No one likes the stress involved when your tax return is under the audit spotlight. Here are some ideas to avoid some of the more common audit triggers.
- Report everything that has an informational tax return. If you are like most Americans, you will receive numerous 1099’s, W-2’s, and 1095-A’s in the mail. The IRS receives them too. If your tax return does not meet or exceed this reported income you can count on receiving a notice from the IRS. Some hints:
- Make a list of the forms received last year
- Update the list with any new vendors or employers
- Check off each of them when you receive them
- Match the reports…even when they are wrong. When reviewing your tax return make it easy for the IRS programs to match what is being reported to them. If an amount is incorrect, try to get it changed. If not possible, report the incorrect amount (so it matches the IRS records) and then correct it with an explanation.
- Get your key information right. Social security numbers must be valid. Names must match social security numbers. Mis-matches here are sure to be noticed.
- Get your dependents right. You and an ex-spouse must consistently report your dependents. Both of you cannot claim a child as a dependent. If an ex-spouse claims paying you alimony, it must match alimony income on your return.
- Understand the chances of audit. Each year the IRS reports audit rates by income level and type of tax return. While the overall audit rate is around 1%, it is much higher for high income tax returns and returns that have small business activity (Schedule C).
Even if you believe you have done everything correctly, audits happen. Should it happen to you please do not hesitate to seek help
If you don’t receive a W-2 or 1099, is this a defense to protect yourself from not reporting the income during an audit?
In short, the answer is no. You are required to report your income whether your employer or customer filed the correct form or not. So what can you do to ensure you do not find an audit surprise in your future due to a simple omission of income from a report you did not receive? Here are some tips:
- Keep good records. Do not depend on someone else’s records to file your taxes. Keep your own records and then use them to ensure the information on your tax return is accurate.
- Make a list. Start making a list of your employers and others you believe should be sending you a W-2, 1095-A, 1098, 1099 or other tax form. Put the list in a file and check off each name when you receive their form. Use last year’s tax return to help you create your initial list.
- Double check. When you receive the forms, review your records to see if you agree with the information reported to you. Use your last paycheck stub to check your wage reporting, use your bank statement to confirm interest income, use your investment statements to confirm stock and mutual information and use invoices to confirm miscellaneous income.
- Take charge. If you are missing a form or the form received is in error, contact the firm supplying you the information and get it corrected as soon as possible. If tax filing due dates are approaching, you may need to file an extension while waiting for the corrected form.
- Record the correct information, no matter what. Record the correct information on your tax return, even if you lack the required form. Not receiving a tax form is not a workable audit defense.
If you receive a notice from the IRS regarding a possible missing item, consider filing an information request to see what the IRS has on file for you. It may help better identify the area of mismatch.
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There are a number of areas in the tax code that cause confusion as to the taxability of money received. Here are some of the most common areas of confusion.
Alimony. Alimony is taxable to the person who receives it and deductible to the person who pays it. Special rules apply. Make sure you have proper documentation as part of a divorce decree to ensure you can support your tax position.
Child Support. Child support is not taxable to the person who receives it on behalf of their dependent. It is also not deductible for the person who pays it.
Free Services. Free service is almost always taxable as ordinary income under IRS barter regulations. You should report the fair market value of services received as income on your tax return. If you exchange services, you can deduct allowable business expenses against the value of services provided.
Illegal Activities. Even income received from illegal activities is taxable income and must be reported. Incredibly, the IRS even states that stolen items should be reported at the fair market value on the date the thief stole the item.
Jury Duty Pay. This is taxable as ordinary income. Yes, even doing your civic duty can be a taxable event.
Legal Settlements. A general rule of thumb with legal settlements is to consider what the settlement replaces. If the settlement revenue replaces a taxable item, like lost wages, the settlement often creates taxable income. This area is complex and often requires a detailed review.
Life insurance proceeds. Generally life insurance proceeds paid to you because of the death of an insured are not taxable. However, there are a number of exceptions to this general rule. For example, if you receive benefits in installments above the value of the life insurance policy at time of death or if you receive a cash payout of a policy you could have taxable income.
Prizes. Most prizes received should be reported as ordinary income using the fair market value of the item received. This area has been a major surprise to contestants on game shows and celebrities who have received large gifts at celebrations like the Academy Awards.
Unemployment Compensation. Typically unemployment compensation is to be reported as taxable income. Many are confused by this because of a temporary federal tax law that made unemployment compensation non-taxable during the recent economic recession. This is no longer the case.
Some of these areas can be complicated. What is most important is to realize when to discuss your situation.
Picture this; for the past few years you have picked up your tax return and have had a small but nice refund. Now imagine your surprise, when next year, you are required to send in a fairly big check to settle your tax bill. Believe it or not, this message is almost as hard to deliver to a taxpayer as it is to hear it. Here are some tips to help ensure tax changes do not come as a surprise to you.
A spouse passes away. The tax surprise related to this event tends to hit older taxpayers the hardest. In the year of death the tax impact in not usually felt. The year following death, the tax surprise hits hard because of the following tax changes:
- You lose standard deductions
- You lose an exemption
- You move from a joint filing status to single (or head of household)
A child is no longer eligible. Just when you think you have it figured out, a child who generated a tax break for you no longer does. Here are some age requirements for popular tax benefits:
- Dependent Care Credit: under age 13
- $1,000 Child Tax Credit: under age 17
- Earned Income Tax Credit: under age 19 (24 if a qualified student)
Earnings with social security benefits. If you are recently retired, collecting Social Security Benefits, and then start working part-time, you are also in for a tax surprise. These extra earnings could not only make your benefits taxable, it could result in a reduction of benefits received.
Other life events. Other life events could provide a tax surprise for you. While some may have positive tax consequences, like a new birth, or becoming head of household, others might surprise you and result in additional tax. Other common life events include retirement, death, and entering/leaving school.
Capital gains surprises from mutual funds. Often sales of investments are a planned event. Unfortunately, many mutual funds sell assets and then you receive a capital gain statement with a surprise taxable event.
New tax laws. 2014 tax law changes create special complications. A number of tax breaks expired at the end of 2013. This includes the educator deduction, state general sales tax deduction, tuition deduction and mortgage insurance deduction. If you took any of these tax deductions in 2013 you can expect a change to your tax return next year unless Congress acts to reinstate any of these provisions.
Want to avoid these surprises? Spend some time now reviewing your anticipated tax situation for 2014. By doing so, perhaps a planned “pleasant” surprise can be in store for you next year.