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Posted in Business Taxes on Jul 26, 2011

Regular corporations are the historic entity choice for those who seek liability protection. They are distinctly their own entity with their own income tax obligations. A regular corporation or C corporation files Form 1120 or 1120A. Corporations are formed by filing Articles of Incorporation with their state of residence and are governed by the laws of that state as well as Federal law. With the distinct separation provided by the corporate structure comes greater complexity and required attentiveness to detail.

Advantages of a C Corporation

There are many good reasons to consider selecting a regular corporation. They offer the following advantages:

• A distinctly separate legal entity, offering limited liability. A shareholder will still have at risk their corporate assets and loans guaranteed personally.
• A corporation exists until it is dissolved, giving it continuity beyond the life of a shareholder.
• Corporate employees, including shareholders, may receive a wide range of tax-advantaged fringe benefits.
• A regular corporation may have a fiscal year other than December 31.
• An unlimited number of shareholders may own more than one class of stock.
• A C corporation has its own tax brackets, potentially increasing the amount taxed at 15 percent by $50,000. Some other income levels show rate advantages.
• Numerous ways exist of receiving funds from a regular corporation, including several that are not subject to Social Security taxes.
• Up to 80 percent of dividends from other corporations may be deductible.
• Ownership transfers are easily accomplished by sale or gift.
• Capital may be raised through stock sales.
  

• Corporations are complex, requiring greater expense to form and operate.
• Some businesses are not sophisticated enough in their management and record keeping for the corporate form of business. The liability protection is negated if the ?corporate veil?, or separation between personal and corporate activity, is ignored.
•  The potential of double taxation exists upon dissolution of the corporation or distribution of earnings.
• Losses in the corporation are not available to the shareholders to offset other income.
• A potential of accumulated earnings, at the highest bracket, exists if large amounts of liquid assets are accumulated within the corporation.
• Certain professions, mainly legal, medical, consulting, and accounting, fall under personal service corporation tax rules, removing lower brackets.
• Capital gains income does not receive the lower rates allowed individuals or flow-through entities.
• Corporate net capital losses cannot be used to offset ordinary income, only capital gains.
• A corporation must go through a liquidation process if business activity ceases. This may have tax consequences.
  

Last Updated by Marcelino Dodge on 2011-07-26 08:39:00

Posted in Business Taxes on Jul 19, 2011

S corporations, first created in 1958, retain some of the features of regular corporations, but differ in several ways. An S corporation, like a partnership, is a flow-through entity with income, losses and credits reported and taxed at the individual shareholder level. The process of forming an S corporation is usually identical to that of a C corporation; it becomes an S corporation by filing Form 2553 with the IRS. S corporations are incorporated at the state level and must satisfy the requirements of their state of registration. The S corporation must file Form 1120-S and provide each shareholder with a Form K-1, which identifies the shareholder?s share of the S corporation?s taxable income, credits, and other tax attributes.


Advantages of an S Corporation
S corporations came into existence out of a demand for a simpler, more flexible corporate form. Their chief advantages include:

•  No double taxation on dissolution of the corporation or on distribution of dividends. ·
  
• Losses may be used to offset other income on the shareholder?s personal return to the extent that their basis allows.
• The shareholder?s liability is limited to their contributions or personal guarantees on debts.
• The corporation does not dissolve at the shareholder?s death.
• Gifting shares to other family members makes it possible to shift income to those in lower tax brackets.
• Shareholders are not subject to self-employment taxes on corporate profits passed through to them on Form K-1, subject to the IRS?s position on adequacy of wage issues.
• Personal service corporation rules and tax rates do not apply.
• Capital gains income is taxed at a maximum of 20 percent.
• Net capital losses may offset up to $3,000 of other income per year, with unused losses carried forward.
  

• Its limitation to one class of stock. Any violation of this rule causes loss of Subchapter S status.
• S corporations must adopt the tax years of the majority of its shareholders, making a non-calendar year nearly impossible.
• All fringe benefits given to more than two percent shareholders are added to their W-2s and taxed personally. Attribution rules do likewise for parents, children, spouses, or siblings of these shareholders.
  
• Only one 15-percent income tax bracket is available as all income is taxed personally.
  
• Shareholders, their spouses, and children are subject to FICA, FUTA, SUTA and workman?s compensation. Watch state rules.
• Retirement plan contributions are based on the shareholder?s salary rather than overall corporate profits.
• The number of shareholders is limited to 75 and can have no non-resident, alien shareholders.
• Only individuals, estates, and certain trusts may be shareholders.
• A shareholder may not include their share of debt in the computation for allowing tax losses to be claimed. 

Last Updated by Marcelino Dodge on 2011-07-19 08:32:48

Posted in Business Taxes on Jul 12, 2011

The Internal Revenue Code defines a partnership as an association of two or more persons or entities carrying on a business that cannot be classified as a corporation, trust, or estate (IRC 761(a)). Upon formation, each partner contributes property or services in exchange for their partnership interest. The partnership reports its income and expenses on Form 1065. Partners share in profits or losses according to their ownership as specified by the partnership agreement, with their share of the partnership?s taxable income and other tax attributes reported to them on Form K-1. All income is therefore taxed at the individual level.

Partnerships may be either general or limited. A limited partnership is one that has at least one limited partner. The partnership agreement must specify which is being formed, or modified by amending or adding to the partnership agreement if a partnership is switching to a limited format. States generally require greater oversight of limited partnership through ongoing registration. Limited partnerships have at least one general partner who must act as an agent for the partnership, in contrast to limited partners who may not act as agents and generally have their liability limited to their investment. A limited partner, however, will likely be limited in claiming partnership losses by passive loss rules.

Advantages of a Partnership

A partnership is a widely-used entity structure due to the following advantages:

· They are easy to form and dissolve, generally with no tax consequences if liabilities contributed do not exceed the tax basis of contributed assets plus the partner?s share of the partnership?s liabilities.

· They require less formality than corporations or other limited liability entities.

· They may use the cash method of accounting, thus delaying income and accelerating expenses.

· No double taxation exists, due to the flow-through nature of partnerships.

· A partnership may have greater continuity, not being required to dissolve unless fifty percent of its ownership withdraws. An interest may be sold or gifted.

· A partnership establishes a legal relationship between the partners and makes provisions for a partner dying, withdrawing, or becoming disabled.

· A partnership may benefit from more than one person?s skills, capital, and labor.

· A partnership may serve as a means of dividing income between family members, resulting in more income taxed at lower rates.

· A partner may include their share of partnership debt in their basis, allowing them to deduct more than their original investment.

· A partner may deduct interest on debt used to acquire their partnership interest or make capital contributions.

· A partner may contribute appreciated property without recognizing a taxable gain. Likewise, a partnership can distribute appreciated property without immediate tax consequences.

· Fringe benefits to spousal employees are allowed.

Disadvantages of a Partnership

· General partners have unlimited liability to the extent of all partnership assets and personal property. They are liable for the actions of other partners as well as themselves.

· General partners are subject to self-employment taxes on trade or business profits; thus a husband-wife partnership could pay self-employment taxes on two OASDI limits ($80,400 in 2001).

· Fringe benefits for partners are deductible, but taxed to them as guaranteed payments.

· Limited partners? losses are subject to passive loss rules.

· A partnership is limited in selecting its year end, generally a calendar year is mandated.

· A partner must pay taxes on their share of partnership profits whether they are distributed or not.

· Losses occurring from the sale of a partnership interest are generally capital losses, subject to the $3,000 limitation.

· A partnership may have disagreements between partners that are difficult or impossible to resolve.

Generally, a partnership is a good choice of entity where two or more individuals want to work together, and the greater informality is not offset by a need for liability protection. A partnership is like a marriage; partners must have compatible personalities, good communication, and mutual respect. If the business involved has substantial business profits and the partners are in tax brackets above the 15 percent level, a partnership may result in excessive overall taxes when Social Security taxes are added. Partnerships may work well for decades, but they are generally of limited duration.

Last Updated by Marcelino Dodge on 2011-07-12 08:34:05

Posted in General on Jun 28, 2011

Taxpayers engaging in business pursuits sometimes find it to their advantage to go beyond operating as a sole proprietorship. Giving up the simplicity of being a sole proprietor is not a move to be taken lightly. The ease of conversion to another entity, the ability to employ one's spouse and minor children exempt from FICA and other taxes, and the lack of double taxation all contribute to the desirability of being the sole owner of a business.

Sole proprietorships do have their limitations, however: exposure to unlimited liability, limitations in raising capital, a lack of continuity, and potential huge tax liabilities when self-employment tax is added to the tax burden. Any one of these is reason enough to consider an entity.

The IRS code makes entities worth considering for several reasons:

1. The concept of a return on equity is a valid one with some entities, allowing funds to be withdrawn as rent, free of Social Security taxes.

2. An entity gives the business owner(s) a new ?person? to interact with, enabling transactions to occur that are prohibited between a business owner and himself?fringe benefits, for example.

3. Self-employment taxes are not imposed on S-corporation distributions.

4. Regular ?C? corporations pay their own taxes and thus provide a new 15 percent bracket for the first $50,000.

5. Because of their ability to have multiple owners, entities allow taxable income to be divided, perhaps resulting in tax savings.

6. The multiple ways of taking funds from an entity include several not subject to Social Security taxes.

7. Because corporate stock or an ownership interest in another entity generally receives capital gains treatment when sold (after meeting the one-year holding period), tax savings should result from the lower capital gains rates.

On a non-tax level, entities provide the following opportunities:

1. Liability protection in the case of corporations, LLCs, LLPs, and limited partnerships, assuming the proper steps are taken to preserve the separation between the individual and the entity involved.

2. Entities may be an excellent transition vehicle in the process of succession planning. The ability to move the younger generation, or other new owners, into partial ownership can serve as a starting point for retiring owners to begin the transfer process.

3. Entities may be necessary to raise capital through stock offerings or to insulate those who would provide capital from liability.

4. Entities serve as a means of allowing more than one individual or entity to operate a business jointly, protecting the interests of those involved.

Each of the entities available has its own features and tax attributes as established by state and federal law.  We will be discussing the advantages and disadvantages of various business entites.

Last Updated by Marcelino Dodge on 2011-06-28 08:56:14

Posted in General on Jun 21, 2011

There is no best choice of entity for those who start their own business.  This important decision must be based on factors that each business owner must weigh in light of their situation.   Consulting a tax professional, is essential to help you understand your situation and goals.  An Enrolled Agent (EA) or CPA will explain the alternatives that are possible solutions for your individual needs.  Determining the your objectives as the future business owner is the first step in this process.  These objectives may not be clear to you at first. The EA or CPA will need to ask you the right questions to help you establish your priorities.  You may be focusing on the proposed business activity rather than the effects of your choice of entity on liability, taxes, management, and succession.  In this blog we will cover what is needed to help you determine your business objectives.

Determining the Your Business Objectives

As a business owner  your entity decision must be based on which entity  will  most effectively help you accomplish your business objectives.  You should consider the following questions:   

• Is legal or financial liability protection desired? 
• Are tax reduction considerations important, perhaps in an existing business??  
• How many owners are involved?  Are any of them entities?   
• Are employee benefits, perhaps for the owner as employee, an important consideration?   
• Does the business expect to see losses?  These may increase the desirability of a flow-through entity.  
• Where will the business be conducted?  Do state or local laws restrict the choice of entity for certain business fields?  
• What business is being conducted?  Certain professions fall under personal service corporation rules if structured as a regular corporation?  
• What role will Social Security tax considerations play in the decision?   
• How capable is the business owner at paper work and formality?  

An advantage in one of the above considerations may be offset by a limitation in another.  Sometimes, a single consideration, perhaps liability protection, will dominate the selection process; in other situations, several objectives may be equally important and require compromise.  In any situation, the default entity, if nothing is done to alter this, is a sole proprietorship.  This should be the starting point of our discussion.    In future blogs we will discuss the advantages and disadvantages of each business entity type.

Last Updated by Marcelino Dodge on 2011-06-21 15:47:45

Posted in General on Jun 14, 2011

The IRS is stepping up audits on employee classification. It is very important to make the proper decision about employee classification If an employee is incorrectly identified as an independent contractor you may be liable for the self employment taxes that you should have paid plus penalties. If you are unsure don't feel bad you are in common company. Congress' General Accounting Office (GAO) has estimated that 38 percent of employers examined misclassified "independent contractors". Both WalMart and FedEx have lost lawsuits or paid penalties relating to misclassification of employees.The general rule is that an individual is an independent contractor if, the person for whom the services are performed have the right to control or direct only the result of the work and not the means or methods of accomplishing the result. In determining whether the person providing service is an employee or an independent contractor, all information that provides evidence of the degree of control and independence must be considered.

Facts that provide evidence of the degree of control and independence fall into three categories:

Behavioral: Does the company control or have the right to control what the worker does and how the worker does his or her job? 

Financial: Are the business aspects of the worker's job controlled by the payer? (these include things like how worker is paid, whether expenses are reimbursed, who provides tools/supplies, etc.)

Type of Relationship: Are there written contracts or employee type benefits (i.e. pension plan, insurance, vacation pay, etc.)? Will the relationship continue and is the work performed a key aspect of the business?Behavioral control refers to facts that show whether there is a right to direct or control how the worker does the work. A worker is an employee when the business has the right to direct and control the worker. The business does not have to actually direct or control the way the work is done as long as the employer has the right to direct and control the work.

The behavioral control factors fall into the categories of:

Type of instructions given Degree of instruction Evaluation systems Training

Types of Instructions Given: An employee is generally subject to the business's instructions about when, where, and how to work. All of the following are examples of types of instructions about how to do work.When and where to do the work.What tools or equipment to use.What workers to hire or to assist with the work.Where to purchase supplies and services.What work must be performed by a specified individual.What order or sequence to follow when performing the work.

Degree of Instruction:

 Degree of Instruction means that the more detailed the instructions, the more control the business exercises over the worker. More detailed instructions indicate that the worker is an employee. Less detailed instructions reflects less control, indicating that the worker is more likely an independent contractor.Note: The amount of instruction needed varies among different jobs. Even if no instructions are given, sufficient behavioral control may exist if the employer has the right to control how the work results are achieved. A business may lack the knowledge to instruct some highly specialized professionals; in other cases, the task may require little or no instruction. The key consideration is whether the business has retained the right to control the details of a worker's performance or instead has given up that right.

Evaluation System:

If an evaluation system measures the details of how the work is performed, then these factors would point to an employee.If the evaluation system measures just the end result, then this can point to either an independent contractor or an employee.

Training:

 If the business provides the worker with training on how to do the job, this indicates that the business wants the job done in a particular way. This is strong evidence that the worker is an employee. Periodic or on-going training about procedures and methods is even stronger evidence of an employer-employee relationship. However, independent contractors ordinarily use their own methods.Financial control refers to facts that show whether or not the business has the right to control the economic aspects of the worker's job.The financial control factors fall into the categories of: Significant investment Unreimbursed expenses Opportunity for profit or loss Services available to the market Method of payment

Significant investment:

An independent contractor often has a significant investment in the equipment he or she uses in working for someone else. However, in many occupations, such as construction, workers spend thousands of dollars on the tools and equipment they use and are still considered to be employees. There are no precise dollar limits that must be met in order to have a significant investment. Furthermore, a significant investment is not necessary for independent contractor status as some types of work simply do not require large expenditures.

Unreimbursed expenses:

Independent contractors are more likely to have unreimbursed expenses than are employees. Fixed ongoing costs that are incurred regardless of whether work is currently being performed are especially important. However, employees may also incur unreimbursed expenses in connection with the services that they perform for their business.

Opportunity for profit or loss:

The opportunity to make a profit or loss is another important factor. If a worker has a significant investment in the tools and equipment used and if the worker has unreimbursed expenses, the worker has a greater opportunity to lose money (i.e., their expenses will exceed their income from the work). Having the possibility of incurring a loss indicates that the worker is an independent contractor.

Services available to the market:

An independent contractor is generally free to seek out business opportunities. Independent contractors often advertise, maintain a visible business location, and are available to work in the relevant market.

Method of payment:

An employee is generally guaranteed a regular wage amount for an hourly, weekly, or other period of time. This usually indicates that a worker is an employee, even when the wage or salary is supplemented by a commission. An independent contractor is usually paid by a flat fee for the job. However, it is common in some professions, such as law, to pay independent contractors hourly.Type of relationship refers to facts that show how the worker and business perceive their relationship to each other.The factors, for the type of relationship between two parties, generally fall into the categories of: Written contracts Employee benefits Permanency of the relationship Services provided as key activity of the business.

Written Contracts:

Although a contract may state that the worker is an employee or an independent contractor, this is not sufficient to determine the worker's status. The IRS is not required to follow a contract stating that the worker is an independent contractor, responsible for paying his or her own self employment tax. How the parties work together determines whether the worker is an employee or an independent contractor.

Employee Benefits:

Employee benefits include things like insurance, pension plans, paid vacation, sick days, and disability insurance. Businesses generally do not grant these benefits to independent contractors. However, the lack of these types of benefits does not necessarily mean the worker is an independent contractor.

Permanency of the Relationship:

When a worker is hired with the expectation that the relationship will continue indefinitely, rather than for a specific project or period, this is generally considered evidence that the intent was to create an employer-employee relationship.

Services Provided as Key Activity of the Business:

If a worker provides services that are a key aspect of the business, it is more likely that the business will have the right to direct and control his or her activities. For example, if a law firm hires an attorney, it is likely that it will present the attorney's work as its own and would have the right to control or direct that work. This would indicate an employer-employee relationship.There is no ?magic? or set number of factors that ?makes? the worker an employee or an independent contractor, and no one factor stands alone in making this determination. Also, factors which are relevant in one situation may not be relevant in another.The keys are to look at the entire relationship, consider the degree or extent of the right to direct and control, and finally, to document each of the factors used in coming up with the determination.When someone is unsure of the status they can file form SS-8 with the IRS and they will make the determination. This can take up to 6 months but if you anyone in a business that continually hires the same types of workers to perform particular services may want to consider this option.

Source: Accountants World

Last Updated by Marcelino Dodge on 2011-06-28 09:02:27

Posted in General on Mar 30, 2011

You may not want to think about your taxes until Tax Day on April 18, but online scammers are already plotting to separate you from your tax refund and your identity. Scams for the 2011 tax season include promises of tax credits for charitable donations to disaster relief in Japan, malware-laden Websites optimized for search engines, dangerous e-mail, and so-called 'likejacking' techniques found on the social network Facebook.

About 19 million people have already filed their taxes at home in 2011, an increase of almost 6 percent from the year previous, according to the Internal Revenue Service. Consequently, this time of year is ripe for tax-related online scams. Crooks know that taxpayers are looking for information on deductions and tax laws. They know that this is the time of year when taxpayers submit personal information online and store sensitive financial documents on their hard drives.

Jennifer Torode, a spokesperson for the security firm Sophos, says that most of us wait until the last minute to file our tax forms. Scammers know this and "take advantage over the next few weeks to find ways to lure frantic filers into their webs," she says.

Here are five tips to help you avoid getting ensnared by tax scammers this tax season.

1. Japan Quake Scam

Among the newest scams for 2011 are bogus e-mail messages promising a tax credit applicable to your 2010 tax return if you make a charitable donation to Japan earthquake relief, according to McAfee consultant and identity theft expert Robert Siciliano.

Tip: You can find many earthquake relief scams online; however, it's not clear how prevalent this particular scam is. For more information on how to make tax-deductible donations safely and effectively, consult this notice on IRS.gov.

2. Gone Phishing

A phony IRS Website designed to trick you into downloading malware. One of the most popular ways to scam people during tax season is to set up Websites that look as if they are an official IRS site or a legitimate tax preparation service.

Tip: The best defense against drive-by downloads is to make sure that you always use the latest version of a modern Web browser, such as Google Chrome or Mozilla Firefox.

3. Black Hat SEO

One of the tricks that crooks use to lure victims into a scam is to optimize their sites for Google searches, a technique known as "black hat SEO" (the acronym stands for "search engine optimization").

Tip: Never use search engines to search for tax documents. Instead, go directly to the government site (such as IRS.gov, USA.gov, or an individual state government site ending in '.gov') to look for tax forms and other tax information.

4. Likejacking

Facebook and other social networking sites are major targets for online scammers looking to make a quick buck off tax season.

Tip: Don't choose a tax preparation service on the basis of Facebook message attributed to a friend. At the very least, talk to the friend directly to confirm that he or she endorses the service.

5. Phony E-Mail

Despite a high degree of public awareness about the dangers of spam e-mail, online scammers find this method profitable enough to keep using it. One trick to watch out for is a message supposedly from the IRS asking you to download a tax form

Tip: The IRS will never send you an e-mail message with a request for your personal information or with tax forms attached.

Source: pcworld.com

Last Updated by Marcelino Dodge on 2011-03-30 15:42:11

Posted in General on Dec 30, 2010

The Internal Revenue Service today released instructions to help employers implement the 2011 cut in payroll taxes, along with new income-tax withholding tables that employers will use during 2011.

Millions of workers will see their take-home pay rise during 2011 because the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 provides a two percentage point payroll tax cut for employees, reducing their Social Security tax withholding rate from 6.2 percent to 4.2 percent of wages paid. This reduced Social Security withholding will have no effect on the employee's future Social Security benefits.

The new law also maintains the income-tax rates that have been in effect in recent years.

Employers should start using the new withholding tables and reducing the amount of Social Security tax withheld as soon as possible in 2011 but not later than Jan. 31, 2011. Notice 1036, released today, contains the percentage method income tax withholding tables, the lower Social Security withholding rate, and related information that most employers need to implement these changes. Publication 15, (Circular E), Employer's Tax Guide, containing the extensive wage bracket tables that some employers use, will be available on IRS.gov in a few days.

The IRS recognizes that the late enactment of these changes makes it difficult for many employers to quickly update their withholding systems. For that reason, the agency asks employers to adjust their payroll systems as soon as possible, but not later than Jan. 31, 2011.

For any Social Security tax over withheld during January, employers should make an offsetting adjustment in workers' pay as soon as possible but not later than March 31, 2011.

Employers and payroll companies will handle the withholding changes, so workers typically won't need to take any additional action, such as filling out a new W-4 withholding form.

As always, however, the IRS urges workers to review their withholding every year and, if necessary, fill out a new W-4 and give it to their employer. For example, individuals and couples with multiple jobs, people who are having children, getting married, getting divorced or buying a home, and those who typically wind up with a balance due or large refund at the end of the year may want to consider submitting revised W-4 forms. Publication 919, How Do I Adjust My Tax Withholding?, provides more information to workers on making changes to their tax withholding.

Source: irs.gov

Last Updated by Marcelino Dodge on 2010-12-30 14:32:07

Posted in General on Dec 23, 2010

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 the 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 bought 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 in 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.

[How the New Tax Law Affects Your Taxes]

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 pretty 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 agreed 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.

Source: http://finance.yahoo.com/taxes/article/111658/irs-audit-red-flags?mod=taxes-filing

Last Updated by Admin on 2010-12-29 16:49:26