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On a scale from one to ten, with one being your dream vacation and ten being a root canal without any pain killers, most people would agree that being audited by the IRS is at least a nine and a half.
The good news is the IRS doesn't audit many taxpayers these days. As a matter of fact, between 1990 and 2002, the IRS only audited two tax returns prepared by my office.
The bad news is it appears that the IRS has begun auditing more people. This past spring alone, three of our clients were audited. Don't get too worried, however, as we have more than 1,700 clients, so the chance of getting audited continues to be quite small.
If you're unlucky enough to be selected for audit, what steps can you take to minimize the additional taxes, interest, and penalties you might owe as a result of the audit? For starters, the IRS will compare all of the deposits you made into your bank accounts with the income you reported on your tax return. If more money showed up on your bank statements than you reported on your return, be prepared to explain why.
The agent will then ask you to substantiate the deductions you claimed. First, they will want to see receipts or other proof of the amounts you're deducting. Even though it's a pain in the neck to file away all of your receipts, they definitely come in handy if you're ever audited.
Then, if you claimed business deductions on your tax return, you'll be asked to prove why each expenditure qualifies as an "ordinary and necessary" business expense. Here's how to substantiate some of the more aggressive deductions:
When deducting business meals that didn't occur while traveling outside the general vicinity of where you live, be prepared to document the time, place, business purpose and amount of each separate expense. Get in the habit of keeping your restaurant receipts and jotting down that information.
Expect to be asked the business purpose of each trip you're deducting.
Home Office Deduction
Even though it's now easier to claim the home office deduction, the IRS still hasn't embraced this deduction. Be prepared to show that a portion of your home was used regularly and exclusively in connection with your business that year. Keeping a photograph of your home office in your tax file is probably a good idea.
This is another deduction the IRS always wants you to prove. Maintaining a log, or jotting down your business miles on your calendar or PDA, is a must. Also, don't forget to note your odometer reading on January 1st of each year.
Did you know that business gifts are limited to $25 per person per year? (You can give up to $25 to as many people as you like, however.) If you're deducting gifts, the IRS will request a list of people who received business gifts from you during the year, and the value of each gift given.
When you donate clothing and household items to a charitable organization, you can claim a deduction based on the fair value of the items donated. Even though you don't need to obtain a written appraisal if you're claiming a deduction of less than $5,000, the agent will ask you to prove how you came up with the value of your deduction. Being able to provide a detailed list of the items you donated, along with the value of each item, is generally sufficient.
Form Over Substance
During an audit, form is usually just as important as substance. Being able to provide paperwork to support your deductions, and having the right answers for the agent's questions, generally go a long way.
A lot is new!!! And it's all good! Check out the memorandum issued by the U.S. District Court in Minneapolis and you'll see that the court found that medical residents and fellows might not be subject to FICA taxes in many instances.
When it comes to your taxes, are you a do-it-yourselfer? With tax preparation software costing less than $50, and an abundance of tax information available over the internet, it's very tempting to prepare your own taxes each year.
Before you start inputting all of your information into the tax software next winter, however, answer this one question. How have you done keeping abreast of the recent tax law changes? During the past three years, President Bush signed two huge tax-cut packages into law. And to complicate your tax planning further, the 2003 Tax Act is scheduled to sunset in 2008, and the 2001 Tax Act is scheduled to sunset in 2010. That means that the rules will change at least two more times before this decade is over.
If you prepare your own tax returns, are you comfortable that you're not paying more than your “fair share” of taxes? Since tax professionals generally keep current with the tax law changes, and see what their other clients are doing to save taxes, they should be able to advise you on what you can do to minimize your tax burden.
And do you want to be on your own if you need to deal with the IRS? Maybe you received a notice from the IRS regarding some information reflected on your tax return. Or perhaps you're one of the unlucky ones selected to be audited. Whatever the reason, by having a relationship with a tax professional, you'll have the option of asking that professional to correspond directly with the IRS on your behalf.
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