to the IRS. Audits of taxpayers in this income

group rose only slightly from 2008 to 2009. With income of more than

$200,000 up to $1 million, your chance of an audit triples to about

3%. Audits of such taxpayers rose by 11% from 2008 to 2009. And with

income of more than $1 million, your chances of facing IRS scrutiny

shoot up to more than 6%. Audits of seven-figure-income taxpayers rose

by 30% from 2008 to 2009.

What to do: The higher your income, the more vigilant you must be

about avoiding errors, omissions and questionable deductions. There

also is more reason to hire a professional tax preparer. And there may

be more reason to lower your taxable income by investing in tax-exempt

bonds and other means.

DON’T CALL A HOBBY A BUSINESS

Be cautious about reporting as a business any hobby that is only

minimally profitable — an increasingly common practice that the IRS

frowns upon because you are not allowed to deduct losses from a hobby

(but you can deduct losses from a business).

A true business may lose money, of course. As long as you have records

showing that you made a legitimate effort to create a real business,

you can deduct the loss. This means running the activity in a

businesslike manner — with a business plan, a separate business bank

account, good records of income and expenses, etc.

If you report business expenses, including auto, travel and

entertainment expenses, that are high relative to your income, that

also could draw extra scrutiny from the IRS. Keep thorough records of

income and expenses for your business.

Be aware that you do have to report all income from a hobby. The good

news is that you can deduct expenses of the hobby to the extent of

that income.

BE CAUTIOUS ABOUT HOME OFFICES

In addition to unreported income, IRS examiners often focus on

deductions for a home office. Therefore, filing Form 8829 (Expenses

for Business Use of Your Home) might attract IRS attention and trigger

an audit.

What’s new: When a taxpayer who is audited has filed Form 8829, many

IRS districts now are making it mandatory for a revenue agent to

physically visit the taxpayer’s home by appointment. During the home

visit, the agent will look around and take pictures to determine

whether there really is a home office, whether it’s set up exclusively

for business and how large a portion of the home is taken up by the

office.

What to do: Consider restricting the square footage you report for a

home office to less than 20% of the total space in your home. You

might end up with a slightly lower tax deduction than you are

technically entitled to, but you may reduce your exposure to an audit.

You even may want to avoid declaring a home office at all.

PROVE YOU DONATED

The IRS appears to be taking a much closer look at cash and noncash

charitable donations, especially ones that are very large relative to

the taxpayer’s income. Giving 10% of your income to charity is far

above the norm, which is around 2%. Thus, donating large amounts

relative to your income may be a red flag to IRS examiners. Gifts of

property, especially those valued at more than $5,000, often draw

scrutiny.

All charitable deductions must be backed up by written verification

now, such as a letter from the charity or a bank record of the gift,

or, for cash donations under $250, a bank record recording the gift.

What to do: If you really donate substantial amounts and have

supporting evidence, such as receipts… letters from the recipient

organizations… and/or your bank statements, take the deductions.

Avoid making cash donations — it’s better to use a check or credit

card.

BACK UP HOME BUYER’S CLAIM

New laws in 2008 and 2009 created tax credits of up to $8,000 for many

first-time home buyers and $6,500 for many repeat buyers.

However, the Treasury Department found that about one out of every 10

claims for the tax credit is faulty, for a total of more than $600

million in claims that will not be allowed. The IRS has frozen

thousands of tax refunds and initiated more than 100,000 examinations

of questionable claims.

Examples: More than 580 people under age 18 (including a four-year-

old) claimed the credit, even though they are not eligible. The IRS

suspects that some high-income parents (who were not eligible for the

credit) had their low-income children claim the credit. Another,

perhaps more innocent, mistake might be claiming the credit if your

income was over the limit.

What to do: To avoid inviting an audit, be familiar with all of the

requirements for the home buyer’s credit, and follow them to the

letter. For details, go to http://www.HomeBuyerTaxCredit.com. Be sure to

attach Form 5405 and proof of closing to your tax return.

DON’T EXAGGERATE MORTGAGE INTEREST

During the housing boom, many people refinanced their homes with “cash-

out” mortgages, pulling out home equity to use for living expenses. In

2009, the IRS announced that it will extend a regional project

scrutinizing mortgage interest to a nationwide level by December 2011.

The regional project found many people reporting large mortgage

interest deductions in relation to their income — a potential audit

red flag.

What to do: If you are reporting, say, $20,000 in mortgage interest

payments but only $25,000 in income for 2009, you would be wise to

attach a brief statement explaining how you can handle such a big

mortgage — for example, that you are tapping your savings to pay the

mortgage.

DECLARE OVERSEAS ACCOUNTS

The IRS has announced that it expects to collect $8.5 billion in back

taxes from Americans with foreign bank accounts over the next few

years. The IRS is pressuring foreign banks to name names. For example,

in 2009, the US and Switzerland reached an agreement requiring Swiss

banks to provide account information if the IRS suspects any tax

evasion by account holders.

What to do: If you own or have authority over a foreign financial

account, you are required to file a Report of Foreign Bank and

Financial Accounts (FBAR) to the IRS if the aggregate value of all

your foreign accounts exceeds $10,000 at any time during the calendar

year. Be sure to do it.

Bottom Line/Personal interviewed Martin S. Kaplan, CPA, who has a

private practice based in New York City. He is a frequent guest

speaker at insurance, banking and financial-planning seminars and

author of What the IRS Doesn’t Want You to Know.