Deductions that raise eyebrows at the IRS

Document, document, document!

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Phillip R. McCollum, Jr., CPA, JD

Although the number of IRS audits is dropping, there’s still the possibility that your return can be pulled for examination for various reasons – random selection, specific industries that the IRS is looking at or issues on a return that set off alarms because they’re above the IRS statistical percentages. There’s also a greater chance that if you are audited, the audit will be via letter correspondence rather than a physical examination of your tax return and supporting documentation. Here are some key issues and items to be aware of so you can minimize the potential impact of an audit happening to you.

Home office deduction

When claiming the home office deduction, you need to be able to substantiate the expenses you’re incurring such as utilities, repairs, your mortgage interest and real estate taxes. One of the key sticking points is that your home office needs to be used regularly and exclusively for your business. These requirements are strict. You can’t have an office that your kids use at night to play on the computer. The office has to be used regularly and exclusively for your business and the office square footage should be reasonable. Your home office being one half of your house is an item that may attract the IRS’s attention.

When you have good documentation and can substantiate this deduction, you should still be able to claim it even if the IRS starts asking questions. That was the case with one taxpayer when the IRS questioned why he had such a large office. He was able to demonstrate that he met with clients at his home office regularly, he had a separate entrance into the office from outside the home and he had separate electronics and security just for the office. The office was also decorated very nicely, something that was expected by his clientele, so it was necessary and ordinary for his business. He was able to substantiate this deduction when the audit was completed.

Employee expenses

The expenses that you’re incurring must be related to the work you’re doing for your employer. One of the most common expenses you will see is meals and entertainment. To take this deduction, you have to substantiate that meeting you had – what was the business purpose of that meal and entertainment? The expenses you claim must also be ones that your employer does not reimburse you for. For example, if you have an expense you didn’t turn in to your employer, you can’t deduct it on your return because your employer would have reimbursed you if you had turned it in.

Some employers do not reimburse expenses for continuing education or travel to continuing education. If that’s the case with your job, make sure you substantiate and document your expenses because they can add up. Keep track of your auto expenses that aren’t reimbursed. I recommend having a contemporaneous calendar you use on a daily basis to keep a record of your mileage, who you’re meeting with, where you’re meeting, etc. This will make it a lot easier for you to gather that information at the end of the year for your tax return.

I’ve seen cases where IRS agents challenge this deduction when there are no records. In one case, the taxpayer did actually win because he was able to provide a few publications and just enough receipts from his trip to an out of town conference. He actually ended up paying more to his CPA in fees to resolve the challenge than what he actually owed to the IRS. A good reminder to keep good records!

Rental losses

Although taking rental losses seems straightforward, this section of the tax law is complex and tricky. The key here is that you have to make sure you are actively participating in the rental of the property. If you’re not, there are limits on how much you can deduct each year. You’ll need to substantiate your activities. Keep track on a calendar or journal of what you do on a monthly basis. Do you make managerial decisions such as contacting contractors, performing work or negotiating leases with customers? These are the types of activities you would need to show in order to take the rental losses. If you take the losses and you’re not actively involved, the IRS is going to limit or disallow them. However, even if the IRS disallows the loss for that tax return, you do not lose the use of the loss forever. This means you can still carry it forward to following tax years and you’ll be able to use it when either the property is profitable or when you sell it.

Schedule C expenses

Revenue. You’ve got to make sure you report all of your revenue. One of the reporting mechanisms the IRS has in place requires credit card companies to issue 1099-Ks to their customers to show the amount of payments that were recovered by credit card and should be included in revenue each year. If the revenue you’re reporting is less than what the 1099-K shows, you need to have a valid reason as to why what you’re reporting doesn’t match up to what this government document is showing.

When it comes to revenue reporting, the IRS also looks at industries and their trends. Let’s say you’re in the medical profession. The IRS will look at the revenue in that line of business to see how much revenue is typically paid by credit card in the medical profession. It’s a test the IRS can do because they have the data to determine if your reporting is accurate and in sync with your 1099-Ks. There can be reasons why it’s different, but you better be ready to explain if questioned.

Speaking of 1099s, the IRS increased penalties on the issuance of these forms. If you’re a sole proprietor, you better make sure you’re issuing 1099s to the recipients that you’re required to do so in order to avoid penalties and the disallowing of a potential deduction.

Expenses. Again, business-related expenses – especially meals and entertainment and travel – may catch the attention of the IRS. Expenses related to education and meetings may also get a closer look from the IRS. Just be sure you can substantiate all of these expenses and keep a contemporaneous calendar to help you track and organize the information you may need in the event of an audit.

Charitable deductions

If you make a donation of $250 or more, you have to have a receipt in order to substantiate this deduction. If you’re audited and you don’t have a receipt from the charity, once again, it’s a straight out disallowance of the donation.

One instance I’ve seen frequently is clients making non-cash contributions. If you give more than $5,000 a year in non-cash items to Goodwill or The Salvation Army, you need to have an appraisal of those items and file it with your return when you claim the deduction. Otherwise, the IRS is going to disallow it. You’re not going to have an opportunity to get the deduction if the IRS challenges it – there’s no going back and getting the appraisal. It’s a tough rule. I’ve only seen one IRS exam where the only issue challenged was the charitable contributions claimed. They asked the client to prove all of his charitable deductions with the supporting letters and checks. In this case, he did have the proof and all of the contributions held. However, the examination was a nuisance to go through. If there’s an exam and you don’t have this stuff, don’t be surprised if the IRS disallows the deductions.

I’m being audited. Now what?

If you are audited by the IRS, it is worth the time and effort to contact your tax advisor to work with you because if the examiner knows you’re taking it seriously, he or she is also going to take it seriously.

Also, don’t let the fear of an audit keep you from claiming the deductions and losses you’re entitled to take. Even if your return is questioned, it’s not a foregone conclusion that you’ll end up owing the IRS. As long as your deductions and losses are legitimate, supportable and you have documentation, they should be allowed.

Phillip R. McCollum, Jr., CPA, JD, Partner, specializes in tax planning, consulting and compliance work for privately held businesses and their owners. He can be reached at (480) 839-4900 or PhilMc@hhcpa.com.