Get Ready for Onerous New 1099 Reporting Rules
Businesses and not-for-profit organizations are accustomed to IRS rules that require them to report certain payments on annual Form 1099 information returns. However, the recently enacted healthcare law imposes surprising new reporting requirements. Complying with them may add significantly to an organization’s paperwork burden. While the new rules don’t apply to payments made before 2012, it’s not too early to start gearing up to deal with them.
Key Point: For many organizations, the new rules will require issuing 1099s for all sorts of business payments that they never had to worry about before. And the IRS will receive 1099s detailing how organizations spend money on a whole new range of business expenses. However, the healthcare legislation does not require Form 1099 reporting of payments that are made for non-business reasons.
The IRS is accepting public comments on the rules until September 29, 2010.
Current Rules in a Nutshell
Background: For many years, businesses have been required to report various payments on different versions of Form 1099. For instance, when a business pays $600 or more during a calendar year to an independent contractor for services, the business must issue the contractor a Form 1099-MISC that reports the amount paid that year. The business must also furnish a copy of the Form 1099-MISC to the IRS. This reporting procedure helps contractors remember to include the payments on their tax returns, and it helps the IRS ensure that income is reported.
Under rules now in effect, other types of payments that businesses must report on Forms 1099 include:
1. Commissions, fees, and other compensation paid to a single recipient when the total amount paid in a calendar year is $600 or more.
2. Interest, rents, royalties, annuities, and income items paid to a single recipient when the total amount paid in a calendar year is $600 or more.
When a Form 1099 is required, it must show:
- The total amount for the calendar year;
- The name and address of the payee;
- The tax ID number (TIN) of the payee (For privacy reasons, truncated TINs can be used on 1099s issued to individuals); and
- The payer’s contact information and TIN.
If a business doesn’t have a payee’s TIN, it may be required to institute backup federal income tax withholding at a 28 percent rate on payments under Internal Revenue Code Section 3406.
In most cases, these rules apply to payments made by not-for-profit organizations since they are generally considered to be businesses for 1099 reporting purposes.
If a payer inadvertently fails to issue a proper Form 1099, the IRS can assess a $50 penalty. The penalty for each intentional failure can be $100 or more.
Reporting Payments to Corporations
Under current rules, most payments to corporations are exempt from Form 1099 reporting requirements. However, there are a few exceptions. For instance, payments of $600 or more in a calendar year to an incorporated law firm must be reported on Form 1099-MISC.
Reporting Payments for Property
Under current rules, there is also generally no requirement to issue 1099s to report payments for property (such as merchandise, raw materials, and equipment).
What Will Change in 2012 and Beyond?�
The healthcare legislation makes two big changes to the existing Form 1099 reporting rules and a third change that is hard to assess without further guidance from the IRS.
First Change: Payments to Corporations Must Be Reported.
Starting in 2012, if a business pays a corporation $600 or more in a calendar year, it must report the total amount on an information return.
Presumably, Form 1099-MISC will be used for this purpose, or the IRS will develop a new form. (Payments to corporations that are tax-exempt organizations will be exempt from this new requirement.)
- In 2012, a business pays $30,000 to rent office space from a corporate lessor. Under the new rules that take effect in 2012, the $30,000 must be reported on a Form 1099.
- A business pays $2,000 for four employees to attend a seminar in 2012 put on by a corporation. Under the new rules that go into effect that year, the $2,000 must be reported on a Form 1099.
- Several employees go on a business trip in 2012, and a business pays $1,500 to a corporate hotel. The $1,500 must be reported on a Form 1099 for that year.
- In 2012, a business spends $1,000 at a local restaurant for an employee holiday dinner. The restaurant is operated by a corporation. Under the rules scheduled to become effective that year, the $1,000 must be reported on a Form 1099.
Second Change: Payments for Property Must Be Reported.
Starting in 2012, if a business pays $600 or more in a calendar year to any party (including an individual) as “amounts in consideration for property,” it must report the total payments on an information return for that year. The term “property” means computer equipment, office supplies, raw materials, and more. Again, Form 1099-MISC might be used to report affected payments, or a new IRS form might be created.
- In 2012, a business buys cash registers from a supplier for $25,000. It also spends $1,000 at a food and beverage store to buy refreshments for a company party. Later that year, the company pays an individual $1,500 for an old pickup truck and spends $750 at an office supply store for copier ink and computer paper. Under the new rules that are scheduled to go into effect in 2012, all these transactions will require the business to issue 1099s.
As you can see, the new requirements to report corporate payments and amounts to buy property will undoubtedly result in the issuance of many millions of additional Forms 1099 each year. (Presumably, payments between related corporations will not be exempt.)
Another burden: A business must also obtain a TIN from each affected payee to avoid the requirement for backup withholding of federal income tax.
On the other side of the coin, if a business sells property or operates as a corporation, it will have to supply customers with its TIN to avoid backup withholding on payments made to it.
Third Change: Payments of “Gross Proceeds” Must Be Reported.
Here’s where the new upcoming rules get more confusing. Under a third new rule that will take effect in 2012, payments of $600 or more in “gross proceeds” to a payee in a calendar year must be reported on an information return. At this point, it is unclear what this new reporting requirement is meant to cover. The best guess is that it is meant to cover payments to non-corporate payees, such as restaurants and other small businesses. We are awaiting IRS clarification on this issue.
Commissioner Says Credit and Debit Card Payments Will Be Exempt
Although no official guidance has been issued, IRS Commissioner Douglas Shulman said in a speech to payroll executives that certain payments will be exempt from the reporting requirements.
“We plan to use our administrative authority to exempt from this new requirement business transactions conducted using payment cards such as credit and debit cards,” Shulman said. “These transactions will already be covered by reporting requirements on payment card processors (going into effect next year), so there is no need for businesses to report them as well.”
Dealing with the new Form 1099 reporting rules is going to be difficult for many organizations — resulting in an avalanche of paperwork. Businesses will likely have to modify their accounting procedures to capture payee information that will be needed to comply with the new requirements.
Remember: TINs must be obtained from vendors to avoid having to institute backup federal income tax withholding on payments made to them. By the same token, a business must ensure that its customers have its TIN to avoid backup withholding on payments made to it.
What if backup withholding does occur on payments made to a business? It must be prepared to track the withheld amounts so it can claim credit for them at tax return time. If a business winds up on either side of the backup withholding rules, it can be a real mess. And with lots more 1099s flying around, the odds of errors rise proportionately.
To compound the problems with the new reporting requirements, many businesses use accounting methods other than the cash basis. In addition, a number of businesses file their returns using reporting periods other than calendar years. In an audit, imagine a business and the IRS attempting to reconcile 1099s with these complications.
Fortunately, the new Form 1099 reporting rules (including any backup withholding implications) don’t cover payments made before 2012. So there’s still plenty of time to plan for what is likely to be a daunting task.
Time for Tax-Wise Transactions
As you know, the 2010 federal income tax rate structure is quite favorable for shareholders of closely-held C corporations for these reasons:
- If a company pays a taxable dividend this year, the maximum federal income tax rate is only 15 percent; and
- That same 15 percent maximum rate applies to 2010 corporate payouts or stock sales that generate long-term capital gains.
Also, if you have an S Corporation with C Corporation accumulated earnings and profits (E&P), you can elect to treat the accumulated E&P as current dividends taxable at 15%. The payment can be in cash, stock or both.
Dividend and Capital Gains Taxes are Almost Certain to Go Up
With the passage of the massive healthcare bill, odds are the current taxpayer-friendly picture will only last through the end of this year.
Unless Congress takes action to extend the status quo, higher taxes on dividends and long-term gains will kick in on January 1, 2011, when the “Bush tax cuts” are scheduled to expire.
Even if the Republicans take back Congress in November, they might not be able to change the tax outlook anytime soon. Through 2012, the President has stated he would likely veto any tax cuts as the revenue will be needed to help pay for government healthcare.
Here are the specifics about what is likely coming down the pike:
The maximum federal rate on dividends is scheduled to increase from the current 15 percent to 39.6 percent on January 1. Although the President has promised more than once to limit the maximum rate to 20 percent, that pledge has changed.
Beginning in 2013, the new healthcare legislation will impose an additional 3.8 percent Medicare tax on a high-income individual’s net investment income, which is defined to include dividends. That raises the maximum dividend tax rate to at least 23.8 percent for 2013 and beyond. For affected individuals, that’s at least a 58.7 percent increase in federal taxes on dividends (23.8 percent is 158.7 percent of 15 percent).
For this purpose, a high-income individual has an adjusted gross income of $250,000 if married and filing jointly or $200,000 for single filers.
Taxes on Long-Term Gains
Starting January 1, 2011, the maximum rate on most long-term capital gains is scheduled to increase from the current 15 percent to 20 percent. And in 2013, the new healthcare legislation will impose an additional 3.8 percent Medicare tax on a high-income individual’s net investment income, which is defined to include long-term gains. As with dividends, that means a maximum federal tax rate of at least 23.8 percent for 2013 and beyond. For affected individuals, that amounts to at least a 58.7 percent increase in federal taxes on long-term gains.
Depending on where your clients live, state income tax rate on dividends and long-term gains may be headed higher, too.
What Can Your Clients Do?
Although next year and beyond look grim from a tax perspective, your clients still have some time to take advantage of this year’s historically favorable rates. Here are three strategies to consider before the end of 2010:
Strategy 1: Take Dividends This Year
Let’s say a profitable C corporation has a healthy amount of earnings and profits (E&P). The concept of E&P is somewhat similar to the more-familiar financial accounting concept of retained earnings. While lots of E&P indicates a financially successful company, it also creates two unfavorable tax side effects:
1. To the extent the corporation has current or accumulated E&P, corporate distributions to shareholders (including owners and executives) count as taxable dividends. Since the 2010 federal tax rate on dividends cannot exceed 15 percent, dividends received before the end of this year will be taxed lightly compared to what is likely to happen in 2011 and beyond. Therefore, shareholders should weigh the possibility of triggering a manageable current tax bill by taking dividends in 2010 against the possibility of absorbing a much bigger (but deferred) tax hit on dividends they would otherwise plan to take in future years.
2. When a C corporation retains a significant amount of earnings, there’s a risk that the IRS will assess the accumulated earnings tax (AET). This tax can potentially be assessed once a corporation’s accumulated earnings exceed $250,000 (or $150,000 for a personal service corporation). When the AET is assessed, the tax rate is the same as the maximum federal rate on dividends received by individuals. Therefore, the AET rate is also scheduled to jump from the current 15 to 20 percent, starting in 2011 (assuming the President’s pledge to keep it at 20 percent rather than 39.6 percent goes through).
Dividends paid in 2010 will be taxed lightly, and they will also reduce a company’s accumulated earnings. So they will also reduce or eliminate the company’s AET exposure in future years, when the AET rate will probably be at least 20 percent.
Strategy 2: Arrange a Low-Taxed Stock Redemption This Year
Another way to convert theoretical C corporation wealth into cash is with a stock redemption transaction in which a client sells back some or all of his or her shares to the company. (When there are several shareholders, this is a common technique to cash out one or more selected shareholders while the others continue to hold their stakes.)
To the extent of the corporation’s current or accumulated E&P, any stock redemption payment is generally treated as a taxable dividend. However, the Internal Revenue Code provides several exceptions to this rule. If one of these exceptions applies, the redemption payment will be treated as proceeds from selling the redeemed shares. In other words, regular stock sale treatment applies.
The distinction between dividend and stock sale treatment may or may not be important to your clients. That’s because when dividend treatment applies, the client receives no offset for his or her tax basis in the redeemed shares. In that case, the entire redemption payment may count as taxable dividend income.
In contrast, when stock sale treatment applies, the client has capital gain (probably long-term) only to the extent the redemption payment exceeds his or her basis in the redeemed shares. So only part of the redemption payment is taxed. In addition, the client can offset capital gain from a redemption treated as a stock sale with capital losses from other transactions (including capital loss carryovers the client may have left over from the 2008 stock market meltdown).
If a client doesn’t have significant basis in the redeemed shares or significant capital losses, there’s usually only a minor distinction between dividend treatment and stock sale treatment under today’s federal income tax system. For 2010, both dividends and long-term capital gains are taxed at the same rates, with a maximum rate of only 15 percent.
However, as explained earlier, both dividends and long-term gains will almost certainly be taxed at higher rates in 2011 and beyond. Therefore, a stock redemption that is completed in 2010 could result in a much lower tax bill than a redemption that’s put off until 2011 or later.
Strategy 3: Sell Stock This Year
Speaking strictly from a federal income tax rate perspective, selling shares this year and paying no more than 15 percent on the resulting gains (assuming the taxpayer has held the shares for more than a year) sure beats paying 23.8 percent (or maybe more) on gains from sales in later years.
Exception: A taxpayer might want to defer capital gains until the following year because of a reasonable expectation that he or she will be experiencing capital losses at that time that could offset the gains.
Clients should consider the possible advantages of taking dividend payments, transacting stock redemptions, or selling shares in a closely-held corporation under today’s favorable federal income tax structure. Waiting until next year or later could prove costly.
2010 Hiring Incentives
to Restore Employment (HIRE) Act
On March 18, 2010, President Obama signed the Hiring Incentives to Restore Employment (HIRE) Act to help businesses hire and retain new employees. Below is an overview of the key tax changes and additional features of the new hiring incentive. Please call our offices for details of how the new changes may affect your specific business.
Extension of enhanced small business expensing (Section 179)
The new law gives a one-year lease on life to enhanced expensing rules, which allow qualifying businesses the option to currently deduct the cost of business machinery and equipment, instead of recovering it via depreciation over a number of years. For tax years beginning in 2010, the maximum amount that a business may expense is $250,000, and the expensing election begins to phase out when a business buys more than $800,000 of expensing-eligible assets. These dollar limits are the same as those that were in effect for 2008 and 2009.
Payroll tax holiday and up-to-$1,000 credit for employers who hire unemployed workers
To help stimulate the hiring of workers by the private sector, the new law exempts any private-sector employer that hires a worker who had been unemployed for at least 60 days from having to pay the employer’s 6.2% share of the Social Security payroll tax on that employee for the remainder of 2010. A company could save a maximum of $6,621 if it hired an unemployed worker and paid that worker at least $106,800-the maximum amount of wages subject to Social Security taxes-by the end of the year. As an additional incentive, for any qualifying worker hired under this initiative that the employer keeps on payroll for a continuous 52 weeks, the employer is eligible for an additional non-refundable tax credit of up to $1,000 after the 52-week threshold is reached, to be taken on their 2011 tax return. In order to be eligible, the employee’s pay in the second 26-week period must be at least 80% of the pay in the first 26-week period.
Workers hired after the date of introduction of the legislation (Feb. 3, 2010) are eligible for the payroll tax forgiveness and the retention bonus, but only wages paid after the date of the new law’s enactment receive the exemption for payroll taxes.
Here are some additional features of the new hiring incentive:
- The tax benefit of the new incentive is immediate. It puts money into a business’ cash flow immediately, since the tax is simply not collected in the first place.
- The tax benefit generally applies only to private-sector employment, including nonprofit organizations-public sector jobs are generally not eligible for either benefit. However, employment by a public higher education institution would qualify.
- There is no minimum weekly number of hours that the new employee must work for the employer to be eligible, and there is no maximum on the dollar amount of payroll taxes per employer that may be forgiven.
- For workers that would otherwise be eligible for the “Work Opportunity Tax Credit,” the employer must select one benefit or the other for 2010-no double dipping.
- An employer can’t claim the new tax breaks for hiring family members.
- A worker who replaces another employee who performed the same job for the employer is not eligible for the benefit, unless the prior employee left the job voluntarily or for cause.
- For the hiring to qualify, the new hire must sign an affidavit, under penalties of perjury, stating that he or she has not been employed for more than 40 hours during the 60-day period ending on the date the employment begins.
- The incentive is not biased towards either low-wage or high-wage workers. Under the measure, a business saves 6.2% on both a $40,000 worker and a $90,000 worker.
- The payroll tax holiday does not apply with respect to wages paid during the first calendar quarter of 2010, but the amount by which the Social Security payroll tax would have been reduced under the payroll tax holiday provision during the first calendar quarter is applied against the tax imposed on the employer for the second calendar quarter of 2010.
- The Act creates a similar new set of rules permitting a payroll tax holiday for railroad retirement tax purposes.
- The credit for retaining qualifying new hires is the lesser of $1,000 or 6.2% of the wages paid by the taxpayer to the retained worker during the 52-consecutive-week period. Thus, the credit for a retained worker will be $1,000 if, disregarding rounding, the retained worker’s wages during the 52-consecutive-week period exceed $16,129.03. However, the credit is not available for pay not treated as wages under the Code (e.g., remuneration paid to domestic workers).
Direct payment option for certain tax credit bonds
State and local governments have the ability to issue special purpose tax credit bonds for school construction, energy conservation and renewable energy. The federal government subsidizes these tax credit bonds by providing investors in these bonds with a federal tax credit in place of interest that would otherwise be payable on the bond. In lieu of providing investors with federal tax credits, the new law allows issuers of qualified school construction bonds, qualified zone academy bonds, clean renewable energy bonds, and qualified energy conservation bonds to elect to receive a direct payment from the federal government equal to the amount of the federal tax credit that would otherwise be provided for these bonds.
To pay for the tax incentives, the Act includes revenue offsets consisting of: (1) a comprehensive set of measures to reduce offshore noncompliance by giving IRS new administrative tools to detect, deter and discourage offshore tax abuses; and (2) a three-year delay (through 2020) of implementation of worldwide allocation of interest-a liberalized rule for allocating interest expense between U.S. sources and foreign sources for purposes of determining a taxpayer’s foreign tax credit limitation.
2010 Estate and Gift
By now many of you have read that Congress is unlikely to pass any estate tax reform in 2010. If Congress doesn’t act before January 1, 2011, those who die in 2010 will have a zero estate tax. However, their assets will not receive an unlimited step-up in basis to fair market value as under pre-2010 law. Instead, they will receive a limited step-up of $1.3 million ($3 million if married) that the executor can apply to certain assets as he or she chooses. But starting in 2011, the estate tax exemption becomes $1 million, which means that assets in excess of $1 million will be subject to estate tax rates from 41 to 55 percent.
Gift taxes are also changing. Gifts made in 2010 are subject to a flat 35 percent gift tax rate once aggregate gifts exceed a $1 million lifetime exclusion. Compare this to gift tax rates of 41 to 55 percent that applied in 2009 and will apply again in 2011. The table below summarizes some of these important changes between now and next year.
|Estate and Gift Tax Rates 2009 – 2011
Many people are scratching their heads over what, if anything, they should do now to prepare for these potential changes ahead. The uncertainty over whether Congress will act, and whether any changes will be retroactive to January 1, 2010 has paralyzed many people from doing any meaningful estate planning. However, this is not a time for inaction. There are many steps that people should consider now. We have summarized a few of them below.
• Dust off your current will and read it in light of a zero estate tax if you were to die in 2010. Do references to obsolete tax laws make your will ambiguous or inadvertently pass too much to the wrong persons? If so, consider a one-page codicil that clarifies how your will applies if you should die in 2010.
• While you are at it, check the ‘executor exoneration’ clause in your will. Does it make your executor a litigation target if you die in 2010 and he or she inadvertently applies the carryover basis rules in a way that is perceived to be unfair to one or more beneficiaries? If so, address that in a one-page codicil.
• Make a record of the tax basis of all your property – stocks and bonds, partnership interests, real estate, family businesses, personal effects, and other significant assets. Your heirs will need this if you die in 2010.
• Continue traditional estate planning strategies that are not affected by what Congress will or will not do. These include creating family limited partnerships, selling assets to a family trust, making annual exclusion gifts of $13,000 per donee, and making aggregate lifetime gifts of up to $1 million.
Don’t let Congress’ inaction cost your heirs money. Take time to review your estate plan now and let us know if we can help you.
The Foreign Account Tax Compliance Act (FATCA) – What’s new and its effects
on tax compliance
FATCA was enacted March 18, 2010 as part of the Hiring Incentives to Restore Employment (HIRE) Act. The HIRE Act was partially paid for by the new measures to heighten foreign assets and accounts disclosure and reporting requirements.
Taxpayers should begin to comply with disclosure requirements where applicable. Otherwise with the heightened focus on reporting, higher penalty provisions and lengthened IRS statute of limitations, failure to comply could be costly.
Currently, U.S. taxpayers with foreign accounts and assets are subject to filing Form TD F 90-22.1, Report of Foreign Bank and Financial Accounts (FBAR) to the Department of Treasury. Now FATCA imposes a new reporting requirement under IRC 6038D, which requires U.S. taxpayers with “specified foreign financial assets” with aggregate value exceeding $50,000 to report on informational returns with their U.S. income tax returns.
IRC 6038D defines “specified foreign financial assets” to include ownership in any financial accounts with a foreign financial institution, any stock or security issued by a non-U.S. person, any financial interest or contract held for investment that has non-U.S. issuer and any interest in a foreign entity. For example, FATCA requires taxpayers to report investments in hedge funds and private equity funds.
Penalty for failure to disclose is at minimum $10,000 for each year. Penalties increase to a maximum of $50,000 upon notification from the IRS.
New reporting requirement for Passive Foreign Investment Company (PFIC)
FATCA also amended the filing requirements for foreign companies that qualify as a passive foreign investment company (PFIC). A PFIC is a company in which either 75% or more of gross income in the tax year is passive income or 50% of average asset balance held by the foreign company produce passive income or held for the production of passive income. Under the previous law, disclosure is required only when companies made a qualifying elective fund election, received certain distributions, or disposed of interest in the PFIC company. The new law, effective March 18, 2010, requires shareholders of PFIC to file an annual information return disclosing ownership interest (IRC 1298(f)).
New withholding tax and disclosure requirements for certain foreign entities with U.S. customers
Effective for payments made after December 31, 2012, foreign financial institutions and foreign non-financial entities with U.S. customers will be required to disclose information about the U.S. customers.
Failure to report certain required information will result in U.S. payers to withhold 30% tax on U.S. source payments. Withholdings are generally required for payments from U.S. payers to nonresident aliens, such as dividends and certain income that were excluded including certain bank interest and capital gains not effectively connected to a U.S. trade or business. Failure to comply will subject the U.S. withholding agent and financial institutions to financial penalties.
Note foreign financial institutions include banks, brokerages and investment funds. Also, non-publicly traded equity and debt interests in foreign financial institutions are included as accounts.
New penalties provisions, expanded statutes of limitations and other provisions
FATCA has added 40% to the accuracy related penalty provision of the portion of underpayment from failure to report transactions that involve undisclosed foreign financial assets. FATCA has also expanded the statute of limitations from 3 years to 6 years where taxpayers omit more than $5,000 of income attributable to specified foreign financial assets. Thus, even without substantial understatement of income, the IRS will now have 6 years to investigate and audit the taxpayer. The extended statute applies to returns filed after March 18, 2010 and returns filed before such date if the statute has yet to expire.
FATCA also added amended provisions for foreign trusts where there are new reporting requirements and penalties for non-compliance. Also, substitute dividends and dividend equivalent payments received by foreign persons from sources within the U.S. are subject to a 30% withholding tax unless reduced by a treaty.
Important Net Operating Loss Expanded Carryback Deadlines
If you want to carry back an NOL 3, 4, or 5 years, you must attach an election to your return.
Information on the Election:
The election gives you either 3, 4, or 5 years to carry back your NOL (instead of the normal 2 years)
The election is irrevocable
The election must be made by the extended due date of the tax return
The election is for EITHER 2008 or 2009 (calendar years). For fiscal years, it’s EITHER of two years that end after 12/31/07 and beginning before 01/01/10. So if you used this election in 2008, you can’t use it again for 2009. (But see the exception below for ARRA NOLs)
If a corporation timely filed its tax return and did NOT make the election, the corporation can still make the election within 6 months of the original due date of the return. EX: A calendar year corporation that filed on March 15th has until September 15th to make this election.
Information on the Carryback:
If you carry back to the 5th preceding tax year, you can only offset HALF of the 5th year’s taxable income. This restriction is ONLY for the 5th year.
THE 90% OF AMT LIMITATION DOES NOT APPLY.
More information is available in Notice 2010-58
The ARRA Exception:
The above provisions are from the WHBA (Worker, Homeownership, and Business Assistance Act). Prior to that, we had a different carry back election. It was just for the 2008 tax year and it came from the ARRA (American Recovery and Reinvestment Act). Those ARRA rules only applied if >half of your income was from an electing small business. The newer WHBA rules are for all NOLs – not just small business ones.
If you carried back a 2008 NOL under the ARRA rules, you can also carry back a 2009 NOL under the WHBA rules.
Get the Latest on IRS Audit Activity
Many clients ask: “How can I avoid being audited by the IRS?” Of course, there’s no 100 percent guarantee that a taxpayer won’t be picked because some returns are chosen randomly. However, completing tax returns in a timely, orderly, and accurate fashion with a trusted tax adviser certainly works in a taxpayer’s favor. It also helps to know the red flags that catch the attention of the IRS.
The overall percentage of taxpayers who are audited is historically around 1 percent, although it varies from year to year. However, certain groups of people and organizations are audited at much higher rates.
We’ll tell you about some of the new and recurring audit targets, but first, here are some of the latest collection statistics from the IRS Data Book for the fiscal year ending September 30, 2009.
Individual Returns: The IRS audited about 1 percent of the 138.8 million individual returns filed. Nearly 23 percent of individual audits were conducted by IRS personnel. The rest were correspondence audits.
Auditors focused heavily on high income taxpayers. For example, 6.4 percent of returns with total positive income of more than $1 million were audited, a jump from 5.6 percent the year before.
Corporate Returns: The tax agency audited 1.3 percent of returns from corporations. Specifically:
• For corporations with assets from $1 million to $5 million, audits edged down to 1.8 percent of returns from 2%
• For corporations with assets between $5 million and $10 million, audits fell to 2.7 percent from 3.1 percent.
• Audits for corporations with $10 million or more in assets dropped to 14.5 percent from 15.3 percent.
• The audit percentage for S corporations and partnerships remained unchanged at 0.4 percent of returns.
So, what’s next? Here are some new and recurring areas that are likely to raise red flags:
Homebuyer Tax Credit – In a new report from the Treasury Inspector General, the IRS was found to have paid more than $27 million in fraudulent homebuyer tax credit claims on 2008 returns. Incredibly, approximately 1,300 prison inmates (some serving life sentences) received $9 million for homes they could not have possibly bought while behind bars.
In response, the IRS plans to scrutinize the returns of taxpayers claiming the homebuyer credit, as well as attempt to recoup money paid erroneously on past claims. There are now special filing requirements that include sending sale-related documents with a tax return claiming the homebuyer credit.
Online Income – Starting in 2011, the IRS will be taking a closer look at transactions by sellers on eBay and other online auction sites. This is the result of a new law that requires any bank or other payment settlement company that processes credit cards, debit cards, and electronic payments such as PayPal to report to the IRS what merchants receive. Not all online sales are taxable, as many sell used items at a loss.
Investment Income – The IRS often discovers unreported taxable income when its computers compare the income reported on tax returns with the information obtained from financial institutions about dividends and interest.
Changes Ahead: Be aware that the IRS will soon receive more information about investors’ activities. Right now, the IRS is informed about how much investors sell securities for, but the tax agency relies on investors to provide the purchase prices.
Beginning with specified securities purchased in 2011, brokers will be required to calculate gains and losses and classify them as short-term or long-term. This information will be reported to customers and the IRS.
The expanded requirements were implemented in response to tax officials’ suspicion that many people overstate the tax basis when they sell securities in order to pay less tax.
Self-Employment Income – The tax system makes it easier for self-employed individuals (rather than employees) to underreport income and fabricate or overstate deductions. The IRS traditionally expends extra effort to ensure self-employed taxpayers filing Schedule C remain compliant. But there is a new focus after a recent report from the Treasury Inspector General found that even when the IRS audited self employed taxpayers, it failed to address significant potential misreporting of income.
Automobile Expenses – Traditionally, this is a high-risk area for business taxpayers. Auditors are suspicious of claims that a personal car is mostly or exclusively used for business. Clients should maintain a daily log of business mileage with odometer readings, dates, locations and purposes of meetings, as well as the names of people they meet with.
High Itemized Deductions – If taxpayers’ itemized tax deductions exceed IRS ranges for their income group, the odds of an audit jump significantly.
Home Office Tax Deductions – As a general rule, the office must be a taxpayer’s principal place of business or a place where he or she regularly meets with clients or patients.
Alimony – These payments have become an audit target after years of perceived abuses. The IRS matches deductions taken by one former spouse with the taxable alimony income reported by the other.
Losses from an Activity the IRS Considers a Hobby – This is another ongoing favorite IRS target and includes activities such as horse breeding and photography. However, taxpayers have effectively fought the IRS by keeping accurate records, following industry practices, and operating at a profit in three out of five consecutive years (two out of seven for horse businesses).
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Get Ready for Onerous New 1099 Reporting Rules
Corporations: Good Time for Tax-Wise Transactions
The HIRE Act
2010 Estate and Gift Tax Changes
The Foreign Account Tax Compliance Act (FATCA)
Important Net Operating Loss Expanded Carryback Deadlines
Get the Latest on IRS Audit Activity
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