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SKIRT AN AUDIT; KNOW TOP IRS “EYEBROW RAISERS”
OCTOBER 2002

It’s true that IRS audit rates are at their lowest point in years. Only 1 in 200 individual returns was audited in fiscal year 2000, Still, now is definitely not the time to get complacent or sloppy. Three reasons:

• Audit rates run much higher for business owners and for people with higher incomes.
  
  
• A 1998 IRS reform law forced the agency to spend more time and money on “customer service”, as opposed to audits. But with a tight economy and declining government revenues, Congress may want the IRS to get tough again.
  
  
• The agency is planning to restart a dormant audit program-dubbed “audits from hell” by accountants-that randomly selects 50,000 taxpayers for audit. To make sure your tax return flies under the radar of IRS auditors, it’s vital to know the issues that will attract the IRS’ attention. Below are some of the biggest red flags. Some are unavoidable, and you should take every deduction you’re due. Just make sure your record keeping is rock solid on these items.

  1. Money-in, money out ratio. Make sure your reported income seems sufficient to support your claimed exemptions and deductions. For example, if you have lots of exemptions, a small amount of reported income could indicate that you have another, unreported source of income.
  
  2. Large refund. A large refund is somewhat suspect in and of itself because taxpayers typically don’t put themselves in the position of prepaying more taxes than they will owe for one year.
  
  3. Profession that self-reports. Be careful if you are in an occupation where you have income that must be voluntarily reported to an employer-for example waiting tables or styling hair. The IRS can assume you have underreported tips or other income. Keep in mind that tax must be paid on income when it is earned.
  
  4. High-income profession. Be especially cautious if you are in a profession that is publicly perceived as earning a lot of money. For example, the IRS becomes suspicious of a doctor whose return reflects only marginal profitability.
  
  5. Business owners who don’t itemize. If you’re in business for yourself, itemize your deductions on Schedule A. Beware if you don’t. Business People who report high gross income from the business, show a small profit and take the standard deduction on their personal returns are waving a red flag. There’s a tendency to believe that they are “burying” nondeductible personal expenses in the business write-off numbers.
  
  6. Rounding Off. Although the IRS permits you to round off figures to the nearest dollar, don’t round off deductions to the nearest hundred or thousand. Why? Round numbers make it appear that you are “guesstimating” which is sure to raise IRS eyebrows. Exact figures on a return appear to be taken from records, which is what you should be doing.
  
  7. Big T&E write-offs. Nothing has changed here, even though meal and entertainment expenses are only 50% deductible. The IRS knows that many taxpayers still will try to write off personal expenses as business costs. To avoid problems, follow the three R’s : recordkeeping, recordkeeping and recordkeeping.
  
  8. Depreciating “listed property”. Some equipment with legitimate business uses also can be used for personal reasons. Some examples: cars, homecomputers, phones, televisions, camcorders, VCRs and photographic equipment. You need records showing business rather than personal usage.
  
  9. High interest expense on individual returns. Because personal interest no longer is deductible and investment interest is deductible and investment interest is deductible only to the extent of investment income, taxpayers have started “moving things around” to beat the system. For example, they may try to write-off personal car loan interest by plopping it on Schedule C, or they may describe credit card interest as investment interest. If you have substantial deductible interest expense other than from your mortgage (which is generally reported to the government on information returns), be ready to prove it.
  
  10. Unreported income shown on information returns. Don’t even think about failing to report income shown on W-2s and 1099s. Doing so is tantamount to begging for an audit. Your odds of getting away with it are very poor.
  
  11. High miscellaneous deductions. To avoid the rule that limits deductions to those above 2% of adjusted gross income, some taxpayers improperly shift these expenses to Schedule C (Profit of Loss from a Business). Be sure to categorized your miscellaneous deductions rather than simply listing the total dollar amount for “miscellaneous”.
  
  12. Losses from sideline businesses. The IRS is going after some businesses that rack up tax losses year after year by trying to characterize them as nondeductible “hobbies”. Under the so-called hobby loss rules, you can deduct expenses only to the extent of income from the activity. In other words, you can’t generate an overall tax loss from the activity. In other words, you can’t generate an overall tax loss from the activity. However, if your sideline business earns at least some profit in 3 out of 5 consecutive years (two out of 7 for raising horses), you generally can escape this categorization.
  
  13. Filing an amended return. This obviously draws extra attention to your return, especially if you forgot to include a deduction. The IRS reasons that if you forgot one thing, maybe you forgot many more. Don’t shy away from amending your return but document everything and take a harder look at your whole return whenever making amendments.
  

NEWSBRIEFS

Avoid costly rollover mistakes. If you inherit an IRA from your spouse, you can roll that money into your own IRA. But this option isn’t available for nonspouse beneficiaries, such as children. In a new IRS ruling, a son was liable for the full amount of tax on an IRA that he inherited from his mother, even though he offered to undo the rollover. One alternative: Roll the funds into another IRA, in the deceased person’s name. That’s OK, as long as it’s done within 60 days of the payout of the original IRA.

Health club dues may be deducted as medical expense. Membership dues at the local health club can be deducted, in certain circumstances, as a medical expense, the IRS affirmed in a recent letter ruling. In April, the IRS recognized obesity as a disease. This allows taxpayers to deduct weight-loss expenses that are related to specific weight-related ailments diagnosed by a doctor. Health club costs can be deductible, if they meet this threshold. Expenses to lose weight for appearance or general health aren’t deductible. Remember medical write-offs can only be deducted once they reach 7.5% of your adjusted gross income.

Lock in 401(k) deductions. In a new ruling the IRS said employers can’t claim current tax deductions for contributions to a 401(k) or defined contribution plan if those contributions are attributable to compensation earned by participants after the end of the year. It doesn’t matter if the employer’s minimum contributions have not yet been fixed under a grace period. Have your company prepay amounts to your 401(k) to ensure a current deduction.

IRS gives green light to hybrid car deduction. The IRS last month certified the first hybrid gas-electric vehicle, the Toyota Prius, as being eligible for the clean-burning fuel deduction. The result: Buyers of the Prius for model years 2001, 2002 and 2003 will be able to claim a $2,000 deduction for the year that the vehicle was first put into use. Taxpayers don’t have to itemize deductions on their tax return to claim this write-off. If you bought a Prius last year, you can get the deduction by filing an amended return.