3 Steps to Avoid an IRS Audit of Your Tax Return
It's that time of year again to pull out your shoebox of W-2s, K-1s, 1099s, and other tax information to grind out your tax return.
While doing your own tax return might give you a lot of pride and satisfaction, I believe the complexity of the tax code has rendered this exercise as tedious, full of frustration, and probably best left to a professional (or at least a tax prep software)--especially since, as an entrepreneur, your time is so valuable.
But if you do decide to journey down this road alone without professional help, here are three questions that will help you avoid an IRS audit.
1. Are the right numbers on the right forms?
Believe it or not, one of the most frequent adjustments to taxpayer returns come when the numbers from the original documentation don't get to the appropriate forms. The IRS has a matching program between forms such as 1099B and schedule D. A tax preparation software product would help you eliminate most math errors, and will often prompt you to look for neglected deductions.
2. Do you really know the rules?
Tax rules can be complex. For example, due to the economic crisis, you may have put a second home or even your primary residence on the rental market. If you move out of your personal residence and rent it, your deductions for real estate tax and mortgage interest are shifted from itemized deductions on Schedule A to rental deductions on Schedule E of Form 1040. The only additional deductions you become entitled to are those for operating expenses and depreciation. Since the rental income is included in your gross income, and the amount of additional deductions you are entitled to may be small, renting out your personal residence could increase your taxable income when you were hoping the deductions would eliminate taxable income. If you change your home or other property (or a part of it) to rental use at any time other than the beginning of your tax year, you must divide yearly expenses, such as taxes and insurance, between rental use and personal use. You can deduct as rental expenses only the part of the expense that is for the part of the year the property was used or held for rental purposes. You cannot deduct depreciation or insurance for the part of the year the property was held for personal use. There are many IRS publications on specific technical areas, such as renting out your home, to assist you in filing a correct return.
3. Do you know what's a business and what's a hobby?
While you may believe that you will be the next Steve Jobs working out of your own garage, the IRS may think otherwise.
Here are the questions the IRS typically asks to discern what's a business from what's a hobby:
- Does the time and effort put into the activity indicate an intention to make a profit?
- Do you depend on income from the activity?
- If there are losses, are they due to circumstances beyond your control, or did they occur in the start-up phase of the business?
- Have you changed methods of operation to improve profitability?
- Do you have the knowledge needed to carry on the activity as a successful business?
- Have you made a profit in similar activities in the past?
- Does the activity make a profit in some years?
- Do you expect to make a profit in the future from the appreciation of assets used in the activity?
An activity is presumed for-profit if it makes a profit in at least three of the last five tax years, including the current year. The key to substantiating a deduction in this area is to document, document, and document some more. You can also see IRS Publication 535 for more details.
If you choose the do-it-yourself method of filing your tax return, buy a tax prep software package to save pencil lead and math frustration, understand the critical tax issues on your return by using the IRS publication library, and document, document, document. Otherwise, do a careful ROI analysis of your time and consider if you ought to outsource.
The views expressed in this article are those of the author and do not necessarily represent the views of Ernst & Young.
JAMES MARKHAM is the Ernst & Young tax leader for the Americas' strategic growth markets and the partner in charge of the firm’s Sacramento office tax practice. He helps companies with tax strategies.
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