It’s that time of year. Cash registers are no longer ring-ting-aling-ing. It’s back to reality. And this year’s reality check is brought to you by the IRS—a group that can suck the fun out of your year quicker than you can say "Ebenezer Scrooge."
So how do you keep from painting a big red bulls-eye on your tax return in 2012? First of all, read last year’s tips—they’re still on the hit list. In addition, you’ll want to add the following to your worry list for 2012.
Passive losses can't be used to offset non-passive income. So, for example, if you’re a silent partner in a small business, and you’re not materially involved in running it, you can’t deduct any losses from that business against your regular income.
In his article The 1 Audit Red Flag to Watch Out For, OPEN Forum writer Mike Periu warns that all forms of non-passive losses—such as those from equipment rental, real estate leasing or vacation rentals—are on the IRS’s radar.
Gail Rosen, a New Jersey based CPA, notes that only a real estate professional can take real estate losses as a non-passive activity. You only qualify as a real estate professional for a particular tax year if:
- More than half of the personal services you perform during that year are performed in real property trades or businesses in which you materially participate.
- You perform more than 750 hours of services during that year in real property businesses and rentals in which you materially participate.
And by the way, any hours you spend “on call” to provide services to rental tenants do not count toward the 750-hour requirement.
You can download a detailed guide for how IRS auditors evaluate passive income activity from the IRS web site.
Rosen also reminds us that worker misclassifications—treating people as contractors rather than employees—are at the top of the hit list again this year.
Consider yourself a prime target for an audit if:
- The income listed on your Schedule C is more than $10,000 and comes from only one source.
- Your entry for “outside services” is higher than average for your industry.
And don’t forget, getting tagged for misclassifying employees by the IRS makes you open season with other federal and even state tax and labor authorities. They do share kills.
If you think there’s a chance you might have accidentally misclassified contractors in the past, now may be the time to fess up and take your medicine. In October of 2011 the IRS initiated a Voluntary Classification Settlement Program (VCSP) that offers a reduction in back taxes owed and a waiver of interest and penalties provided that certain conditions are met.
Rosen points out some caveats of the VCSP program that could influence the preparation of your 2011 tax returns:
- You need to apply for VCSP at least 60 days before switching people to the employee category.
- You need to have properly filed 1099s, in each of the past three years, for any workers that will be reclassified.
- Other conditions of acceptance apply. You can read about them by downloading IRS Form 8952.
Other possible triggers
While the IRS doesn’t publish a handy list of what triggers an audit, in addition to the above, be sure you’ve got plenty of proof if you’re running a business that is known to collect a lot of cash or if you’re claiming:
- A lifestyle that’s out of line with your reported income.
- Travel and entertainment expenses in excess of industry norms.
- Charitable deductions that are higher than average for your tax bracket—particularly those for non-cash contributions.
- Home office deduction—particularly if it’s in excess of the norm or you are claiming the deduction and you report W-2 income.
- A loss for a business that might be perceived as hobby—particularly if you haven’t reported a profit in three out of five reporting years.
As a taxpayer you can choose to either eat well or sleep well. Take it from someone who’s been through a line-item audit (and come out clean), the latter is way better.
Over the past 30 years, Kate Lister has owned and operated several successful businesses and arranged financing for hundreds of others. She’s co-authored three business books including Undress For Success—The Naked Truth About Making Money at Home (Wiley, 2009) and Finding Money—The Small Business Guide to Financing (2010). Her blogs include Finding Money Advice and Undress4Success.
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