One of the advantages of being a lawyer as well as a tax preparer, is that I have the opportunity to clean up the messes that other tax preparers make. There are a number of things that tax preparers, and self filers as well do that trigger the IRS. When the letter from the IRS arrives, the self filer often does not know what to do; the tax preparer is often unavailable, or the tax preparer is unwilling or unable to deal with the problem. Often times, those people come to see me as I am available willing and able.
Audit Avoidance for People Claiming Dependents and Tax Credits
Roughly six years ago the IRS started a program that they called “Paid preparer due diligence”. For the 2012 tax year, this requirement was restricted to taxpayers claiming their income credit and it asked paid preparers to look for specific documents tending to show that the children being claimed for the income credit actually lived with the tax payer. This requirement has been expanding over time. For the upcoming 2018 tax year, paid preparers are being asked to perform “due diligence” for any tax payer claiming any dependent whatsoever. As such, preparer due diligence is required not only for the earned income tax credit, the child tax credit and the American Opportunity tax credit (tuition tax credit), which has been in place for the past few years, but it is also being required for any tax payer claiming head of household or claiming an additional tax credit. Basically, this is for everyone who is not filing simply single or married filing joint with no dependence or tax credit.
The documentation requirement is also non specific. The IRS wants paid preparers to look at any document that may be relevant to determining rather or not the tax payer is eligible for this credit deduction or status, and tell the IRS what they looked at. Needless to say this is a pain in the neck for paid preparers. Done right, it is a pain in the neck for the taxpayer as well. One option that the paid preparer has is not to bother. I have observed that there are certain tax preparers who simply do not report looking at documents. This can be a good short run business model, as they do not bother their clients with having to do any extra work. It also makes tax season a little bit less painful, as they are not entering all this information into the tax return. However, they are putting a red flag on the client’s tax return. When the IRS put in the preparer due diligence requirements specially to weed out fraud in the claiming of credits and deductions. When a tax preparer reports that a taxpayer has produced zero documentation indicating that they are entitled to the credit deduction, that tax payer would be the first person that IRS would target.
I have had a number of people come to my office with audit letters from the IRS and when I look at their tax return their preparer indicated that they had no documents to justify the claimed tax credit. Next in line would be self prepared returns as no documents had been provided and third in line would be the tax returns that have a very small amount of supporting documentation. The best way to avoid an IRS audit of any claimed credit or dependent would be to simply come to the tax preparer with as much documentation as is reasonable showing that your dependent lives with you, is related to you, and is supported by you. How much material you want to bring probably depends on your relationship to the dependent. If you are a married couple and the dependent is your minor child who has lived with the two of you for the child’s entire life and you are that child’s sole support, I would not come in with too much documentation, but you probably want to bring something showing that the child in fact lives with you and is your child and if the child is on your health insurance you would be bringing that in anyway.
On the other hand, if this relative or dependent is not related to you or is a niece or nephew who you are now claiming for the first time, you may want to bring in some significantly more documentation to give to the tax preparer showing that this person lives with you and that you support them and that the biological parents do not. A diligent tax preparer will list every document or thing that you bring in tending to show the relationship and the fact of support and that should help to keep the IRS away. Keep in mind that the burden to produce documents is yours and not the tax preparer’s. You tax preparer is not your auditor and your tax preparer is free to file a tax return that does not have substantial documentation. However, if your return is selected for audit, the IRS will demand proof of the relationship and proof that you support the dependent. This is a lot more documentation than is necessary to ward off an audit in the first place. Also, gathering up the documentation to give to your tax payer may be annoying but it will not cause you to lose any sleep gathering up the documentation for the answers to an IRS audit will cost you many nights of sleep. As such it is a good idea to bring your tax preparer anything you have handy showing that you know this person, are related to this person. live with this person and or support this person.
Beware the “Long Form” and other Bogus Deductions
One scam that has been prevalent here in Lowell and elsewhere is the so called “Long Form” and particularly the employee business expense deduction. I have had people come to me who are getting slammed by the IRS and when I look at their tax return what I found was even though they had regular jobs, they were writing off thousands, and sometimes tens and thousands of “employee business expenses”. These things would include vehicle mileage expenses, meals and entertainment, education and training, uniforms, and the like. Often times these people have jobs that did not require any of these things. (Keep in mind that commuting to work has never been deductible). In addition, such tax preparers would often put on these folks returns medical expenses and charitable deductions that people that were simply out of line with their income and ability to pay. At the end of the day, they might have little or no taxable income. By the way the same tax preparers would have similar scams elsewhere on the tax return. If the taxpayer also had an owner occupied two family house, the tax preparer may put down ten or twenty thousand vehicle miles to go with the ownership of that house, not standing that the only place they would have driven to was Lowes or Home Depot.
The fraudulent employee business expense deduction is so well known that Congress eliminated it in the recent tax reform. There will be very few bogus itemized tax returns in the future, but a new scam is certain to replace it and that is the nonexistent business.
Beware of Bogus and Inappropriate Business Schedules
When Congress eliminated the employee business expense deduction to cut down on the amount of tax fraud, the IRS immediately became weary that unscrupulous tax preparers will start making up business so that they can write off business losses to replace the lost employee’s business expense. A very easy way to reduce your taxable income is to claim that you have started a money losing business where you can take all those same deductions that use to show up as employee business expenses under the itemized deductions. The IRS is expecting people to do that this year and is on the lookout for that. Bottom line being, if you do not have a money losing business, do not claim one. More importantly when your taxpayer gives you your tax return to review look and see if the tax preparer is claiming losses for a business you do not have.
Remember, you are responsible for your tax return. The IRS is not sympathetic when you file a tax return showing business losses you do not have and you say you “did not know that my tax preparer did that”.
However, there is another inappropriate business claim that the IRS is also on the lookout for as a result of the change in the tax law. There is a beautiful provision in the tax code that allows most businesses to deduct twenty percent of their “qualified open business income” or profits. The IRS is very concerned that people will recharacterize their status as independent contractors instead of employees. The IRS has actually put forward a regulation indicating that if you were employed by someone and you are now being characterized as an independent contractor, there is a presumption that you are really an employee. However, there is still concern about people changing jobs and calling themselves being characterized as independent contractors when they are really employees. And there is concern that new employers will be “encouraging” new employees to take on the status of independent contractors because that is of significant advantage to the employer who can now tell the employee that it is advantageous to them as well. Be aware that this is what the IRS is very much on the lookout for this year.
Is a Business that Loses Money Every Year Really a Business?
Business commonly lose money their first year. That by itself is not a red flag, although as discussed above it may be a bit of one this year because of other things happening in the tax code. It is not uncommon for some businesses to lose money their first two or even three years. Amazon.com lost money its first probably ten years in business, an Uber has never made a profit. However, most small businesses either become profitable the first couple of years, or they close. Most small businesses either turn a decent income for their proprietor in the first few years or the proprietor goes on to do something else. As such, when a business loses money year end and year out, the IRS begins to wonder if it is really a business, and if so if its income and expenses are being accurately reported. Similarly, when a person could be making more if they simply went out and got a job continues to run the same business for years making a very modest living the IRS wonders if the income and expenses are being accurately reported, these are audit triggers.
Published on 02/02/2019