Yes, it’s true that we’re just coming out of the longest government shutdown in the history of the United States. It will take many government agencies – including the Internal Revenue Service – a significant period of time to get back up to speed. But if you think that all this means that the chances of your getting audited are lower than ever, you’re going to want to think again.
According to one recent study, the IRS audited about 0.6 percent of individual tax returns in 2016, which means that your chances of getting that unfortunate letter in the mail were about one in 160. When you expand the definition of a traditional audit to include all of the other types of notices that you may receive to re-examine your taxes or provide backup documentation, for example, that number jumps to about 6.2 percent— or roughly one in 16.
So not only were your chances of getting audited always higher than you thought, but a government shutdown isn’t going to prevent this particular train from running on time. There are a few common IRS audit red flags in particular that you’ll want to know more about as April approaches once again.
The Dreaded Math Errors
A lot of people don’t realize just how much of the IRS’s own processes are automated. When you file your income tax return, that information gets entered into a computer, and a lot of the processing is done before a human ever looks at it — if one ever comes into contact with your return at all.
Therefore, one of the major red flags that will certainly trigger an audit are math errors, because a computer doesn’t care whether the government was shut down or not. A math error is a math error, and if you make one (or multiple), it’ll send up a red flag within the IRS’s system, and an automated notice will likely be issued as a result.
HOW You Make Your Money
The people who work for the IRS aren’t amateurs; they know that certain types of industries feature more instances of unreported cash earnings than others. This is why another one of the major red flags that could see you on the receiving end of an IRS audit has to do with the industry you’re operating in to begin with.
If you work in the restaurant industry where cash tips are common, for example, you are probably always going to garner more attention from IRS professionals than someone who may have a more rigid salary. Simply being a part of these types of industries automatically raises your odds of being audited, and no government shutdown is going to change that.
At this point, it’s important to note that taking this credit intentionally when you shouldn’t is fraud, and that is not a situation you want to find yourself in. If you can prove that you took the credit by accident, you don’t necessarily have anything to worry about. But you’ll likely still be audited, and you’re certainly going to have some explaining to do.
Large Charitable Contributions
Finally, one of the biggest red flags that the IRS always looks for when determining whom to audit ultimately comes down, not to charitable contributions as a concept, but to significantly large contributions under peculiar circumstances.
When viewing charitable contributions, the IRS always looks at the amount you gave relative to the overall amount you made during a year. The IRS definitely knows, on average, how much people in certain income brackets are likely to donate. Sure, there are always special circumstances – but if you give two years’ worth of donations in a single year in an effort to maximize the deduction you can take, you’re almost always going to attract the type of attention you don’t necessarily want.
Provided that you’ve got the documentation to back up your donations, you have absolutely nothing to worry about. But a lot of people try to game the system by saying that they gave X amount of dollars in one year when they really gave that money over the last few years, and that is something the IRS will try to put a stop to.
An audit isn’t necessarily a bad thing, especially if you have the documentation to support every move you made and why it was the right one for you at the moment. But again, don’t assume that the government shutdown means that your chances of an IRS audit are practically zero. They never were, but they certainly aren’t now, which is why you’ll always want to make sure that you’ve crossed your T’s and dotted your I’s before you submit your tax return information this year.
If you use independent contractors to perform services for your business or your rental that is a trade or business, for each individual whom you pay $600 or more for the year, you are required to issue the service provider and the IRS a Form 1099-MISC after the end of the year, to avoid losing the deduction for their labor and expenses. (This requirement generally does not apply to payments made to a corporation. However, the exception does not extend to payments made for attorney fees and for certain payments for medical or health care services.)
It is not uncommon to have a repairman out early in the year, pay him less than $600, then use his services again later and have the total for the year exceed the $600 limit. As a result, you might overlook getting the information needed to file the 1099s for the year. Therefore, it is good practice to always have individuals who are not incorporated complete and sign the IRS Form W-9 the first time you use their services. Having a properly completed and signed Form W-9 for all independent contractors and service providers will eliminate any oversights and protect you against IRS penalties and conflicts.
The government provides IRS Form W-9, “Request for Taxpayer Identification Number and Certification,” as a means for you to obtain the data required from your vendors in order to file the 1099s. It also provides you with verification that you complied with the law, should the individual provide you with incorrect information. We highly recommend that you have a potential vendor or independent contractor complete a Form W-9 prior to engaging in business with him or her.
Many small business owners and landlords overlook this requirement during the year, and when the end of the year arrives and it is time to issue 1099-MISCs to service providers, they realize they have not collected the required documentation. Often, it is difficult to acquire the contractor’s, handyperson’s, gardener’s, etc., information after the fact, especially from individuals with no intention of reporting and paying taxes on the income.
This has become even more important in light of the tax reform’s 20% pass-through deduction (Sec. 199A deduction), since the regulations for this new tax code section caution landlords that to be treated as a trade or business, and therefore to be generally eligible for the 199A deduction, they should consider reporting payments to independent contractor service providers on IRS Form 1099-MISC, which wasn’t generally required for rental activities in the past and still isn’t required when the rental is classified as an investment rather than as a trade or business. This caution was included in IRS regulations issued after the close of 2018, which caught everyone by surprise and left most rental property owners to deal with obtaining W-9s after the fact from service providers and issuing the 1099-MISCs after the due date of January 31, 2019. Each late-filed 1099-MISC is subject to a penalty of $100 if not filed by August 1, 2019.
1099-MISC forms must be filed electronically or on special optically scannable forms. If you need assistance with filing 1099-MISCs or have questions related to this issue, please give this office a call. Also, make sure you have all of your independent contractors or service providers complete a Form W-9 for 2019.
You know the old line about the inevitability of death and taxes? It’s still true. What isn’t inevitable, however, is the need to pay penalties to the IRS. It happens, but it doesn’t have to, and the main reason that it does is because taxpayers don’t educate themselves about the rules. When you get hit with an IRS penalty, it adds on to a number that you already wish you didn’t have to pay.
To ensure that you get through tax season without unnecessary costs and aggravation, here’s a list of the tax penalties that the IRS most frequently assesses against taxpayers.
The 8 Most Common Tax Penalties Assessed
Penalty for underpaying estimated tax payments
Penalty for taking early withdrawals from tax-advantaged retirement accounts, including IRA accounts and 401(k) accounts
Penalty for taking nonqualified withdrawals from 529 plans, health savings accounts (HSAs), and similar tax-favored accounts
Penalty for failing to take required minimum distributions (RMDs) from tax-favored retirement accounts
Penalty for making excess contributions to IRAs and other tax-favored accounts
Penalty for failing to file, or for filing your required tax return after the designated due date
Penalty for failing to pay your taxes on time
Penalty for filing a substantially incorrect tax return or taking frivolous positions on a return
Let’s take a deep dive into each. The more you know, the better you’ll understand how to avoid these mistakes.
1. Penalty for not making estimated tax payments
Where does your income come from? If you’re a W-2 employee whose employer withholds your federal income tax on your behalf, then estimated tax payments are not something you need to worry about. On the other hand, if you get income from which withholding isn’t deducted, then you are legally obligated to submit estimated quarterly tax. Failure to do so is subject to penalty.
Who has to submit quarterly estimated taxes? You do if you’re a part of the “gig” economy which makes part or all of your income from freelance jobs or independent contracting work, or if you’re a retiree who relies on or derives income from Social Security and your personal savings accounts or other accounts whose withdrawals are taxable (or subject to capital gains). Own a small business? If you’re subject to self-employment tax, then you’re supposed to submit it quarterly. Though this requirement is straightforward, most people start their income journey as W-2 employees: they may have no familiarity with estimated quarterly taxes, or if they do they may not be in the habit of paying it and have forgotten. Whatever the reason, the penalties for failure to make these payments can add up pretty quickly.
The government has set up the quarterly payments so that the IRS Form 1040-ES is marked with four dates throughout the year — April 15th, June 15th, September 15th and January 15th (or the next business day if the 15th falls on weekend or legal holiday) of the year that the year’s tax filing is due. In doing so, they have it set up so that the majority of the taxes that are owed are paid throughout the year, though not on a weekly, biweekly or monthly basis the way that W-2 employees withholding is sent in. Failing to send the monies in for each quarter of 2018 is set to be penalized on an annualized basis of 4 to 5 percent. The best way to avoid the penalty is to pay your taxes on the dates that they’re due, calculating the payments accurately enough to represent either 90 (85% for 2018) percent of the actual amount you end up owing or 100% of the amount that was appropriate from the previous tax year. That 100% of the previous year’s amount is acceptable under what is known as safe-harbor, though for those whose income is more than $150,000, the percentage needed is 110% of the previous year’s income tax. Conversely, those who owe less than $1,000 in annual taxes do not get penalized at all. It is important to note that the penalty percentage has jumped to 6 percent as of the first quarter of 2019.
2. Penalty for taking early withdrawals from tax-advantaged retirement accounts, including IRA accounts and 401(k) accounts
Having a retirement account is a smart thing to do, and it’s something that the government has encouraged by allowing for the creation of special tax-advantaged vehicles. These tax advantages represent a tremendous incentive and benefit, but they come with strings: until you are 59 ½, you are not permitted to take money out of those accounts prior to retirement without having to have to pay a hefty 10% penalty.
As important as it is to know about the penalty so that you don’t take money out hastily and without a full understanding of the impact of doing so, but it’s also important to know when you can take the money out without being penalized. You’re permitted to take out up to $10,000 from and IRA for the purchase of a first home, as well as to pay any uncovered, unreimbursed medical bills that add up to more than ten percent of your adjusted gross income from any retirement plan. If you’ve been out of work and received unemployment compensation for a minimum of 12 weeks, you can take out up to $10,000 from and IRA to pay for your health insurance premiums. Distributions can also be taken from an IRA to pay for qualified higher education expenses, including fees, room and board and of course tuition, all without penalty. And if you’re leaving your job during the same year that you’re turning 55 or older, you can take money out of a 401(k) account from the job that you’re leaving without penalty. The fact that there is no penalty does not negate the income taxes that you would be required to pay on withdrawals from any retirement account.
3. Penalty for taking nonqualified withdrawals from 529 plans, health savings accounts (HSAs), and similar tax-favored accounts
Just as the government works hard to make sure that the retirement accounts they’ve allowed to be tax-advantaged are used as intended, they take a similar approach to other tax-advantaged accounts, penalizing improper use and withdrawals from 529 plans, health savings accounts, and similar vehicles.
529 plans – These plans provide the ability to set aside funds to pay for the cost of college, and were expanded under the recent tax reform act to also allow for funds to grow tax-free for eligible expenses for K-12 education too. Any money that is deposited into a 529 can be withdrawn without penalty as long as the money is going to pay for tuition, books and similar school-related expenses, but if the money is withdrawn for any other purpose, the withdrawn amount is subject to both income taxes on appreciation and a 10% penalty on the entire distribution. One important thing to note: if you have set up a 529 in one child’s name and wanted to use the monies for another child, that is not subject to penalty as long as you change the beneficiary. The same is true for Coverdell ESAs.
Health Savings Accounts (HSAs) – These plans were created to assist with the payment of out-of-pocket healthcare expenses. Money deposited into those accounts can grow to be withdrawn tax free as long as they are used for eligible costs; however, if you’re under the age of 65 and you use any of those funds for nonmedical expenses, the withdrawn amount will be subject to a 20% penalty and will also need to be reported on your tax return as income.
4. Penalty for failing to take required minimum distributions (RMDs) from tax-favored retirement accounts
If you are a person who has been dedicated to putting money into your 401(k), your IRA, or another retirement account, then the idea of taking money out before you feel like you need it will just feel wrong. Unfortunately, the government requires that you do so once you hit a certain age. The IRS’ rules say that once you are 70 ½ you have to take what is known as a required minimum distribution, a percentage that is based on a published table that factors in your life expectancy and how much your account holds. As much as you might want to let your money continue to grow, the government wants to limit the amount of tax-deferred growth that each taxpayer can realize and start claiming its portion of the money you’ve been keeping it from taxing: that’s the reason for the requirement.
No matter how much you’d prefer not to touch your principal, the IRS takes an aggressive approach to make sure that you do so: the penalty for failure to take the amount out on the government timetable is more than significant – it’s 50% of the amount that you were supposed to take out, and if you don’t take out the right amount then you’re going to have to pay half of whatever you should have taken out but didn’t. The annual deadline is December 31st, though for the first year that you owe you have until April 1st to take the withdrawal. Not only do you have to make sure that you make your payment on time, but you have to calculate it correctly, and that can be somewhat complicated because the amount changes each year as your life expectancy and the value of your account shift. The good news is that the bank or investment company where you’re holding your money is generally equipped to assist with the calculation, and can even make things easier by arranging for automatic dispersals. Setting this up makes a lot of sense, as it eliminates the emotional twinge of writing a check and makes sure that it gets done so you can avoid that draconian penalty. However, the IRS does have the power to waive the penalty if you can show reasonable cause for failing to take the distribution and have a made a corrective distribution before applying for a penalty waiver.
5. Penalty for contributing too much to tax-favored accounts
Have you ever heard the phrase “they get you coming and going?” It may have been written for the IRS. Just as you’re learning that they’ll penalize you for not taking out enough money, you find out that they’ll also penalize you for depositing too much. Tax-deferred accounts like IRAs and 401(k)s limit the amount that you can contribute each year, and if you end up putting in too much, you’re going to be hit with a 6% charge. Though that penalty is a significantly lower percentage than is imposed for not taking the annual required minimum distribution, the amount can grow over the years if it isn’t addressed: if you make the mistake of leaving the excess funds in the account, you’ll face the same penalty each year until it’s been withdrawn. That can add up quickly, especially if you aren’t aware of the mistake you made until the government hits you with the penalty several years later.
The solution is to review the amount that you’ve deposited to make sure that there is no overage, and if there is to take it out before the deadline for your tax return. If you’ve filed an extension, then you’ve also extended the deadline for the withdrawal. This penalty applies to all tax-deferred accounts that limit the amount of money you can deposit in a given year.
6. Penalty for failing to file, or for filing your required tax return after the designated due date
The tax deadline is set in stone every year. It’s in the news; it’s on the IRS website and your tax forms. There’s no escaping it, and if you try, then you’re going to get penalized. Some people miss the deadline because they are procrastinators or they just forgot, while others make the mistake of thinking that if they don’t send in paperwork, then they won’t have to pay. Whatever the reason, you’re going to end up getting caught one way or another and having to pay the penalty. Those who run on the idea of “if I don’t send them my name and income then they’ll never know that I owe them money” fail to realize that the entity that provided that income also is required to send in paperwork to the government. When there is no tax return filed to match the tax information filed by your employer or investment, the government is going to begin an audit, and you’ll be in far bigger financial trouble than you would have been if you’d filed a return and let the government know that you couldn’t afford to pay what you owe. Failure to file results in penalties that add up quickly: 4.5% of the tax due will be assessed and added to your tax liability for each month that you’re late, up until you pass the five-month mark and hit the maximum penalty of 22.5%. There is also a minimum penalty amount of smaller of $210 or 100% of your tax due where it greater the percentage amount.
7. Penalty for failing to pay your taxes on time
In all fairness, some people don’t file their tax return because they don’t have the money available to pay what they owe. The truth is that the amount that is penalized for failing to file is much more than what you would be penalized if you did file without paying. Though you’re looking at a penalty one way or another, it makes sense to file, even without sending in the money that you owe.
We’ve already gone over the 4.5% monthly penalty for failure to file, up to a maximum penalty of 22.5%. On top of the failure to file penalty, there is 0.5% penalty per month for failure to pay to bring the total penalty for failing to file and pay for the first five months to 5% per month. However, If you get your paperwork on time without actually sending in a payment, you avoid the 4.5% late filing penalty. Even after the first 5 months, the late payment penalty continues to accrue until the tax is paid. One important thing to remember is that the requirement to pay begins on the tax due date – even if you request an extension for filing your return, the clock starts ticking on the non-payment penalty on the tax deadline date. If you’re at all able to send in money, then do so – even if it’s only a portion of what you owe.
For those who are suffering from financial difficulties, the IRS offers installment arrangements to make things easier. Though penalties are still likely to be tacked on to your tax liability, setting up an arrangement will prevent you from getting into arrears with the government and stop them from initiating a collection action. There are also negotiations available for those who provide proof of their inability to pay. The government is willing to help and does help many taxpayers, offering compromises where appropriate. You’re much better off coming forward, submitting all necessary paperwork on time, and asking for help.
8. Penalty for filing a substantially incorrect tax return or taking frivolous positions on a return
The IRS understands that mistakes happen: people have trouble with mathematical calculations or misunderstand definitions, and when that happens, and they discover the errors, they generally send out a letter notifying the taxpayer of their mistake and are open to hearing explanations. Sometimes they forgive the mistake and allow a correction to be made, and in other cases, they impose a penalty, usually no more than 20% of the underpayment for innocent errors. When the penalty is that high, it’s generally an indication that the government has reason to believe that the mistake represents legal negligence. It can also be a reflection of the magnitude of the underpayment, with larger underpayments resulting in more significant penalties.
However, none of these penalties are as significant as what you will face if the government has reason to believe that your underpayment was intentional.
Purposely understating the information on your tax return to minimize your liability constitutes civil fraud, and subjects you to 75% penalties of the amount that you underpaid. Of course, you will also still be on the hook for the amount that you should have paid in the first place if your tax return had been accurate and reflective of your real income. The IRS has little patience for either fraud or for what they refer to as frivolous tax arguments meant to help people evade paying what they owe. Depending upon the individual situation, some taxpayers are penalized with no concern for the amount that they actually owed, and are required to pay a flat rate of $5,000.
These penalties are what results from civil fraud, but that is not the worst penalty you can face. The IRS has the right to charge a person who perpetrates significant underpayment or tax evasion as a criminal fraud subject to jail time in addition to economic penalties. Where the line between civil tax fraud and criminal tax evasion is drawn is subjective, but assume that when the government can prove that you purposely tried to get out of paying what you owe, you’re going to be held accountable in a way that’s going to hurt. Lying on a return is considered a form of perjury, and there are plenty of tax evaders who have been forced to spend years in jail and to pay hundreds of thousands of dollars in penalties.
IRS Penalties Are A Entirely Preventable Problem
Though the list of penalties provided here is not exhaustive, it gives you a good idea of where you can get into trouble, as well as how to avoid trouble. Learn the requirements, follow them, and when in doubt, seek help. It’s also important to know that if you do get yourself into trouble, you’re much better off facing your situation then trying to pretend they don’t exist. A tax professional will guide you through the process and help you find your best answers.
As they do at the beginning of every year, employers will be requesting employees to complete the IRS Form W-4. Its purpose is to provide employers with the information they need to determine the amount of federal income taxes to withhold from an employee’s paycheck. So, it is very important that the form be completed correctly.
The problem is that as simple as the form looks, getting those entries on the form to produce the desired withholding amount can be tricky. The passage of the tax reform added additional complications, and the IRS has delayed a major revision of the W-4 until the 2020 tax year. In the meantime, taxpayers must get along as best they can using the old version of the W-4.
Even though the W-4 form itself appears to be simple, the instructions come with an extensive worksheet, which may or may not produce the desired results. In addition, there are other issues to consider, such as:
Perhaps you desire to have a substantial refund when your taxes are completed next year. This generally requires custom W-4 adjustments, to produce excessive withholding. Keep in mind: when you have a large refund, you have provided Uncle Sam with an interest-free loan.
Your spouse may also work, and your combined incomes may put you in a higher tax bracket. Although the IRS provides a special worksheet for married taxpayers if both spouses work, it may not always provide the desired results.
In addition to payroll income, you may also have self-employment income, which is subject to both income tax and self-employment, and so you may require a combination of payroll withholding and estimated tax payments, adding additional complications to the W-4.
These are just the tip of the iceberg, as there may be investment income or losses, business losses, tax credits, special deductions and loss carryovers, just to name a few more situations that could impact your tax prepayments and withholding for the year.
If you are concerned about getting your withholding correct, please contact this office. We can project your 2019 tax liability and complete your W-4 after taking into account multiple employments, a working spouse, self-employment income and other tax issues unique to your specific tax situation.
Taxpayers are required to pre-pay their taxes for any tax year through payroll withholding, estimated tax payments or a combination of the two. Employees and retirees generally accomplish this through withholding, and self-employed individuals and those with investment income by paying quarterly estimated payments.
The late-2017 passage of tax reform that became effective for 2018 and its radical changes added considerable confusion for taxpayers trying to determine how much they should prepay for 2018. This confusion was made worse because the existing W-4 that employees complete and that their employers use to determine the correct withholding was designed for prior law and does not work well with the new tax law. As a result, there has been ongoing concern by the IRS that many taxpayers will end up owing tax this year when they file their 2018 returns, even though they got a tax reduction due to the tax reform changes, simply because their pre-payments through withholding and estimated tax payments were not enough.
For most of 2018, the IRS was issuing alerts that taxpayers may be under-withheld because of tax reform and the fact the W-4 could no longer be relied upon to produce a correct withholding amount.
Taxpayers whose pre-payments are less than certain safe harbor amounts are penalized. Those safe harbors are:
90% of the current year’s tax liability or
100% of the prior year’s tax liability (110% where the prior year AGI is over $150,000 ($75,000 if married and filing separate returns).
Recently several members of Congress have called upon the IRS to waive underpayment penalties for 2018. On January 16, 2019, although not waiving the penalties entirely, the IRS did change the current year safe harbor from 90% of the 2018 tax liability to 85%, providing a break for some taxpayers.
Even if you don’t meet one of the safe-harbor exceptions, a waiver of the penalty for 2018 may apply if you:
Retired (after reaching age 62) or became disabled in 2017 or 2018.
You did not make payments because of one of the following situations and it would be inequitable to impose the penalty: a. Casualty b. Disaster, or c. Other unusual circumstance.
There are two other exceptions to the penalty for 2018:
If the total tax shown on your 2018 return minus the tax that was withheld is less than $1,000, you will not owe a penalty.
If you had no tax liability in 2017, were a U.S. citizen or resident alien for all of 2017, and your 2017 return was for a full 12 months (or would have been had you been required to file), you won’t be charged an under-prepayment penalty.
In addition, where your tax liability and /or tax pre-payments were uneven, the penalty amount may be mitigated by figuring it on a quarterly basis.
If you have questions or would like to make sure your withholding and estimated payments are adequate for 2019, please give this office a call.
Ever since tax reform was passed, over a year ago, taxpayers have been uncertain whether rental property will be classified as a trade or business for purposes of qualifying for the new IRC Sec 199A 20% pass-through deduction (commonly referred to as the 199A deduction).
Finally, on January 18, 2019, the IRS issued a notice which provided “safe harbor” conditions under which a rental real estate activity will be treated as a trade or business for purposes of the 199A deduction.
It’s important to note that this notice prescribes several conditions that must be met for a rental real estate enterprise (a tax term introduced by the IRS in this notice) to be deemed to be a trade or business and eligible for the section 199A 20% deduction. For purposes of this safe harbor, a rental real estate enterprise is defined as an interest in real property held for the production of rents and may consist of an interest in multiple properties.
Failure of the taxpayer to satisfy the requirements of this safe harbor does not preclude a taxpayer from otherwise establishing that a “rental real estate enterprise” is a trade or business for purposes of section 199A. The following are the requirements that must be satisfied for the safe harbor:
Separate books and records must be maintained for each rental real estate enterprise;a. A real estate enterprise can consist of a single or multiple real estate rentals. b. Commercial and residential rentals cannot be combined in the same real estate enterprise.
For years prior to 2023, at least 250 hours of rental services must be performed by the taxpayer and workers for the taxpayer for the year in question with reference to each rental real estate enterprise.A three-year lookback rule applies for taxable years for 2023 and following. It specifies that the taxpayer must meet the 250-hour requirement for the rental enterprise for any three of the five prior consecutive taxable years; and
The taxpayer must maintain contemporaneous records, including time reports, logs, or similar documents, to document the following:a. hours of all services performed; b. a description of all services performed; c. dates on which such services were performed; and d. who performed the services.
Because the safe harbor requirements were issued after the close of 2018, the requirement for contemporaneous records for 2018 will not apply.
Rental services that may be counted toward the 250 hour requirement include: (i) advertising to rent or lease the real estate; (ii) negotiating and executing leases; (iii) verifying information contained in tenant applications; (iv) collecting rent; (v) daily operation, maintenance, and repair of the property; (vi) management of the real estate; (vii) purchase of materials for operation such as repairs; and (viii) supervision of employees and independent contractors.
However, rental services do NOT include financial or investment management activities, such as arranging financing; procuring property; studying and reviewing financial statements or reports on operations, planning, managing, or constructing long-term capital improvements; or hours spent traveling to and from the real estate.
Rental services counted toward the 250 requirement may be performed by owners or employees, agents, and/or independent contractors working for the owners.
Triple net Leases are not eligible for safe harbor. Real estate rented or leased under a triple net lease agreement is not eligible for this safe harbor. A triple net lease includes a lease agreement that requires the tenant or lessee to pay taxes, fees, and insurance, and to be responsible for maintenance activities for a property in addition to rent and utilities. Also ineligible for the safe harbor is a property leased under an agreement that requires the tenant or lessee to pay a portion of the taxes, fees, and insurance, and to be responsible for maintenance activities allocable to the portion of the property rented by the tenant.
Vacation rentals are not eligible for safe harbor. Real estate used as a residence by the taxpayer for any portion of the taxable year is not eligible for the safe harbor rules.
The Statement must be attached to the tax return. A statement signed by the taxpayer, or the person responsible for keeping the records with personal knowledge of them, must be attached to the return declaring that all of the safe harbor requirements have been met and must include the following language: “Under penalties of perjury, I (we) declare that I (we) have examined the statement, and, to the best of my (our) knowledge and belief, the statement contains all the relevant facts relating to the revenue procedure, and such facts are true, correct, and complete.”
Double-edged sword. The 199A deduction is 20% of a taxpayer’s qualified business income from all of the taxpayer’s trades or businesses subject to certain limitations. Many rentals do not show a profit and a rental that is treated as a trade or business that shows a loss for the year will reduce the qualified business income of other trades or businesses of an individual, and as a result, reduces the 199A deduction of that individual.
If you have questions regarding rentals as a trade or business or other issues related to this new 199A deduction, please give this office a call.
If you’re facing outstanding tax debt that you cannot pay, you may want to consider looking into an Offer in Compromise from the IRS. Specifically, an Offer in Compromise is an option offered from the IRS to qualifying individuals that allows them to settle tax debt for less than what they actually owe.
Unfortunately, there seem to be a lot of misunderstandings about Offers in Compromise; many people falsely believe that these are seldom accepted by the IRS. In reality, it is estimated that the current acceptance rate is over 40%, with the average dollar amount of a settlement reaching more than $10,000.
If you’re worried about your inability to pay tax debt, knowing the basic qualifications of an IRS Offer in Compromise and what to expect from the application process can be extremely helpful moving forward.
How to Know if You Qualify
Generally, there are three factors that are considered by the IRS when somebody applies for an Offer in Compromise. Most commonly, the IRS must have a belief that you will not be able to pay your tax debt off at any point in the near future. This means that your financial situation is probably not going to improve anytime soon and that the IRS would not likely be successful in forcing collections on you.
At the end of the day, the IRS needs to believe they are getting a fair deal – so if you have any potential to pay your debt at any point in the near future, you may not qualify.
You might also qualify for an Offer in Compromise if there is doubt as to your actual tax liability; if you have documentation proving that you owe less in taxes than the IRS believes to be true, or if an assessor has made a mistake on your reporting, you may be more likely to have an Offer in Compromise accepted by the IRS.
Finally, if paying your tax bill would create a significant financial hardship, you may also qualify for an Offer in Compromise. Of course, proving financial hardship can sometimes be a challenge.
In addition to all of these considerations, there are several other eligibility requirements that you must meet in order to qualify for an Offer in Compromise:
You must pay the application fee
You must have filed all of your required tax returns
You cannot be going through a bankruptcy at the time of filing
You must submit all required documentation
What to Expect From the Process
One of the most complicated aspects of going through the application process for an IRS Offer in Compromise is filling out and submitting all the required paperwork. There are several documents you may need to complete to even be considered for an Offer in Compromise, including:
IRS Form 433-A – this form requires information on your assets, liabilities, expenses, and income to determine your Reasonable Collection Potential.
IRS Form 433-B – this form needs to be filled out for businesses applying for an Offer in Compromise.
IRS Form 656 – use this form to apply for an Offer in Compromise so long as there are no doubts as to your tax liability.
IRS Form 656-L – use this form to apply if you are disputing your tax liability to the IRS.
In addition to completing these official forms as part of the application process, you will also need to provide some documentation, such as:
health care statements
bank and credit card statements
proof of living expenses
car loan, mortgage, and similar loan statements
copies of related tax returns
Working With a Tax Professional Can Help
As you can probably see, the process of determining your eligibility and applying for an Offer in Compromise with the IRS can be quite time consuming and complex. This is where it can be helpful to consult with a tax professional for assistance. A qualified and experienced tax professional will be able to assess your current tax situation and give you a better idea as to whether or not going through the Offer in Compromise application process is worth your time and efforts.
If so, he or she will also be able to assist you with the application process, ensuring that you’re filling out the correct forms and that you submit all required documentation as well. This can increase your chances of reaching a successful offer with the IRS and take a lot of the stress and burden off your chest.
Even if you don’t qualify for an Offer in Compromise, your tax professional may be able to assist you in figuring out other alternatives for making your tax payment more financially manageable for you. This might include options to work out a payment/installment program with the IRS, among other options.
The Bottom Line
Overall, getting an Offer in Compromise accepted by the IRS is nearly a 50/50 shot – but if you meet the eligibility requirements and take the time to correctly submit all paperwork and documentation, your chances of reaching an offer are high. And the best way to get the help you need in gathering this documentation and submitting this paperwork is to consult with an experienced tax professional, so reach out to yours today. If you don’t already have a tax professional that you can turn to, schedule a consultation with one at your earliest convenience to get the ball rolling.
Switching between the Actual Expense and Standard Mileage Rate Methods
Employee Deductions Suspended
Special Allowances for SUVs
The Internal Revenue Service (IRS) computes standard mileage rates for business, medical and moving each year, based on a number of factors, to determine the standard mileage rates for the following year.
As it does annually around the end of the year, the IRS has announced the 2019 optional standard mileage rates. Thus, beginning on Jan. 1, 2019, the standard mileage rates for the use of a car (or a van, pickup or panel truck) are:
58 cents per mile for business miles driven (including a 26-cent-per-mile allocation for depreciation). This is up from 54.5 cents in 2018;
20 cents per mile driven for medical or moving* purposes. This is up from 18 cents in 2018; and
14 cents per mile driven in service of charitable organizations.* For years 2018 through 2025, the deduction for moving is only allowed for members of the armed forces on active duty who move pursuant to a military order.
The business standard mileage rate is based on an annual study of the fixed and variable costs of operating an automobile. The rate for medical and moving purposes is based on the variable costs determined by the same study. The rate for using an automobile while performing services for a charitable organization is statutorily set (it can only be changed by Congressional action) and has been 14 cents per mile for 20 years).
Important Consideration: The 2019 rates are based on 2018 fuel costs. Based on the potential for substantially higher gas prices in 2019, it may be appropriate to consider switching to the actual expense method for 2019 or at least to keep track of the actual expenses, including fuel costs, repairs and maintenance, so that the option is available for 2019.
Taxpayers always have the choice of calculating the actual costs of using their vehicle for business rather than using the standard mileage rates. In addition to the potential for higher fuel prices, the extension and expansion of the bonus depreciation as well as increased depreciation limitations for passenger autos in the Tax Cuts and Jobs Act may make using the actual expense method worthwhile during the first year when a vehicle is placed into business service.
However, the standard mileage rates cannot be used if you used the actual method (using Section 179, bonus depreciation and/or MACRS depreciation) in previous years. This rule is applied on a vehicle-by-vehicle basis. In addition, the business standard mileage rate cannot be used for any vehicle used for hire or for more than four vehicles simultaneously.
Employer Reimbursement – When employers reimburse employees for business-related car expenses using the standard mileage allowance method for each substantiated employment-connected business mile, the reimbursement is tax-free if the employee substantiates to the employer the time, place, mileage and purpose of the employment-connected business travel.
The Tax Cuts and Jobs Act eliminated employee business expenses as an itemized deduction, effective for 2018 through 2025. Therefore, employees may no longer take a deduction on their federal returns for unreimbursed employment-related use of their autos, light trucks or vans. Members of a reserve component of the U.S. Armed Forces, state and local government officials paid on a fee basis and certain performing artists continue to be allowed to deduct unreimbursed employee travel expenses, including the business standard mileage rate, because they are deductible from gross income rather than as an itemized deduction.
Faster Write-Offs for Heavy Sport Utility Vehicles (SUVs) – Many of today’s SUVs weigh more than 6,000 pounds and are therefore not subject to the limit rules on luxury auto depreciation. Taxpayers who purchase a heavy SUV and put it into business use in 2019 can utilize both the Section 179 expense deduction (up to a maximum of $25,500) and the bonus depreciation (if the Section 179 deduction is claimed, it must be applied before the bonus depreciation) to produce a sizable first-year tax deduction. However, the vehicle cannot exceed a gross unloaded vehicle weight of 14,000 pounds. Caution: Business autos are 5-year class life property. If the taxpayer subsequently disposes of the vehicle before the end of the 5-year period, as many do, a portion of the Section 179 expense deduction will be recaptured and must be added back to the taxpayer’s income (self-employment income for self-employed individuals). The future ramifications of deducting all or a significant portion of the vehicle’s cost using Section 179 should be considered.
If you have questions related to the best methods of deducting the business use of your vehicle or the documentation required, please give this office a call.
Receiving notification from the Internal Revenue Service that there’s some kind of problem is one of the most bone-chilling situations an American taxpayer can experience. Just receiving an envelope with a return address from the IRS can strike fear. There are many different reasons that the IRS might reach out, but some are more common than others.
Here are the top issues that would cause a taxpayer to hear from the IRS or require you to resolve an issue:
An Error On Your Tax Return – Nobody’s perfect, and filling out tax returns is not an easy thing. If you’ve made a mistake, whether it’s something simple like filing status or number of dependents or something bigger like total income or incorrectly claiming a deduction, if you discover it on your own, all you need to do is file an amended return using form 1040X, the Amended Individual Income Tax Return. If the mistake means that you owe more money, quickly submitting the amount that you owe will help you avoid having to pay too much in penalties or interest. It’s not at all unusual for the IRS to discover mistakes – especially math mistakes – and they will generally notify you that they have made corrections on your behalf.
Mismatched/Underreported Income – Along the lines of the mistakes referenced above, there is a specific form that the IRS will send you if they determine that the amount of income you report on your tax return is different from what has been reported by employers. That form is the CP2000 Notice, and the agency will send it to you, notifying you of the corrected amount, should they review your return and feel that it is appropriate.
Failure to File a Tax Return – Filing a tax return isn’t necessarily required if you don’t owe money or if you’re owed a tax refund, but it’s not a good idea. Failing to file a return when you’re owed a refund puts you at risk of losing out on receiving the money you’ve owed – you have just three years to amend the problem if you want to get your money. For those who are in arrears to the IRS, there is a significant negative outcome to failing to file a return, including having to pay a “failure to fee” penalty that can go as high as 25 percent of your unpaid tax bill: 5 percent of the amount you owe, plus interest, will be charged for each month for up to five months
You Owe the IRS for Taxes Not Paid – When the IRS calculates that you have not paid them the full amount that you owe, they will send you notification of what they believe the difference is via form CP14.
You Owe the IRS Penalties and Fees – When you don’t pay your taxes or you fail to file a return, the IRS will notify you that you owe them penalties, and possibly interest.
You Owe the IRS But Can’t Afford to Pay – There are many taxpayers who find themselves facing a tax bill that they are simply unable to pay all at once. If you fall into this category, the IRS does offer the option of paying in installments. To request this type of payment plan, contact the agency. If even paying in small increments is outside of your ability, you may be able to negotiate a reduced tax bill through what is called an Offer in Compromise.
Tax Debt Resulting in Tax Levy – If you are unable or unwilling to satisfy your tax debt, the IRS may opt for a tax levy, which is the legal seizure of your property in lieu of payment. A tax levy can take the form of real property such as real estate, your vehicle or personal property, or your wages, the money in your bank accounts or your financial accounts. Notification that a levy is being issued against you comes via either notice LT11, CP504, CP90, or CP91.
Notification that A Tax Lien Has Been Filed – If you have failed to pay your tax debt, the IRS may take action to protect its own interests ahead of other creditors by filing a tax lien. This comes in the form of Letter 3172, which will be sent to both you and your other creditors to let them know of the government’s claim against your financial assets, personal property and real estate. By sending this letter out, the government ensures that it will benefit from the liquidation of any of your property in order to satisfy the amount that it is owed. Once a lien has been placed on your property, it is extremely difficult to get out of until you’ve paid up.
A notification from the IRS is not something to be ignored. The best step is to take a deep breath, read the notice carefully, and if needed, contact our office for assistance.
Unlike a C corporation, which itself pays the tax on its taxable income, an S corporation does not directly pay taxes on its income; instead, its income, losses, deductions, and credits are distributed across its shareholders’ individual tax returns on a pro rata basis. These distributions are not subject to self-employment (Social Security and Medicare) taxes. As a result, many S corporations ignore the requirement that each shareholder-employee must take reasonable compensation in the form of W-2 wages in exchange for services performed for the corporation. These wages are subject to Social Security and Medicare taxes (which the corporation and the employee generally split equally); the corporation is also responsible for paying the Federal Unemployment Tax (as well as any state unemployment taxes).
The Internal Revenue Code establishes that an officer of an S corporation is an employee of that corporation for Federal Unemployment Tax purposes. S corporations should not attempt to avoid paying this tax by treating their officers’ compensation as distributions rather than as wages.
This has been an issue for decades; in 1974, the IRS issued a ruling stating that, when a shareholder-employee fails to take a salary, or if that salary is unreasonable, an auditor should assert that the salary is unreasonable. The officer’s distributions will then be shifted to account for reasonable compensation, and he or she will be assessed the related employment taxes and penalties. At stake here are the employee’s 6.2% Social Security and 1.45% Medicare payroll taxes, the S corporation’s matching amounts, the Federal Unemployment Tax, and whatever state taxes happen to apply.
Who Is an Employee of the Corporation? – Generally, an officer of a corporation is considered an employee of that corporation. The fact that an officer is also a shareholder does not change the requirement that any payments made to that officer must be treated as wages. Courts have consistently held that S corporation shareholders who provide more than minor services to their corporation (and receive payment in return) are employees whose compensation is subject to federal taxes.
Tax regulations do provide an exception for officers who do not perform services or who perform only minor services. These officers are not considered employees.
What’s a Reasonable Salary? – The instructions for Form 1120S (“U.S. Income Tax Return for an S Corporation”) state: “Distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation.” There are no specific guidelines in the tax code regarding the definition of reasonable compensation. The various courts that have ruled on this issue have based their determinations on the facts and circumstances of the individual cases. These are some factors that courts have considered when determining reasonable compensation:
The officer’s training and experience
The officer’s duties and responsibilities
The time and effort that the officer devotes to the business
The corporation’s dividend history
The corporation’s payments to non-shareholder employees
The timing and manner of the bonuses paid to key people at the corporation
The payments that comparable businesses have made for similar services
The corporation’s compensation agreements
The formulas that similar corporations have used to determine compensation
The problem here, of course, is that it is easy for the IRS to simply list contributing factors that courts have used when determining reasonable compensation and leave it to each corporation to quantify these factors and determine a reasonable salary—all while retaining the ability to challenge the selected amount later if an auditor decides that the compensation is not reasonable. The IRS has a long history of examining S corporations’ tax returns to ensure that reasonable compensation is being paid, particularly when a corporation pays no compensation to employee-stockholders.
New Issue For 2018 – The late-2017 tax reform added a new flow-through deduction (also referred to as the “199A deduction” after the section of the tax code that describes it). This deduction applies to S corporations (among many other business entities) and adds another level of complexity to the determination of reasonable compensation.
The wages of an S corporation’s employee-stockholder are NOT treated as qualified business income (QBI) that is eligible for the individual’s 199A deduction. However, the corporation deducts these wages as a business expense when it calculates the profit that passes through to the shareholder as QBI on Schedule K-1. Thus, larger wages mean less K-1 flow-through income (QBI) and thus a smaller 199A deduction (as that is equal to 20% of QBI). In this case, S corporations tend to minimize stockholders’ salaries in order to maximize flow-through income; this strategy increases the employee-stockholder’s 199A deduction and lowers the payroll taxes for both the corporation and the employee-stockholder.
If married taxpayers who are filing a joint return have 1040 taxable income that exceeds $315,000 (or $157,500 for those with other filing statuses), the 199A deduction begins to be subject to a wage limitation. Once the 1040 taxable income for married taxpayers filing jointly exceeds $415,000 (or $207,500 for those with other filing statuses), the wage limitation is fully phased in. In that event, the 199A deduction becomes the lesser of the wage limitation or 20% of the QBI; if the wage limitation is zero, there is no 199A deduction.The wage limitation comprises the wages that the corporation paid, including those paid to stockholders, plus the unadjusted cost of the qualified property that the corporation owned and used during the year. To be more specific, the wage limitation is the larger of
50% of the wages that the corporation paid or
25% of the corporation’s paid wages plus 2.5% of the unadjusted cost of its qualified property.
Thus, for those high-income shareholders for whom the wage limitation applies, if the corporation pays no wages and has no qualified property, the shareholder will not have a 199A deduction.
If an S corporation is a specified service trade or business, the 199A deduction phases out; for married taxpayers who are filing a joint return, it phases out at taxable incomes between $315,000 and $415,000 (for those with other filing statuses, it phases out between $157,500 and $207,500). The IRS describes specified service trades or businesses are those in the fields of health, law, accounting, actuarial science, performing arts, athletics, consulting, financial services, and brokerage services, as well as those for which reputation and/or skill are contributing factors (for more details on what constitutes an specified service trade or business, please give this office a call).
Thus, if married taxpayers who are filing jointly have taxable income in excess of $415,000 (or $207,500 for those with other filing statuses), they receive no benefit from the wage limitation; therefore, they also tend to minimize their reasonable compensation in order to minimize their FICA taxes.
Of course, taxpayers cannot pick and choose a particular level of reasonable compensation to minimize their taxes or maximize their deductions; therein lies a trap. Taxpayers instead should consider all the factors related to reasonable compensation. However, pulling all the data together to support such a determination can be difficult and time-consuming. Some commercial firms have the necessary data and resources to properly apply the various factors mentioned in this article so as to determine the proper level of reasonable compensation; this can provide backup in the case of an IRS challenge.
Please give this office a call if you have questions related to reasonable compensation for S corporation shareholders or how it impacts your specific tax situation.