Audit proof your business by eliminating these 5 Tax Audit Triggers
Without proper due diligence, business owners can find themselves in sticky situations. Compliance is important in every aspect of business, but it’s especially important to pay attention to the current issues that the IRS has in focus. Your chances of being audited or otherwise hearing from the IRS escalate depending on various factors, including your income level, the types of deductions or losses you claim, the business you’re engaged in, and whether you own foreign assets.
Here’s how someone is chosen for an audit: An IRS software program may randomly select the taxpayer and compare the return to other similar returns to detect any anomalies, or the taxpayer in question may be linked to a family member or business partner who is being audited. The IRS can audit returns up to three years old. Inaccuracies could lead to penalty charges: 20% of the disallowed amount for filing an “erroneous claim for a refund or credit,” the IRS stated, or $5,000 if the tax return was deemed “frivolous,” where there isn’t enough information to assess correct or incorrect information.
According to Scott Abolafia, CPA, “less than 1 percent of tax returns get audited by the IRS, but this percentage varies significantly depending on several factors.” The items below will help identify whether you, or your business, might be at risk for one—or more—of the IRS’ high probability audit situations for this year.
☐ Do you make charitable gifts through a donor advised fund or conservation easement? IP monetization/royalty transactions, easements and donor advised fund transactions are under high IRS scrutiny. If your charitable deductions are disproportionately large compared with your income, it raises a red flag. Also, if you don’t get an appraisal for donations of valuable property, or if you fail to file Form 8283 for noncash donations over $500, you become an even bigger audit target. And if you’ve donated a conservation or façade easement to a charity, chances are good that you’ll hear from the IRS.
☐ Are you planning to change your compensation structure considering tax reform law changes? The IRS position for reasonable compensation is reasonable replacement, which can complicate changes to wages, guaranteed partner payments or compensation from S corporations. IRS statistics for 2016 show that people with an income of $200,000 or higher had an audit rate of 1.70%, or one out of every 59 returns. Report $1 million or more of income? There’s a one-in-17 chance your return will be audited. The audit rate drops significantly for filers making less than $200,000: Only 0.65% (one out of 154) of such returns were audited during 2016, and most of these exams were conducted by mail.
☐ Do you have a transfer pricing policy in place, foreign assets or operations? International transactions are of special interest to the IRS. Returns not filed properly are subject to significant penalties but requesting penalty relief and filing unfiled returns can alleviate potential penalties. he IRS gets many reports of cash transactions more than $10,000 involving banks, casinos, car dealers and other businesses, plus suspicious-activity reports from banks and disclosures of foreign accounts. So, if you make large cash purchases or deposits, be prepared for IRS scrutiny. Also, be aware that banks and other institutions file reports on suspicious activities that appear to avoid the currency transaction rules (such as a person depositing $9,500 in cash one day and an additional $9,500 in cash two days later).
☐ Do you have a lot of deductions? One of the most common reasons for an audit is when the taxpayer is taking higher-than-average deductions in relation to his income. This can come from various types of deductions: Charitable contributions, real estate interest or student loans interest. If the deductions on your return are disproportionately large compared with your income, the IRS may pull your return for review. But if you have the proper documentation for your deduction, don’t be afraid to claim it.
☐ Did you make early withdrawals from your IRA or 401k? The IRS is examining SDIRAs to determine if they have violated the unrelated business income tax rules. There are some scenarios where an individual can take withdrawals from a retirement account prior to 59 ½ years old — when, for example, the taxpayer uses a portion of that money for a first-time home, qualified education expenses or emergency medical costs. But the IRS charges a 10% penalty (on top of the tax paid on the withdrawal) when none of those exceptions are met. Almost 40% of taxpayers did not report the withdrawal when they did not qualify for the exceptions, according to Kiplinger, but the IRS still knows the withdrawal was made. The IRS is notified of taxable early withdrawals from an individual retirement, according to personal-finance site The Nest, and the government’s system will likely notice if the taxpayer did not include it in reportable income.
If any of the above scenarios apply to you and if they have not been addressed, you might be at risk for an audit. You should consult with your Tax Professional for guidance.
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