Being prepared for an IRS audit
The IRS recently announced it intends to hire thousands of new employees as part of a tax-enforcement push. This could mean an uptick in audits sometime soon, likely focused on wealthier individuals and business owners. (Some tax returns are chosen randomly as well.)
The best way to survive an IRS audit is to prepare for one in advance. On an ongoing basis, you should systematically maintain documentation — invoices, bills, canceled checks, receipts and other proof — for the items that you report on your tax return. Maintain and back up these records safely. With that said, it also helps to know what might catch the tax agency’s attention.
Audit hot spots
Certain types of tax-return entries are known to the IRS to involve inaccuracies, so they may lead to an audit. One example is significant inconsistencies between tax returns filed in the past and your most current tax return. If you miscalculate deductions or try to claim unusually high ones, your return could be flagged. And if you’re a business owner, gross profit margin or expenses markedly different from those of similar companies could subject you to an audit.
Certain types of deductions, such as auto and travel expense write-offs, may be questioned by the IRS because there are strict recordkeeping requirements involved. In addition, an owner-employee salary that’s inordinately higher or lower than those of similar and similarly located companies can catch the IRS’s eye ― especially if the business is a corporation.
The IRS normally has three years within which to conduct an audit, and often an audit doesn’t begin until a year or more after you file a return. If you’re selected for an audit, you’ll be notified by letter. Generally, the IRS doesn’t make initial contact by phone. If there’s no response to the letter, the agency may follow up with a call. Ignore unsolicited email messages about an audit. The IRS doesn’t contact people in this manner; these are scams.
Many audits simply request that you mail in documentation to support certain deductions that you’ve claimed. Others may ask you to provide receipts and other documents to a local IRS office. Only the harshest version, the field audit, requires you to meet personally with one or more IRS auditors.
Keep in mind that the tax agency won’t demand an immediate response to a mailed notice. You’ll be informed of the discrepancies in question and given time to prepare. You’ll need to collect and organize all relevant income and expense records. If any records are missing, you’ll have to reconstruct the information as accurately as possible based on other documentation.
How we can help
If the IRS chooses you for an audit, our firm can help you understand what the IRS is disputing (it’s not always clear) and then gather the documents and information needed. We can also help you respond to the auditor’s inquiries in the most expedient and effective manner.
Above all, don’t panic! Many audits are routine. By taking a meticulous, proactive approach to how you track, document and file your tax-related information, whether for an individual or business return, you’ll make an audit easier and even decrease the chances that one will happen in the first place.
The deductibility of medical expenses
Individual taxpayers may be able to claim medical expense deductions on their tax returns. However, the rules can be challenging, and it can be difficult to qualify. Here are five points to keep in mind:
- You must itemize to claim the deduction and have quite a few expenses. For 2021, the medical expense deduction can only be claimed to the extent your unreimbursed costs exceed 7.5% of your adjusted gross income. If your total itemized deductions for 2021 will exceed your standard deduction, moving or “bunching” nonurgent medical procedures and other controllable expenses into this year may allow you to exceed the 7.5% floor and benefit from the deduction.
- Health insurance premiums may help. This can total thousands of dollars a year. Even if your employer provides health coverage, you can deduct the portion of the premiums that you pay. Long-term care insurance premiums are also included as medical expenses, subject to limits based on age.
- Transportation counts. The cost of getting to and from medical treatments counts as a medical expense. This includes taxi fares, public transportation or using your own car. Car costs can be calculated at 16 cents a mile for miles driven in 2021, plus tolls and parking. Alternatively, you can deduct certain actual costs (such as for gas and oil) that directly relate to your medical transportation.
- Controllable costs are key. These include the costs of glasses, hearing aids, dental work, mental health counseling and other ongoing expenses in connection with medical needs. Purely cosmetic expenses generally don’t qualify. Prescription drugs (including insulin) qualify, but over-the-counter aspirin and vitamins don’t. Neither do amounts paid for treatments that are illegal under federal law (such as medical marijuana), even if state law permits them. The services of therapists and nurses can qualify if they relate to medical conditions and aren’t for general health.
- Don’t overlook smoking-cessation and weight-loss programs. Amounts paid for participating in smoking-cessation programs and for prescribed drugs designed to alleviate nicotine withdrawal are deductible. However, nonprescription nicotine gum and patches aren’t. A weight-loss program is deductible if undertaken as treatment for a disease diagnosed by a physician. Deductible expenses include fees paid to join a program and attend periodic meetings. The cost of diet food isn’t deductible.
Don’t get blown away by a windfall
Receiving a sudden and sizable influx of cash may seem like a dream come true. It can be, but many people get blown away by a windfall and end up in worse financial shape.
Perhaps the most obvious example is you may be tempted to immediately buy an expensive new car or home. Or fraudulent charities may come knocking. You can avoid these potential pitfalls by stashing your windfall in a bank or money market account as soon as you receive it. Let it sit there until you identify a few specific, reasonable goals — such as funding your retirement or a child or grandchild’s education. Waiting at least a month before you touch the money can help prevent impulse buys and other mistakes.
Also, you may owe taxes. Some windfalls, such as lottery winnings and certain legal settlements, are subject to federal tax — as much as 37% federal tax if your windfall pushes you into the top income tax bracket. State and local taxes may apply as well. A tax professional can help you determine what you owe.
Shelter from the storm
What you eventually decide to do with your windfall depends on many factors. If you have certain types of debt, you’ll probably want to pay it off ― especially if it carries a high interest rate and the interest isn’t deductible. Also, establishing or boosting your emergency savings can minimize the need to incur future debt.
Next, consider where you’d like to be five, 10 or 20 years into the future. Develop a budget that will help you move toward your goals — whether that means retiring early, starting a business or something else. You probably shouldn’t quit your job. Few windfalls are large enough to see anyone all the way through retirement.
A final word of warning: Be careful when asked for money. Friends and family members may expect to share in your bounty or may pitch “sure-fire” investment opportunities. We can help you formulate a long-term plan to put a windfall to optimal use.
State taxes impact business sales, too
For various reasons, business owners sometimes decide to put their companies on the market. To successfully negotiate the sale of a business, it’s critical to understand the tax implications. Armed with this knowledge, you can assess the impact of various transaction structures and sales price allocations on your net proceeds from the sale and potentially adjust the sales price accordingly.
Business owners tend to focus on the federal tax implications of a sale, but don’t ignore state taxes. Now that federal tax rates are lower than they’ve been in the past, state taxes may take on added significance. If you’re contemplating relocating or retiring to another state, it may make sense to consider moving before you sell the business ― especially if the new state has low, or even no, income tax.
Before you attempt this strategy, however, be sure to consult a qualified tax advisor. Changing your domicile and residence for tax purposes isn’t like flipping a switch. You’ll need to take several specific actions to demonstrate your intent to establish a permanent place of abode in the new state, such as obtaining a driver’s license, registering to vote, and becoming involved with local organizations and activities.
Keep in mind, too, that there may be rules about the number of days spent in the state. So, you may have to do more than take the steps above to show that you’re a resident of your new state. For instance, if you live in your “old” state most of the year and spend only a couple months in your new state, you could find that, at least for tax purposes, you’re deemed a resident of both states. We can help you prepare for the state tax implications of a business sale.
October 15 — Personal federal income tax returns for 2020 that received an automatic extension must be filed today and any tax, interest and penalties due must be paid.
- The Financial Crimes Enforcement Network (FinCEN) Report 114 “Report of Foreign Bank and Financial Accounts” (FBAR) must be filed by today, if not filed already, for offshore bank account reporting. (This report received an automatic extension to today if not filed by the original due date of May 15th.)
- If an extension was obtained, calendar-year C corporations should file their 2020 Form 1120 by this date.
- If the monthly deposit rule applies, employers must deposit the tax for payments in September for Social Security, Medicare, withheld income tax and nonpayroll withholding.
November 1 — The third quarter Form 941 (“Employer’s Quarterly Federal Tax Return”) is due today, and any undeposited tax must be deposited. (If your tax liability is less than $2,500, you can pay it in full with a timely filed return.) If you deposited the tax for the quarter in full and on time, you have until November 10 to file the return.
- If you have employees, a federal unemployment tax (FUTA) deposit is due if the FUTA liability through September exceeds $500.
November 15 — If the monthly deposit rule applies, employers must deposit the tax for payments in October for Social Security, Medicare, withheld income tax and nonpayroll withholding.
- If an extension was obtained, calendar-year tax-exempt organizations should file their 2020 returns by this date.
December 15 — Calendar-year corporations must deposit the fourth installment of estimated income tax for 2021.
- If the monthly deposit rule applies, employers must deposit the tax for payments in November for Social Security, Medicare, withheld income tax and nonpayroll withholding.
About Batley CPA
Batley CPA, LLC is a full-service CPA firm providing tax, accounting, payroll and advisory services to businesses and individuals throughout Green Bay and the Fox Cities. Batley CPA regularly provides clients with best practices and strategies to maximize cash flow, profit, reduce taxes, manage costs and risk, and bring meaning to financial and operational data. The company has offices in Appleton, Neenah and Green Bay.