Parents who pay attention to their tax return can often recover thousands of dollars for everything from raising children to sending them to day care or college. Yet, taxpayers leave billions of unclaimed credits on the table, according to federal figures.
Maybe it's a lack of knowledge. Maybe it's intimidation from the rules and regulations that come in tax forms and publications. But tax software such as TurboTax or TaxAct, which are free on the IRS site (freefile.irs.gov) for people with an adjusted gross income of $58,000 or less and available in stores for others, will help you hunt for the credits that fit your situation and do the number crunching for you.
Whether you do taxes on paper or online, watch for these potential deals. And take advantage of them because many could be reduced in a couple of years as short-term tax laws expire. Here are ways to save money:
Child tax credit: Parents can cut their tax bill by as much as $1,000 a child, up to a total of $3,000. Children must be under age 17, and there are income requirements to meet. The credit starts to phase out when married couples' incomes top $110,000 and single parents' exceed $75,000. But parents still might qualify for some limited credit with incomes up to $130,000 for couples and $95,000 if single, said Terrence Rice, CPA. Typically, this credit reduces your regular taxes, but for some low-income families it is possible to get some money back from the government even if their income is too low to pay taxes.
Use Publication 972 and Form 8812 to qualify for a refund that exceeds what you owe in taxes.
Earned income tax credit: This credit is intended to help people who work but earn little. The amount of the credit is influenced by the number of children you have. For example, a couple with three children could have an income up to $48,362 and qualify, but a single person with no children would have to have an income under $13,460. The maximum credit with three children is $5,666, but if you are childless it's $457. To find out if you are eligible, use the table in IRS Publication 596.
Sending kids to college: The American Opportunity Tax Credit can take some of the sting out of paying college tuition and fees. You can get a credit of up to $2,500 per student per year for each of four years for college. To get the full benefit, income for a couple must be no more than $160,000; for singles, $80,000. But some credit is available for couples with income up to $180,000, or $90,000 for singles. The rules are covered in Publication 970.
Keep in mind that recent tax changes allow you to use the credit for each year of a four-year education up to the end of the 2010 tax year. Previously, the Hope Credit for college applied only to the first two years.
Rice notes that parents may be able to claim the credit if a grandparent pays a student's college costs directly to the college. In addition, if a student borrowed with student loans, either they or their parents can deduct the interest payments they make on the loans.
Adopted child: Recent tax changes have enhanced the credits available to parents who adopt children, said Rice. Parents can receive a credit for up to $13,170 for expenses, such as legal fees, incurred while adopting a child. In some cases, travel costs may also be covered if the adoption was done away from home. Parents adopting special needs children may be able to get the full $13,170 credit even if they did not spend that much. Use Form 8839.
Child care expenses: If you pay someone to care for a child under age 13 while you work, you can get a credit for up to 35 percent of the costs up to $3,000 per child or $6,000 for two children. This can cover care in your home as long as it's not provided by a spouse or one of your other children. The benefit can also extend to facilities such as day camps but not overnight camps. See Publication 503.
Moving for a job: If you had to move at least 50 miles for a new job, you can deduct your moving expenses. Job-seeking expenses are also deductible. Use Publication 521.
Insuring the kids: If you were self-employed in 2010 and bought health insurance for yourself and your family, you will be able to deduct the premiums you paid for children under 27, even if you don't claim the child as a dependent, said Rice. This is a result of health care overhaul. Dates matter, however. Rice notes the deduction is possible only for the portion paid from March 30 to the end of 2010.
Showing posts with label Audit. Show all posts
Showing posts with label Audit. Show all posts
Sunday, February 20, 2011
Saturday, February 12, 2011
4 questions to ask before hiring a tax preparer
To take advantage of all the tax breaks available, preparers must keep up with changes in the tax code. Late last year, for example, Congress extended several deductions that had expired in 2009.
In most states, anyone can prepare taxes for a fee. There are no training or licensing requirements. Some individuals use the promise of low-cost tax preparation to sell dubious products, such as high-cost refund-anticipation loans.
That's changing, though. Last year, the IRS announced that tax preparers will be required to register with the government, pass a competency test and take continuing-education courses. The IRS plans to phase in the program over several years.
Starting this year, all paid preparers must obtain a Preparer Tax Identification Number from the IRS and include it on all returns they file. At this point, all a PTIN signifies is that the individual has registered with the IRS. Still, you should make sure a preparer has a PTIN. Someone who hasn't gone to the trouble to comply with this requirement may be slipshod in other areas.
Before hiring a preparer, check with your local Better Business Bureau to find out if there have been any complaints against the individual or company. Once you've done that, be prepared to ask some questions, including:
•Do you have any professional designations?CPAs, enrolled agents and attorneys must fulfill continuing-education and licensing requirements and are bound by ethical standards. They're also authorized to represent taxpayers before the IRS in all matters, including audits, collections and appeals. If the preparer doesn't have one of those designations, ask him if he belongs to any professional organizations that have continuing-education requirements.
•How much experience do you have with my type of return? Everyone has to learn the ropes somehow, but you probably don't want someone learning them on your tax return. Ask the preparer how long they have been preparing tax returns and whether they are familiar with your type of return.
•How do you determine your fees? Many reputable preparers charge a flat fee based on the complexity of your tax return. For example, someone with a 1040EZ will usually pay less than someone who has income from rental property and investments, she says. Ask the preparer to put the billing and payment terms in writing.
Steer clear of any preparer who bases fees on a percentage of your refund. Likewise, avoid preparers who claim they can get you a bigger refund than the guy down the street. No one can estimate your refund without first reviewing your financial information.
•Have you represented many clients in IRS audits? A preparer who has experience with IRS audits could provide valuable assistance if your return is scrutinized. But be wary of someone who has been through the process numerous times. That may be a sign he claims a lot of questionable deductions.
Keep in mind that you're responsible for the information on your tax return. Ideally, your tax preparer should e-mail or call with questions before completing your return. And you should always review and sign your return before it's filed with the IRS.
Saturday, February 5, 2011
Can you claim home buyer tax credit?
If you bought a home last year, you may be eligible for a tax credit of up to $8,000 when you file your 2010 tax return. But before you start shopping for hardwood floors, make sure you qualify. And even if you're eligible, you'll need to take extra steps to prove that your claim is legitimate.
Congress first enacted a home buyer's tax credit in 2008 in an effort to revitalize the housing market. Since then, the credit has been revised and extended several times. Here are the factors that will determine your eligibility for the credit:
•When you signed the contract to buy your home. To claim the credit on your 2010 tax return, you must have signed a contract to purchase your primary residence before May 1, 2010.
•When you closed. Home buyers who closed as late as Sept. 30, 2010, qualify for the credit, as long as their original contract called for the purchase to be completed by June 30. Congress added the extension because many of last year's home purchases involved short sales or homes in foreclosure, and banks have been slow to process those transactions, says Terry Rice.
•Where you lived before you bought the home. For homes purchased Nov. 7, 2009, to April 30, 2010, there are two tax credits: a first-time home buyer credit and a repeat home buyer credit.
The first-time home buyer credit is worth 10% of the purchase price of the home, up to a maximum of $8,000. The law defines a first-time home buyer as someone who hasn't owned a principal residence in the three years before the purchase. The repeat home buyer credit is worth up to 10% of the purchase price, up to a maximum of $6,500. The law defines a repeat buyer as someone who has owned and lived in the same home for at least five consecutive years of the eight years. If you're married, both spouses must meet the residency test.
•How much you paid for the home. The first-time and repeat home buyer credits are limited to homes purchased for less than $800,000.
•Your income. The full credit is available to taxpayers with a modified adjusted gross income of up to $125,000, or $225,000 for joint filers. (Those limits apply to homes purchased after Nov. 6, 2009; there are lower cutoffs for homes purchased before that date.) A reduced credit is available for home buyers with MAGI of up to $145,000, or $245,000 for married homeowners.
Payback time
Now comes the bad news for taxpayers who claimed the home buyer's credit in 2008. Starting this year, they'll have to pay it back.
That's because the original first-time home buyer's tax "credit" was in fact an interest-free loan that had to be paid in equal installments over 15 years. The law gave home buyers who claimed the credit a two-year grace period, which means the first installment is due this year. H&R Block estimates that more than 950,000 taxpayers claimed the credit in 2008.
The maximum 2008 "credit" was $7,500, so if you claimed the full amount, you'll have to pay $500 when you file your 2010 tax return, Roth says. "A lot of people will end up owing a fair amount of taxes this year because of the additional $500 they'll have to repay," he says.
If you bought a house in 2008 then sold it, you could owe even more, because in that instance, you're required to repay the entire amount of the credit all at once.
Tax credits claimed for homes purchased in 2009 and 2010 don't have to be repaid, as long as the home remains your primary residence for three years. If you sell the home within 36 months after the purchase, you'll have to repay the credit. The repayment can't exceed the gain on the sale, so if you didn't make any profit on the sale, you may not owe anything. However, your "basis" for purposes of calculating the loss or gain on the sale is the amount you paid for the home minus your tax credit, says Rice. For example, if you bought your house for $100,000 and claimed an $8,000 first-time home buyer's credit, your basis is $92,000.
Be prepared to wait
The IRS is requiring taxpayers who claim the home buyer's tax break to provide documents proving that they purchased a home within the required time frame. To meet that requirement, you must file your tax return by mail.
The IRS imposed the requirement to deter fraud. The Treasury Department's inspector general reported last year that thousands of individuals, including nearly 1,300 prison inmates, had fraudulently claimed the tax credit.
Documents you may need to include:
•A copy of your settlement statement. For most home buyers, that's the HUD-1 provided at closing. Sign the settlement statement, even if the document doesn't have a line for your signature.
•For newly constructed homes, a dated copy of the certificate of occupancy that shows your name and the address of the home.
•For repeat buyers, copies of documents showing that you lived in your previous residence for five consecutive years during the past eight years. Acceptable documents include mortgage interest statements, property tax records or homeowners insurance statements. You don't need to provide five years of the same documents, the IRS says. You can use a combination of documents to verify the years you were in the home.
Paper-filed returns take the IRS up to six weeks to process, vs. less than two weeks for e-filed returns. Returns that claim the credit may get extra scrutiny from the IRS, which could also delay your refund. "It's worth it to get the credit," Pickering says, "but people need to be patient."
Wednesday, January 26, 2011
10 Ways to Avoid a Tax Audit
Worried about extra scrutiny from the Internal Revenue Service?
While you can never completely "audit-proof" your business's income tax return, you can take actions that will greatly reduce your chances of being flagged.
Here are 10 ways to avoid a tax audit:
1. Choose your tax return preparer with care. Today, according to the recent National Taxpayer Advocate report, 60% of individuals and even a greater percentage of businesses use paid preparers to do their income tax returns. Yet, preparers now face more intense IRS review. If the IRS believes a preparer is claiming unwarranted deductions or taking other fraudulent steps on clients' returns, then the preparer's clients are at risk for audit.
The IRS has eight tips for choosing a tax preparer. Key among them is to check the preparer's history to see if there has been any disciplinary action. For example, if you use an enrolled agent, check with the IRS' office of Professional Responsibility at opr@irs.gov (include the preparer's name and address).
2. Report all of your income. The IRS uses information returns, such as W-2s and 1099s, to cross-check income reporting. Under its document-matching program, the IRS' computers compare information on the forms with the income reported by taxpayers on their returns. If the information doesn't match, this leads to an automatic audit. But don't panic; it's merely a correspondence asking about the discrepancy. It can be easily cleared up by submitting an explanation by mail if you think you are correct, or paying the tax owed if the omission was your oversight and the IRS is correct.
Sole proprietors, freelancers and independent contractors who use the cash method of accounting may be vulnerable to year-end payment problems. For instance, a sole proprietor that performed work for a client may have received a payment in early January – but the client might have mailed (and recorded) the payment in December. The client will include the payment on Form 1099-MISC for 2010, but it isn't taxable until 2011. What to do: Include the payment as it is reported on the 2010 return, but then subtract the payment and attach an explanation with the return. Then include the payment on the 2011 return, even though no 1099 will be issued for this year.
3. Provide complete information. All questions should be answered and all required information should be included on the forms and schedules necessary for your return. That means if you're a sole proprietor, include your business code number, accounting method, and, where applicable, inventory valuation method on Schedule C. If information is missing, it could trigger a more extensive look at the return.
Also add information where necessary to explain entries or omissions that are not easily understood—such as in the prior example, when income received in January is reported on a prior year 1099.
4. Avoid claiming deductions that are audit red flags.Advice is easy to give, but unfortunately, the IRS does not say which deductions are likely to provoke a closer look. There are no official audit red flags. While many warn that claiming a home office deduction can prompt an audit, there's no proof of this. If you meet the qualifications for claiming a home-office deduction, there's no good reason not to take the write-off. Check your eligibility in IRS Publication 587, Business Use of Your Home.
A number of years ago, the Government Accountability Office (formerly the General Accounting Office) compiled statistics on deductions claimed by sole proprietors to show the types of deductions relative to the amount of their revenue. Some tax professionals believe that taking more than the "average" can raise an IRS eyebrow, but again, there is no concrete support for this view. A business that is entitled to deductions, even if they are high relative to the amount of their income, should claim them—but be prepared to prove entitlement if the return is questioned.
5. Don't file certain forms or schedules. Some optional forms and schedules virtually guarantee an audit. For example, if you turn a hobby into a sideline and show a business loan, the IRS may question whether some of your deductions are legitimate. If that happens, you might file a Form 5213, which keeps the IRS from auditing you for the first five years of the business. If you can show that you're profitable in at least three of the years, then the business isn't a hobby and the losses in the other years aren't questioned. The problem: Filing the form virtually guarantees an examination at the end of five years.
Better way: If you have loss years, be prepared to prove that you are operating the activity with a profit motive.
6. Pay attention to details. Math errors or incorrect entries of Social Security numbers or tax identification numbers can easily trigger an inquiry into your return. Math errors can be greatly reduced by electronic filing rather than filing paper returns. In the past, the IRS had said that errors are less than 1% on returns that are filed electronically, compared with about 20% on returns submitted via paper. If an e-filed return has a math error, it won't be accepted; instead it is sent back for correction and refiling.
But information on electronically filed returns is only as good as the information you submit. Reporting $2,000 in income when it should have been $20,000 is your mistake and one that likely won't be noticed as a math error by a computer.
7. Mind your personal entries. If there are entries related to the personal side of your return, this can ultimately lead to scrutiny of your return activities. The IRS selects returns for audit in some cases based on a Discriminant Function System or DIF score, which is based on IRS experience with taxpayers claiming certain deductions or credits within set income levels. For example, if you claim charitable contributions that are higher than the average deductions for your income level, this could lead to a personal audit; the personal audit may be expanded to include your business activities.
8. Change your business status. IRS Statistics show that you are 10 times as likely to be audited as a Schedule C filer than if you incorporate your business and elect S corporation status. While it costs a bit of money to incorporate, the move affords you greater personal liability protection and reduces your chances of being audited. In deciding whether to change your business status, include both tax and non-tax factors.
Note: Forming a limited liability company for one owner will not give you any audit protection, because the owner still files a Schedule C.
9. Watch your state tax return. The IRS has information-sharing agreements with the states. If you are audited at the state level and owe additional taxes because of omitting income or for other reasons, this information is shared with the IRS. The information may then prompt the IRS to contact you asking for additional tax payment or to audit your return in more depth.
10. Plan for an audit, just in case. Because the IRS conducts random audits from time to time (such as a three-year random audit program for S corporations in 2007 and a current three-year random audit program for employment tax returns), any return could be selected for review at any time. Be prepared:
While you can never completely "audit-proof" your business's income tax return, you can take actions that will greatly reduce your chances of being flagged.
Here are 10 ways to avoid a tax audit:
1. Choose your tax return preparer with care. Today, according to the recent National Taxpayer Advocate report, 60% of individuals and even a greater percentage of businesses use paid preparers to do their income tax returns. Yet, preparers now face more intense IRS review. If the IRS believes a preparer is claiming unwarranted deductions or taking other fraudulent steps on clients' returns, then the preparer's clients are at risk for audit.
The IRS has eight tips for choosing a tax preparer. Key among them is to check the preparer's history to see if there has been any disciplinary action. For example, if you use an enrolled agent, check with the IRS' office of Professional Responsibility at opr@irs.gov (include the preparer's name and address).
2. Report all of your income. The IRS uses information returns, such as W-2s and 1099s, to cross-check income reporting. Under its document-matching program, the IRS' computers compare information on the forms with the income reported by taxpayers on their returns. If the information doesn't match, this leads to an automatic audit. But don't panic; it's merely a correspondence asking about the discrepancy. It can be easily cleared up by submitting an explanation by mail if you think you are correct, or paying the tax owed if the omission was your oversight and the IRS is correct.
Sole proprietors, freelancers and independent contractors who use the cash method of accounting may be vulnerable to year-end payment problems. For instance, a sole proprietor that performed work for a client may have received a payment in early January – but the client might have mailed (and recorded) the payment in December. The client will include the payment on Form 1099-MISC for 2010, but it isn't taxable until 2011. What to do: Include the payment as it is reported on the 2010 return, but then subtract the payment and attach an explanation with the return. Then include the payment on the 2011 return, even though no 1099 will be issued for this year.
3. Provide complete information. All questions should be answered and all required information should be included on the forms and schedules necessary for your return. That means if you're a sole proprietor, include your business code number, accounting method, and, where applicable, inventory valuation method on Schedule C. If information is missing, it could trigger a more extensive look at the return.
Also add information where necessary to explain entries or omissions that are not easily understood—such as in the prior example, when income received in January is reported on a prior year 1099.
4. Avoid claiming deductions that are audit red flags.Advice is easy to give, but unfortunately, the IRS does not say which deductions are likely to provoke a closer look. There are no official audit red flags. While many warn that claiming a home office deduction can prompt an audit, there's no proof of this. If you meet the qualifications for claiming a home-office deduction, there's no good reason not to take the write-off. Check your eligibility in IRS Publication 587, Business Use of Your Home.
A number of years ago, the Government Accountability Office (formerly the General Accounting Office) compiled statistics on deductions claimed by sole proprietors to show the types of deductions relative to the amount of their revenue. Some tax professionals believe that taking more than the "average" can raise an IRS eyebrow, but again, there is no concrete support for this view. A business that is entitled to deductions, even if they are high relative to the amount of their income, should claim them—but be prepared to prove entitlement if the return is questioned.
5. Don't file certain forms or schedules. Some optional forms and schedules virtually guarantee an audit. For example, if you turn a hobby into a sideline and show a business loan, the IRS may question whether some of your deductions are legitimate. If that happens, you might file a Form 5213, which keeps the IRS from auditing you for the first five years of the business. If you can show that you're profitable in at least three of the years, then the business isn't a hobby and the losses in the other years aren't questioned. The problem: Filing the form virtually guarantees an examination at the end of five years.
Better way: If you have loss years, be prepared to prove that you are operating the activity with a profit motive.
6. Pay attention to details. Math errors or incorrect entries of Social Security numbers or tax identification numbers can easily trigger an inquiry into your return. Math errors can be greatly reduced by electronic filing rather than filing paper returns. In the past, the IRS had said that errors are less than 1% on returns that are filed electronically, compared with about 20% on returns submitted via paper. If an e-filed return has a math error, it won't be accepted; instead it is sent back for correction and refiling.
But information on electronically filed returns is only as good as the information you submit. Reporting $2,000 in income when it should have been $20,000 is your mistake and one that likely won't be noticed as a math error by a computer.
7. Mind your personal entries. If there are entries related to the personal side of your return, this can ultimately lead to scrutiny of your return activities. The IRS selects returns for audit in some cases based on a Discriminant Function System or DIF score, which is based on IRS experience with taxpayers claiming certain deductions or credits within set income levels. For example, if you claim charitable contributions that are higher than the average deductions for your income level, this could lead to a personal audit; the personal audit may be expanded to include your business activities.
8. Change your business status. IRS Statistics show that you are 10 times as likely to be audited as a Schedule C filer than if you incorporate your business and elect S corporation status. While it costs a bit of money to incorporate, the move affords you greater personal liability protection and reduces your chances of being audited. In deciding whether to change your business status, include both tax and non-tax factors.
Note: Forming a limited liability company for one owner will not give you any audit protection, because the owner still files a Schedule C.
9. Watch your state tax return. The IRS has information-sharing agreements with the states. If you are audited at the state level and owe additional taxes because of omitting income or for other reasons, this information is shared with the IRS. The information may then prompt the IRS to contact you asking for additional tax payment or to audit your return in more depth.
10. Plan for an audit, just in case. Because the IRS conducts random audits from time to time (such as a three-year random audit program for S corporations in 2007 and a current three-year random audit program for employment tax returns), any return could be selected for review at any time. Be prepared:
- Compile good books and records for your business activities.
- Retain required receipts and other documentation.
- Use separate bank accounts and credit cards for your business and personal activities.
Monday, January 17, 2011
Study Finds Audited Financial Statements Help Businesses' Loan Prospects
Small businesses whose books are audited—by a hired certified public accountant, not the Internal Revenue Service—improve their chances of getting a loan, and at far better terms, than businesses with less scrutinized financial statements, a new study shows.
Yet even as owners continue to struggle with tight credit, few can afford the time, effort or cost of preparing complex financial statements, let alone having them audited, small-business owners, lenders and accountants say.
"Banks love when you have audited financials because they view it as a form of insurance," says Buzz Rose, a certified public accountant in Pittsburgh. "But audits have become very expensive and to have one done 'just in case' would seem to be a waste of time and money."
But the benefits might outweigh the costs.
Based on data from more than 10,000 closely held companies—about half of which have less than 500 employees—a study by the University of Chicago Booth School of Business found audited businesses save an average of $6,900 for every $1 million in outstanding debt every year as a result of lower interest rates, which were more than half a percentage point below rates paid by nonaudited businesses. For a loan of $3.3 million, the average size of loans analyzed in the study, the savings was about $23,000.
A small-business audit costs anywhere from $5,000 to $75,000, depending on the size of the company, the complexity of its data and other factors—typically double the cost of a financial statement review, the next highest level of CPA-verified assurance after an audit.
An audit provides third-party assurance that a company's financial statements are correctly prepared and based on verified business data, while a review shows the statements are at least internally consistent with data provided by management.
"There appears to be a very real cost benefit to getting an audit, beyond the obvious value of having your financial statements in order," says Michael Minnis, a Booth School assistant professor of accounting who led the study. The Booth School study is expected to be published in the Journal of Accounting Research in May.
Similarly, a joint study last year by Michigan State University and Indiana University found small businesses with audited financial statements were "significantly less likely" to be denied credit from banks.
David Leuthold, chief executive of Century Negotiations Inc., a North Huntingdon, Pa., consumer-debt settlement firm, says he started having his books audited annually in 2005 to double-check his own bookkeeping, paying about $8,000 an audit. The move paid off when he applied for a $100,000 line of credit the following year.
"The bank required audited financial statements," says Mr. Leuthold, whose company made $8 million in revenue last year. Even without audited books, he believes the bank might have approved the loan, though at less favorable terms. "We had what they wanted, so it was definitely worth it," he says.
Still, for many small businesses seeking a loan, lenders say an audit is costly and unnecessary.
"Audits provide good information. The more concrete information a lender can get, the better," says Tom Burke, the director of Wells Fargo's Small Business Administration lending division. But he questioned the necessity of audits for every business.
Mr. Burke says a business with less than $1 million in annual revenue can ask a CPA to prepare a compilation, which is a cheaper, unaudited financial statement based on recorded sales, inventory and other data. Since owners often use these statements to manage daily operations—and they're prepared by CPAs—lenders have some assurance of the statements' accuracy in making loan decisions.
"I'd hate to see people taking steps that aren't necessary, or that they can't afford," Mr. Burke says.
Small-business accountant David Wilke, of Carnegie, Pa., says he helps borrowers and lenders negotiate loan terms based on mutually acceptable levels of assurance, ranging from compilations to audits. He says a CPA "adds value by determining what a bank wants and what a business can provide at an early stage," rather than trying to convince every client to get audited.
Mr. Rose, the accountant in Pittsburgh, says it's only worth going through an audit—which can require days and even weeks of a manager's time—when a business owner has a loan in hand that's contingent on providing audited financial statements.
Audited or not, less than a quarter of businesses with fewer than 500 employees keep financial statements of any kind, according to the Federal Reserve Board's National Survey of Small Business Finances.
"There's a lot of criticism that it's expensive and difficult to prepare and audit your financial statements," says Teri Yohn, an Indiana University associate professor of accounting who sits on the Financial Accounting Foundation's blue-ribbon panel on private-company accounting standards. "But there are clearly benefits."
Yet even as owners continue to struggle with tight credit, few can afford the time, effort or cost of preparing complex financial statements, let alone having them audited, small-business owners, lenders and accountants say.
"Banks love when you have audited financials because they view it as a form of insurance," says Buzz Rose, a certified public accountant in Pittsburgh. "But audits have become very expensive and to have one done 'just in case' would seem to be a waste of time and money."
But the benefits might outweigh the costs.
Based on data from more than 10,000 closely held companies—about half of which have less than 500 employees—a study by the University of Chicago Booth School of Business found audited businesses save an average of $6,900 for every $1 million in outstanding debt every year as a result of lower interest rates, which were more than half a percentage point below rates paid by nonaudited businesses. For a loan of $3.3 million, the average size of loans analyzed in the study, the savings was about $23,000.
A small-business audit costs anywhere from $5,000 to $75,000, depending on the size of the company, the complexity of its data and other factors—typically double the cost of a financial statement review, the next highest level of CPA-verified assurance after an audit.
An audit provides third-party assurance that a company's financial statements are correctly prepared and based on verified business data, while a review shows the statements are at least internally consistent with data provided by management.
"There appears to be a very real cost benefit to getting an audit, beyond the obvious value of having your financial statements in order," says Michael Minnis, a Booth School assistant professor of accounting who led the study. The Booth School study is expected to be published in the Journal of Accounting Research in May.
Similarly, a joint study last year by Michigan State University and Indiana University found small businesses with audited financial statements were "significantly less likely" to be denied credit from banks.
David Leuthold, chief executive of Century Negotiations Inc., a North Huntingdon, Pa., consumer-debt settlement firm, says he started having his books audited annually in 2005 to double-check his own bookkeeping, paying about $8,000 an audit. The move paid off when he applied for a $100,000 line of credit the following year.
"The bank required audited financial statements," says Mr. Leuthold, whose company made $8 million in revenue last year. Even without audited books, he believes the bank might have approved the loan, though at less favorable terms. "We had what they wanted, so it was definitely worth it," he says.
Still, for many small businesses seeking a loan, lenders say an audit is costly and unnecessary.
"Audits provide good information. The more concrete information a lender can get, the better," says Tom Burke, the director of Wells Fargo's Small Business Administration lending division. But he questioned the necessity of audits for every business.
Mr. Burke says a business with less than $1 million in annual revenue can ask a CPA to prepare a compilation, which is a cheaper, unaudited financial statement based on recorded sales, inventory and other data. Since owners often use these statements to manage daily operations—and they're prepared by CPAs—lenders have some assurance of the statements' accuracy in making loan decisions.
"I'd hate to see people taking steps that aren't necessary, or that they can't afford," Mr. Burke says.
Small-business accountant David Wilke, of Carnegie, Pa., says he helps borrowers and lenders negotiate loan terms based on mutually acceptable levels of assurance, ranging from compilations to audits. He says a CPA "adds value by determining what a bank wants and what a business can provide at an early stage," rather than trying to convince every client to get audited.
Mr. Rose, the accountant in Pittsburgh, says it's only worth going through an audit—which can require days and even weeks of a manager's time—when a business owner has a loan in hand that's contingent on providing audited financial statements.
Audited or not, less than a quarter of businesses with fewer than 500 employees keep financial statements of any kind, according to the Federal Reserve Board's National Survey of Small Business Finances.
"There's a lot of criticism that it's expensive and difficult to prepare and audit your financial statements," says Teri Yohn, an Indiana University associate professor of accounting who sits on the Financial Accounting Foundation's blue-ribbon panel on private-company accounting standards. "But there are clearly benefits."
Saturday, January 8, 2011
IRS Audit Red Flags: The Dirty Dozen
Ever wonder why some tax returns are audited by the IRS while most are ignored? Well, there’s a whole host of reasons to this age-old question. The IRS audits only about 1% of all individual tax returns annually. The agency doesn’t have enough personnel and resources to examine each and every tax return filed during a year. So the odds are pretty low that your return will be picked for an audit. And of course, the only reason filers should worry about an audit is if they are cheating on their taxes.
However, the chances of you being audited or otherwise hearing from the IRS can increase depending upon various factors, including whether you omitted income, the types of deductions or losses claimed, certain credits taken, foreign asset holdings and math errors, just to name a few. Although there’s no sure way to avoid an IRS audit, you should be aware of red flags that could increase your chance of drawing some unwanted attention from the IRS. Here are the 12 most important ones:
1. Failure to report all taxable income.
The IRS receives copies of all 1099s and W-2s that you receive during a year, so make sure that you report all required income on your tax return. the IRS computers are pretty good at matching these forms received with the income shown on your return. A mismatch sends up a red flag and causes IRS computers to spit out a bill. If you receive a 1099 for income that isn’t yours or the income listed is incorrect, get the issuer to file a corrected form with the IRS.
2. Returns claiming the home-buyer credit.
First-time homebuyers and longtime homeowners who claimed the homebuyer credit should be prepared for IRS scrutiny. Make sure you submit proper documentation when taking this credit. First-time homebuyers have to attach a copy of their settlement statement to the return, and longtime homeowners should also attach documents showing prior ownership of a home, including records of property tax and insurance coverage. All claims for this credit are being screened. As of May 2010, more than 260,000 returns had been selected for correspondence audits (examinations done by mail rather than face-to-face) because filers did not attach the necessary documents to their tax returns. And those numbers will continue to grow.
Also, the IRS has ways of policing the recapture of the homebuyer credit. Generally, the credit is required to be recaptured if the home is sold within three years for homes brought in 2009 or 2010 and within 15 years for homes bought before 2009. The IRS is checking public real estate databases for sales of homes for which the credit was taken.
3. Claiming large charitable deductions.
This comes up again and again because the IRS has found abuse on audit, especially with those taking larger deductions. We all know that charitable contributions are a great write-off and help you to feel all warm and fuzzy inside. However, if your charitable deductions are disproportionately large compared to your income, it raises a red flag. That’s because the IRS can tell what the average charitable donation is for a person in your tax bracket. Also, if you don’t get an appraisal for donations of valuable property or if you fail to file Form 8283 for donations over $500, the chances of audit increase. Be sure you keep all your supporting documents, including receipts for cash and property contributions made during the year, and abide by the documentation rules. And attach Form 8283 if required.
4. Home office deduction.
The IRS is always very interested in this deduction, primarily because it has a pretty high adjustment rate on audit. This is because history has shown that many people who claim a home office don’t meet all the requirements for properly taking the deduction, and others may overstate the benefit. If you qualify, you can deduct a percentage of your rent, real estate taxes, utilities, phone bills, insurance, and other costs that are properly allocated to the home office. That’s a great deal. However, in order to take this write-off, the space must be used exclusively and on a regular basis as your principal place of business. That makes it difficult to claim a guest bedroom or children’s playroom as a home office, even if you also use the space to conduct your work. Exclusive use means a specific area of the home is used only for trade or business, not also where the family watches TV at night. Don’t be afraid to take the home-office deduction if you’re otherwise entitled to it. Risk of audit should not keep you from taking legitimate deductions. If you have it and can prove it, then use it.
5. Business meals, travel and entertainment.
Schedule C is a treasure trove of tax deductions for self-employeds. But it’s also a gold mine for IRS agents, who know from past experience that self-employeds tend to claim excessive deductions. Most under-reporting of income and overstating of deductions are done by those who are self-employed. And the IRS looks at both higher-grossing sole proprietorships as well as smaller ones.
Big deductions for meals, travel and entertainment are always ripe for audit. A large write-off here will set off alarm bells, especially if the amount seems too large for the business. Agents know that many filers slip in personal meals here or fail to satisfy the strict substantiation rules for these expenses. To qualify for meals or entertainment deductions, you must keep detailed records generally documenting the following for each expense: amount, place, persons attending, business purpose and nature of discussion or meeting. Also, receipts are required for expenditures over $75 or any expense for lodging while traveling away from home. Without proper documentation, your deduction is toast.
6. Claiming 100% business use of vehicle
. Another area that is ripe for IRS review is use of a business vehicle. When you depreciate a car, you have to list on Form 4562 what percentage of its use during the year was for business. Claiming 100% business use for an automobile on Schedule C is red meat for IRS agents. They know that it’s extremely rare that an individual actually uses a vehicle 100% of the time for business, especially if no other vehicle is available for personal use. IRS agents are trained to focus on this issue and will closely scrutinize your records. Make sure you keep very detailed mileage logs and precise calendar entries for the purpose of every road trip. Sloppy recordkeeping makes it easy for the revenue agent to disallow your deduction. As a reminder, even if you use the IRS’ standard mileage rate to deduct your business vehicle costs, ensure that you are not also claiming actual expenses for maintenance, insurance and other out-of-pocket costs. The IRS has found filer noncompliance in this area as well and will look for this.
7. Claiming a loss for a hobby activity.
Your chances of “winning” the audit lottery increase if you have wage income and file a Schedule C with large losses. And, if your Schedule C loss-generating activity sounds like a hobby…horse breeding, car racing, and such…the IRS pays even more attention. It’s issued guidelines to its agents on how to sniff out those who improperly deduct hobby losses. Large Schedule C losses are audit bait, but reporting losses from activities in which it looks like you might be having a good time is just asking for IRS scrutiny.
Tax laws don’t allow you to deduct hobby losses on Schedule C; however, you do have to report any income earned from your hobbies. In order to claim a hobby loss, your activity must be entered into and conducted with the reasonable expectation of making a profit. If your activity generates profit three out of every five years (or two out of seven years for horse breeding), the law presumes you’re in business to make a profit, unless the IRS establishes to the contrary. If audited, the IRS is going to make you prove you have a legitimate business and not a hobby. So, make sure you run your activity in a business-like manner and can provide supporting documents for all expenses.
8. Cash businesses.
Small business owners, especially those in cash-intensive businesses…taxi drivers, car washes, bars, hair salons, restaurants and the like…are an easy target for IRS auditors. The agency is well aware that those who primarily receive cash in their business are less likely to accurately report all of their taxable income. the IRS wants to narrow the tax gap, and history has shown that cash-based businesses are a good source of audit adjustments. It has a new guide for agents to use when auditing cash intensive businesses, telling how to interview owners and noting various indicators of unreported income.
9. Failure to report a foreign bank account.
The IRS is intensely interested in people with offshore accounts, especially those in tax havens. U.S. tax authorities have had some recent success in trying to get foreign banks (such as UBS in Switzerland) to disclose information on U.S. account holders. Also, the IRS had a voluntary compliance program where people came in and reported their foreign bank accounts and foreign assets in exchange for lesser penalties than they would have otherwise been subject to. The IRS has learned a lot from these probes.
Failure to report a foreign bank account can lead to severe penalties, and the IRS has made this issue a top priority. Make sure that if you have any such accounts, you properly report them when you file your return. Keep in mind, though, that if you have never previously reported the foreign bank account on your return, and you decide to do so for the first time in 2010, that might also look suspicious to the IRS.
10. Engaging in currency transactions.
The IRS gets many reports of cash transactions in excess of $10,000 involving banks, casinos, car dealers and other businesses, plus suspicious activity reports from banks and disclosures of foreign accounts. A recent report by Treasury inspectors concluded that these currency transaction reports are a valuable source of audit leads for sniffing out unreported income. The IRS agrees and it will make greater use of these forms in its audit process. So if you are a person who makes large cash purchases or deposits, be prepared for IRS scrutiny. Also, beware that banks and other institutions file reports on suspicious activities that appear to avoid the currency transaction rules (such as persons depositing $9,500 cash one day and an additional $9,500 cash two days later).
11. Math errors.
One of the biggest reasons that people receive a letter from the IRS is because of mathematical mistakes they make on their tax returns. If you make an error in your favor, you are going to hear from the tax man, and there is a greater risk of the IRS pulling the whole return for audit. So take time to ensure all your calculations are correct. Even though math errors may not lead to a full-blown audit, it’s always best to remain under the radar of IRS computers.
12. Taking higher-than-average deductions.
If deductions on your return are disproportionately large compared to your income, the IRS audit formulas take this into account when selecting returns for examination. Screeners then pull the most questionable returns for review. But if you’ve got the proper documentation for your deduction, don’t be scared to claim it. There’s no reason to ever pay the IRS more tax than you actually owe.
However, the chances of you being audited or otherwise hearing from the IRS can increase depending upon various factors, including whether you omitted income, the types of deductions or losses claimed, certain credits taken, foreign asset holdings and math errors, just to name a few. Although there’s no sure way to avoid an IRS audit, you should be aware of red flags that could increase your chance of drawing some unwanted attention from the IRS. Here are the 12 most important ones:
1. Failure to report all taxable income.
The IRS receives copies of all 1099s and W-2s that you receive during a year, so make sure that you report all required income on your tax return. the IRS computers are pretty good at matching these forms received with the income shown on your return. A mismatch sends up a red flag and causes IRS computers to spit out a bill. If you receive a 1099 for income that isn’t yours or the income listed is incorrect, get the issuer to file a corrected form with the IRS.
2. Returns claiming the home-buyer credit.
First-time homebuyers and longtime homeowners who claimed the homebuyer credit should be prepared for IRS scrutiny. Make sure you submit proper documentation when taking this credit. First-time homebuyers have to attach a copy of their settlement statement to the return, and longtime homeowners should also attach documents showing prior ownership of a home, including records of property tax and insurance coverage. All claims for this credit are being screened. As of May 2010, more than 260,000 returns had been selected for correspondence audits (examinations done by mail rather than face-to-face) because filers did not attach the necessary documents to their tax returns. And those numbers will continue to grow.
Also, the IRS has ways of policing the recapture of the homebuyer credit. Generally, the credit is required to be recaptured if the home is sold within three years for homes brought in 2009 or 2010 and within 15 years for homes bought before 2009. The IRS is checking public real estate databases for sales of homes for which the credit was taken.
3. Claiming large charitable deductions.
This comes up again and again because the IRS has found abuse on audit, especially with those taking larger deductions. We all know that charitable contributions are a great write-off and help you to feel all warm and fuzzy inside. However, if your charitable deductions are disproportionately large compared to your income, it raises a red flag. That’s because the IRS can tell what the average charitable donation is for a person in your tax bracket. Also, if you don’t get an appraisal for donations of valuable property or if you fail to file Form 8283 for donations over $500, the chances of audit increase. Be sure you keep all your supporting documents, including receipts for cash and property contributions made during the year, and abide by the documentation rules. And attach Form 8283 if required.
4. Home office deduction.
The IRS is always very interested in this deduction, primarily because it has a pretty high adjustment rate on audit. This is because history has shown that many people who claim a home office don’t meet all the requirements for properly taking the deduction, and others may overstate the benefit. If you qualify, you can deduct a percentage of your rent, real estate taxes, utilities, phone bills, insurance, and other costs that are properly allocated to the home office. That’s a great deal. However, in order to take this write-off, the space must be used exclusively and on a regular basis as your principal place of business. That makes it difficult to claim a guest bedroom or children’s playroom as a home office, even if you also use the space to conduct your work. Exclusive use means a specific area of the home is used only for trade or business, not also where the family watches TV at night. Don’t be afraid to take the home-office deduction if you’re otherwise entitled to it. Risk of audit should not keep you from taking legitimate deductions. If you have it and can prove it, then use it.
5. Business meals, travel and entertainment.
Schedule C is a treasure trove of tax deductions for self-employeds. But it’s also a gold mine for IRS agents, who know from past experience that self-employeds tend to claim excessive deductions. Most under-reporting of income and overstating of deductions are done by those who are self-employed. And the IRS looks at both higher-grossing sole proprietorships as well as smaller ones.
Big deductions for meals, travel and entertainment are always ripe for audit. A large write-off here will set off alarm bells, especially if the amount seems too large for the business. Agents know that many filers slip in personal meals here or fail to satisfy the strict substantiation rules for these expenses. To qualify for meals or entertainment deductions, you must keep detailed records generally documenting the following for each expense: amount, place, persons attending, business purpose and nature of discussion or meeting. Also, receipts are required for expenditures over $75 or any expense for lodging while traveling away from home. Without proper documentation, your deduction is toast.
6. Claiming 100% business use of vehicle
. Another area that is ripe for IRS review is use of a business vehicle. When you depreciate a car, you have to list on Form 4562 what percentage of its use during the year was for business. Claiming 100% business use for an automobile on Schedule C is red meat for IRS agents. They know that it’s extremely rare that an individual actually uses a vehicle 100% of the time for business, especially if no other vehicle is available for personal use. IRS agents are trained to focus on this issue and will closely scrutinize your records. Make sure you keep very detailed mileage logs and precise calendar entries for the purpose of every road trip. Sloppy recordkeeping makes it easy for the revenue agent to disallow your deduction. As a reminder, even if you use the IRS’ standard mileage rate to deduct your business vehicle costs, ensure that you are not also claiming actual expenses for maintenance, insurance and other out-of-pocket costs. The IRS has found filer noncompliance in this area as well and will look for this.
7. Claiming a loss for a hobby activity.
Your chances of “winning” the audit lottery increase if you have wage income and file a Schedule C with large losses. And, if your Schedule C loss-generating activity sounds like a hobby…horse breeding, car racing, and such…the IRS pays even more attention. It’s issued guidelines to its agents on how to sniff out those who improperly deduct hobby losses. Large Schedule C losses are audit bait, but reporting losses from activities in which it looks like you might be having a good time is just asking for IRS scrutiny.
Tax laws don’t allow you to deduct hobby losses on Schedule C; however, you do have to report any income earned from your hobbies. In order to claim a hobby loss, your activity must be entered into and conducted with the reasonable expectation of making a profit. If your activity generates profit three out of every five years (or two out of seven years for horse breeding), the law presumes you’re in business to make a profit, unless the IRS establishes to the contrary. If audited, the IRS is going to make you prove you have a legitimate business and not a hobby. So, make sure you run your activity in a business-like manner and can provide supporting documents for all expenses.
8. Cash businesses.
Small business owners, especially those in cash-intensive businesses…taxi drivers, car washes, bars, hair salons, restaurants and the like…are an easy target for IRS auditors. The agency is well aware that those who primarily receive cash in their business are less likely to accurately report all of their taxable income. the IRS wants to narrow the tax gap, and history has shown that cash-based businesses are a good source of audit adjustments. It has a new guide for agents to use when auditing cash intensive businesses, telling how to interview owners and noting various indicators of unreported income.
9. Failure to report a foreign bank account.
The IRS is intensely interested in people with offshore accounts, especially those in tax havens. U.S. tax authorities have had some recent success in trying to get foreign banks (such as UBS in Switzerland) to disclose information on U.S. account holders. Also, the IRS had a voluntary compliance program where people came in and reported their foreign bank accounts and foreign assets in exchange for lesser penalties than they would have otherwise been subject to. The IRS has learned a lot from these probes.
Failure to report a foreign bank account can lead to severe penalties, and the IRS has made this issue a top priority. Make sure that if you have any such accounts, you properly report them when you file your return. Keep in mind, though, that if you have never previously reported the foreign bank account on your return, and you decide to do so for the first time in 2010, that might also look suspicious to the IRS.
10. Engaging in currency transactions.
The IRS gets many reports of cash transactions in excess of $10,000 involving banks, casinos, car dealers and other businesses, plus suspicious activity reports from banks and disclosures of foreign accounts. A recent report by Treasury inspectors concluded that these currency transaction reports are a valuable source of audit leads for sniffing out unreported income. The IRS agrees and it will make greater use of these forms in its audit process. So if you are a person who makes large cash purchases or deposits, be prepared for IRS scrutiny. Also, beware that banks and other institutions file reports on suspicious activities that appear to avoid the currency transaction rules (such as persons depositing $9,500 cash one day and an additional $9,500 cash two days later).
11. Math errors.
One of the biggest reasons that people receive a letter from the IRS is because of mathematical mistakes they make on their tax returns. If you make an error in your favor, you are going to hear from the tax man, and there is a greater risk of the IRS pulling the whole return for audit. So take time to ensure all your calculations are correct. Even though math errors may not lead to a full-blown audit, it’s always best to remain under the radar of IRS computers.
12. Taking higher-than-average deductions.
If deductions on your return are disproportionately large compared to your income, the IRS audit formulas take this into account when selecting returns for examination. Screeners then pull the most questionable returns for review. But if you’ve got the proper documentation for your deduction, don’t be scared to claim it. There’s no reason to ever pay the IRS more tax than you actually owe.
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