Imagine getting a letter from the IRS that questions whether you paid what you owe in taxes. The letter is not a full-on audit but a challenge to prove that what you reported is true. Chilling, right? That’s exactly what happened to tens of thousands of small-business owners the IRS suspected might have underpaid their tax bills in recent years. However, the agency didn’t have the hard proof required to conduct an actual audit. “Your gross receipts may have been underreported,” said the form letters that went to mom-and-pop outfits all over the country. In its quest to close what it calls the tax gap—the difference between what Americans owe and what they pay—the IRS is using new and questionable tactics to uncover what it says are hundreds of billions of dollars in unpaid taxes each year. Mining databases of detailed credit card and debit card transactions, the service scours records to identify companies whose sales receipts fall outside normal patterns. This is the sort of thing marketers do every day to find potential customers, but it is a poor substitute for the level of proof that should be required to determine whether a business or individual is paying the right amount of taxes. In short, it’s nothing more than a fishing expedition and an exercise that puts a heavy burden on mom-and-pop businesses, which are required to prove a negative: that they didn’t underreport income. It’s this kind of behavior that is making more and more Americans wonder whether the IRS has gone off the rails.
No federal agency strikes more fear into the hearts of Americans than the Internal Revenue Service, and for good reason. The IRS has the power to garnish your wages or seize your property for nonpayment, and unlike other creditors, it doesn’t have to go to court to obtain a judgment against you to do so. When it comes to adjudicating tax claims, the IRS is both judge and jury. With its extensive power, you’d expect the agency to be judicious in its actions, but in recent years the opposite has been true. Even as it enforces a complex and confusing array of tax laws, internally it operates as anything but a watchful sentry for the nation’s treasury. Top officials have allowed unrestrained spending for questionable uses. Units within the service have gone rogue, pursuing political agendas of their own. Fraud artists, sensing opportunity, have targeted the agency with scams to lighten taxpayers’ wallets. On top of all this, the White House has settled more responsibilities on the agency’s narrow shoulders. It’s a recipe for disaster, not one to encourage the confidence of taxpayers. Let me show you how to handle this prickly pear and protect your wealth at the same time.
If there is one number among the many you need to remember when you think about the IRS, it’s this: 4 million. That’s the number of words in the tax code. That’s longer than the Bible and longer than the Declaration of Independence, the Constitution, and the Gettysburg Address all put together! Reading and understanding the code is virtually impossible unless you are a highly trained tax professional. The language Congress has used to write the code is arcane and obtuse. To an outsider, it seems that Uncle Sam doesn’t want people to understand the code, and for that reason, we spend more time and money every year complying with these byzantine rules. Americans spend an average of 15 hours completing their tax filings, of which 8 hours is for record keeping, 2 for tax planning, and 5 for form completion and submission. The average cost is $260.
Unfortunately, many Americans look at calls for simplification of the tax code as a shibboleth of the Right. In fact, the most trained and knowledgeable tax authorities say a simpler code should be a national priority. “The complexity of the tax code as it stands today is overwhelming, making compliance difficult for taxpayers and enforcement difficult for the IRS,” says Nina Olson, who runs a special office advocating for taxpayers at the IRS. “With a simpler tax code, taxpayers would not need as much help complying, and the IRS could deliver on its revenue-collection mission with a smaller budget.” Yet the IRS has virtually given up on its mission to help taxpayers understand what they owe. The agency was on track to answer less than half the calls to its information phone lines in 2015, the worst performance it has recorded since 2001. Nearly 9 million callers were disconnected by the IRS, a phenomenon the tax service calls “courtesy disconnects.” Some courtesy! Hold times for taxpayers who did manage to get their calls answered stretched to 30 minutes, up from just 4 minutes in 2005. Even professionals said getting through to an IRS representative was virtually impossible and reported hold times of up to six hours. One tax pro I know said he combated the problem by getting into the office early, calling the help line, and working on returns while he waited for someone to pick up, usually at the end of the day. The IRS is printing and distributing fewer tax forms and explanatory pamphlets. Tax preparation that once was offered by satellite offices is a thing of the past.
All this adds up to an IRS that is ignoring its core mission of serving taxpayers. Instead, the agency is more focused on enforcement and closing the tax gap as a way of dealing with a shrinking budget. But this strategy is perilous for both taxpayers and tax collection. Currently, 98 percent of all tax collections are voluntary, and Olson maintains that boosting voluntary tax collections by distributing more information and answering more questions would result in higher tax collections than would conducting fishing expeditions such as the small-business enforcement effort I just described. Think of it this way: if the IRS collected 10 percent less in enforcement revenue, tax revenue would decline by less than $6 billion. If voluntary tax payments dropped by 10 percent, tax revenue would decline by more than $300 billion. Helping the vast majority of Americans pay their taxes would help both taxpayers and tax collections, but the agency has had other preoccupations.
The most astonishing of these is the outright abuse of the IRS’s extensive powers. Beginning in March 2010, the IRS delayed or held up indefinitely applications by conservative groups for nonprofit status with words or phrases such as Tea Party and Patriot in their names. By withholding approval, the tax agency essentially stopped these groups from operating and silenced conservative voices. It’s exactly as Supreme Court Justice John Marshall said in 1819: “The power to tax is the power to destroy.” After its review, the General Accounting Office concluded that oversight at the IRS was so lax that it made it more likely that these conservative groups were targeted for audits. These abuses started with employees in the Cincinnati office of the IRS, who were tasked with reviewing applications by nonprofit organizations for tax-exempt status. IRS employees developed a “Be on the Lookout” (BOLO) spreadsheet of candidates that required extra scrutiny, including names related to the Tea Party movement. The practice of slowing reviews spread from Cincinnati to other IRS offices, including Laguna Niguel, California, and Washington, D.C. The IRS, by the way, is still refusing to release these BOLO lists, citing privacy concerns.
This hyperscrutiny of tax-exempt applications from conservative groups coincided with the Obama administration’s political attacks on conservative donors such as the Koch brothers. One telling example is that of Media Trackers, a conservative organization that applied to the IRS for recognition of tax-exempt status and received no response after waiting 16 months. When the organization’s founder, Drew Ryun, applied for tax-exempt status for an organization with the liberal-sounding name Greenhouse Solutions, that application was approved in three weeks. This would be funny if it weren’t so tragic. Ryun is a former Republican Party staffer.
However, the brunt of the IRS’s scrutiny was endured not by members of the media or their critics but by Americans who had been inspired by the Tea Party movement and wanted to get involved. Most chilling is the story of Catherine Engelbrecht, who says the application for tax-exempt status for her organization, True the Vote, which seeks to prevent voter fraud, was delayed for three years. The IRS asked her hundreds of questions, requesting every Facebook post and Twitter tweet she had ever written as well as information about her family, what organizations she had belonged to, and whether she had ever sought office. But that was just the beginning. What started as a lengthy and probing investigation into True the Vote by the IRS became a witch hunt. The Bureau of Alcohol, Tobacco, Firearms and Explosives audited the machine shop owned by Engelbrecht and her husband even though it doesn’t make firearms. Next, the Occupational Safety and Health Administration inspected the shop, levying a $25,000 fine despite the fact that the inspector congratulated them on how tightly their operation was run. The FBI also came calling, probing for details about attendees at meetings of another political group Engelbrecht had founded. Daniel Henninger, an editor for the Wall Street Journal’s editorial page, wrote: “The IRS tea-party audit story isn’t Watergate, it’s worse than Watergate….The Watergate break-in was the professionals of the party in power going after the party professionals of the party out of power. The IRS scandal is the party in power going after the most average Americans imaginable.”
Although the scandal was viewed largely as a partisan debate by the mainstream media, the truth is that it was an astonishing misuse of government power. Despite the president’s protestations that there wasn’t a “smidgeon of corruption” at the IRS, the agency eventually had to admit its overreach after the inspector general for the Treasury Department released a report saying the agency had in fact targeted certain nonprofit groups for extra scrutiny. As always in American politics, it’s the cover-up that proves to be the downfall of those in power. In spring 2015, the Treasury Department’s inspector general for tax administration found that the e-mails in question from the IRS regarding the scandal that its own commissioner had said had been lost and were irretrievable were in fact still sitting on the same backup tapes on which they had always been. IRS employees simply hadn’t requested them. In other words, congressional investigators had been denied information that had been in plain view by an IRS unwilling to cooperate. It was that move which turned the IRS investigation into a criminal probe that took years to resolve. Is it any wonder that the left-leaning ACLU and others bristled when it was learned that the tax agency reserved for itself the power to read individual e-mails and other electronic communication without a subpoena?
The IRS’s problems aren’t limited to the exempt organizations unit. In fact, a variety of recent scandals point to an agency that is both arrogant and unrestrained in its use of taxpayer dollars. The agency spent $49 million between 2010 and 2012 to send employees to elaborate conferences all over the country. The most elaborate was a three-day junket to Anaheim, California, in 2010 called Leading into the Future. The event was worthy of a Wall Street clientele. IRS managers were greeted with a wine reception and free gifts such as briefcases. Many luxuriated in two-bedroom presidential suites. A speaker was paid $27,000 to pontificate on “radical innovation.” A total of 15 outside speakers made presentations at a cost of $135,350. Planning the event cost the government a pretty penny. Three independent event planners were hired to find hotels and plan the proceedings at a cost of $133,000. More than 25 employees were sent on scouting trips to Anaheim at a cost of $36,000. Training videos prepared for the conference cost $50,000. One was a Star Trek parody that showed IRS employees discussing ways of finding tax fraud. Other conferences were held in luxury resorts in Las Vegas, where IRS workers stayed at the Caesar’s Palace hotel and conference center, Mandalay Bay, and New York–New York Hotel & Casino. That’s not the only financial abuse at the agency responsible for collecting our tax dollars. Another government watchdog report flagged misuse of government credit cards by IRS employees. More than 5,000 IRS card accounts racked up $103 million in purchases, some of them for wine and online pornography, between 2010 and 2011. IRS chieftains ignored Obama administration directives to cancel $70 million in discretionary employee bonuses when automatic spending cuts were in place in 2013. When the tax administrator handed out bonuses totaling $2.8 million to employees with disciplinary issues in 2014, including more than $1 million to workers who didn’t pay their taxes, it barely lifted an eyebrow inside the Beltway. Three million dollars? That’s pocket change. But it’s this lack of concern about the dollars and cents of taxpayers that shows just how far the IRS has strayed from its mission as the nation’s top tax collector. Clearly, the internal culture of the IRS is at odds with its mission, yet IRS commissioner John Koskinen blames tax cuts for what he admits is “crummy taxpayer service.”
The tax agency’s myriad problems are making it easy pickings for fraud artists. In recent years, emboldened scammers have found ways to steal tax refunds from taxpayers. Some breach the private accounts of tax software users, stealing account passwords to steal refunds. Others hack the IRS website itself. Some 100,000 accounts of U.S. taxpayers were hacked through the IRS website’s “Get Transcript” function. Using information gleaned from other sources, the scammers correctly answered personal identity verification questions. In return, the thieves got the actual tax filings, including names and Social Security numbers, of filers and their children—a treasure trove of personal data. Taxpayers don’t realize there is a problem until they file their taxes and the IRS tells them their refund check has already been sent—to someone else! The number of suspicious returns filed is growing rapidly. In 2012 the number was 2.5 million, up from 900,000 in 2010. Whistle-blowers say software providers may be inadvertently giving criminals cover, but it’s clear the IRS isn’t doing enough to flag fraudulent returns. Another scam involves fake IRS agents harassing taxpayers with threatening phone calls. The bad guys demand payment and threaten jail time if the victims don’t send money. And they do. Some 366,000 people have paid $15.5 million to scammers over the last two years. It’s hard to imagine that these scams could continue if the IRS was playing at the top of its game. But instead of reacting quickly, the agency’s efforts are minimal.
It seems strange indeed that an agency that can barely manage to execute its core mission has been given a huge new responsibility at the president’s direction. Under this administration, the agency has received vast new powers to interpret and enforce Obamacare. The law generated 47 major changes to the tax code, the most sweeping changes to tax law in 20 years. The responsibility for tracking the details of who has coverage and who does not has fallen to IRS agents. That means the agency will be responsible for determining who gets insurance subsidies and who does not, whether your coverage meets the requirements of Obamacare or whether it does not. The IRS will police the individual mandate and determine whether the coverage offered by private companies meets the rigorous requirements of the healthcare law. In short, the tax agency has expanded its mandate beyond tax collection to the interpretation and implementation of social policy. Early reports regarding the IRS’s capacity for handling this vast responsibility were poor. Confusion reigned among Obamacare subsidy recipients. As many as half of the 6.8 million first-year recipients of Obamacare received subsidies that were too large as a result of a glitch at Healthcare.gov, wiping out highly anticipated tax refunds for many of them. Things were so disorganized and baffling that the government delayed refunds altogether for tens of thousands of Obamacare recipients. It was a disappointing showing for the tax agency and another reason the nation’s tax collection authority has lost respect.
The problem for conservatives isn’t simply how the IRS is doing its job; the tax law itself is infuriating. President Obama repeatedly and in many contexts has said that the rich should pay their “fair share” in taxes, but a recent study from the independent Congressional Budget Office (CBO) shows that the wealthy paid their fair share and more even before Obama imposed tax hikes targeting the well-to-do. The analysis takes as its starting point the idea that all income should be considered in interpreting tax payments across income lines. That means that Social Security, Medicare, and unemployment insurance payments are added into the equation as well as business income and income from capital gains. That broader reach reveals a highly unequal system of taxation, not one that shows that the wealthy aren’t contributing. In fact, the CBO study shows that the bottom three-fifths of Americans (by income), or 60 percent of all households in this country, are net recipients of government payments. In other words, they get more money in transfer payments from government programs than they pay in federal taxes. Those in the second-highest income quintile pay just slightly more in federal taxes ($14,800) than they receive in government transfer payments ($14,100), for a difference of just $700 a year. The vast preponderance of tax payments is made by the top one-fifth of U.S. households by income. In fact, the top 20 percent of American households in terms of income finance 100 percent of the transfer payments to the bottom 60 percent and nearly all the tax revenue collected to run the federal government.
These facts point out that the president’s rhetoric regarding the 1 percent is just that: rhetoric or political speech. Likewise, his idea that soaking the rich can fill tax coffers simply doesn’t work. Consider Britain. After Prime Minister Gordon Brown’s government announced a plan to levy a 50 percent income tax on people earning 1 million pounds or more, the number of folks in that category shrank. The number of millionaire tax filers in Britain in 2009 was 16,000. By 2010, that number had dropped to 6,000. The government had pinned its hopes on raising 2.5 billion pounds in new revenue, but the law of unintended consequences took hold. Before the law changed in 2009–2010, British millionaires contributed 13.5 billion pounds, or 9 percent of the total tax liability paid by taxpayers. After the change in the tax law, millionaires contributed 6.5 billion pounds, or less than 4.5 percent of the total tax liability. To be sure, some of the well to do in Britain might have become thousandaires in the Great Recession that started in the United States, but another reason for the strange disappearance of England’s well heeled is that people in this class don’t necessarily stay put when things turn against them. Like Gérard Depardieu in France, some pull up stakes and move to a more welcoming spot. In short, raising tax requirements doesn’t mean that increased tax revenue follows.
Even so, the president continues to propose changes that would burden those who guide their own ships. Obamacare alone has 20 new taxes. The president has increased capital gains taxes twice and proposed raising them yet again in January 2015. Then there is his death tax proposal. President Obama has proposed changes to inheritance and capital gains taxes that would raise the estate tax to the highest levels in the industrial world. The plan would eliminate what accountants call the step-up basis at death on capital gains taxation, raising the top capital gains tax rate to 28 percent from 20 percent. Under current law, when a parent or a grandparent dies, the increase in value of his or her assets is not taxed as income (because the inheritor will pay estate tax). But the president’s plan would tax estates and impose the regular capital gains tax on inherited assets, whether business, property, or stocks, bringing the effective death tax rate to 57 percent. That’s two taxes where one existed before. The administration says its intention is to close a tax loophole, but the impact of such a move if it became law would effectively prevent family businesses from being passed between generations. Conservatives think of estate taxes as wrong on their face. Remember, estate taxes are levied on money that already has been taxed!
I’d like to write that we’ve come a long way on the nation’s fiscal policy in the last six years, but the opposite is true. The president’s mind seemed open to change when in 2010 he appointed a bipartisan National Commission on Fiscal Responsibility and Reform piloted by two people who had spent many years studying the topic, Erskine Bowles and Alan Simpson. They were charged with proposing recommendations to balance the budget and address the rapid-fire growth of entitlement spending and the gap between revenues and spending by the federal government. The group met and produced a very nice bound report full of sane solutions, but nothing happened as a result of those recommendations. Instead, five years later, the administration began to consider the possibility of using executive orders to raise taxes. It started with a trial balloon floated by Vermont senator Bernie Sanders, who called on the president to raise more than $100 billion in taxes through executive action. Instead of batting away the suggestion as undemocratic, the president’s aides declared that Obama was “very interested” in the idea. In the short span of five years, the president had moved 180 degrees, from attempting to find solutions to our nation’s fiscal crisis by consensus to getting the money for his pet programs on his own and ignoring the directive of the Constitution that “all Bills for raising Revenue shall originate in the House of Representatives.” Shocking!
PAYING ONLY WHAT YOU OWE
Since the IRS has shown itself not to be an advocate for taxpayers and is burdening us with new responsibilities, it’s up to you to protect your wealth. Your goal is to preserve as much of your wealth as possible to pass it along to your family. Nothing I advocate here is contrary to tax law. That would be stupid and could end up costing you more than you save in back taxes and penalties. The idea is to stay within the law and take advantage of the benefits that the law offers to shelter income and pass it on to the next generation. Tax law rewards certain behaviors, such as buying a home and saving in a 401(k) or IRA. Taking advantage of these offerings requires planning and strict attention to detail, especially saving and cataloging records. The time-tested methods for managing your tax burden include shifting income and deductions to the tax years that will result in lowest taxes, maximizing tax-free sources of income (a topic we explored in Chapter 5), and exploiting every single deduction you can find.
HIRING A PRO
Tax fraud, especially the sort in which crooks steal the refunds of unsuspecting tax filers, has gone through the roof. The bad guys have been stealing refunds for years by surreptitiously getting Social Security numbers and filing returns under those numbers. But these days they’ve gone one better. Some are finding ways to steal the passwords that tax filers use to set up accounts to file their taxes by using popular tax software packages. The impact is the same: the bad guys steal the victims’ refunds. One accountant told me that a client of his was due tens of thousands from the government the year Superstorm Sandy demolished his house. The man desperately needed that refund, but a crook had stolen it before he filed his taxes. Fixing that problem, my accountant friend said, had taken literally years of IRS badgering and filling out forms. According to some state tax authorities, online tax fraud by thieves using legitimate tax software is up 37 percent. The incidence of fraud was so common that Intuit, the maker of the nation’s most popular tax software, TurboTax, temporarily suspended the transmission of e-filed state tax returns early in the 2014 tax filing season.
Protecting yourself isn’t easy, but hiring a responsible tax professional will at least give you an ally if the worst happens. Truth is, tax professionals also use tax software and file electronically, but if you fall victim to tax fraud, at least you’ll have someone to argue your case. And let’s face it, having a tax professional at your side makes all the sense in the world in light of the complexity of the tax code. For my money, the only reason not to have a professional is that you are in a first job. There’s nothing like doing your own taxes to learn firsthand the basics of how the tax system works. But for most of us there are plenty of reasons to hire a tax pro. It’s best to use a professional when you own your own business, you’ve gone through a major life change such as marriage or divorce, you’ve bought or sold a home in the previous year, you own rental property, or you have a large investment portfolio. In other words, if your finances are complicated for any reason, it pays to hire a professional. If you manage to pick an experienced accountant, you’ll find that he or she probably has prepared a return for someone in your exact situation or a very similar one. What’s more, if the IRS has issues with the filing, such as wanting more information, your professional will handle the exchange.
Finding the right tax pro is a whole other kettle of fish. If you pick a tax preparer the IRS considers a cheat or incompetent, the chances of getting audited go through the roof. Every IRS district manager knows the problem tax filers in his or her district. Consider a man I met several years ago who was driving home from work one wintry night listening to the radio and heard a report of a man who had fallen 100 feet to his death in a river. The man wasn’t surprised to find out that the suicide was his accountant, who had pushed questionable tax strategies. The man I met was audited by the IRS for tax filings going back three years and ended up with a $5,000 bill in back taxes and penalties. He wasn’t the only one. The accountant left a long trail of troubles.
Okay, most people’s accountants don’t fling themselves to their death, but screwups are commonplace. Some are innocent, such as transposing numbers or forgetting a signature, but others are more serious, such as the ones committed by the wintry weather suicide, who once had suggested to a client that he claim more dependents than he actually had. You won’t get much help from trade groups or even the IRS in trying to make sure the tax professional you pick is on the up and up, and so some due diligence is essential. Check out your state board of accountancy to make sure any CPA you use is licensed and doesn’t have any disciplinary actions against him or her. You can get contact information at NASBA.org. Interview anyone you consider working with face-to-face and ask the tough questions, such as how many of his or her clients have been audited and whether he or she has ever been audited. It’s critical that you pick a pro whom you can trust and can work with for years to come. A qualified individual won’t just fill out the tax form for you but also give you advice on how to position your assets for the long term to result in the lowest possible tax bill. Unfortunately, there are many varieties of people who put themselves out as tax professionals. Sorting them out isn’t easy.
Certified public accountants are the gold standard, having completed a four-part accounting exam, and they can represent you in front of the IRS if it ever comes to that. However, there are less expensive ways to get help. Enrolled agents who have passed a tax exam may have worked at the IRS and are licensed to file taxes. You can find an enrolled agent at www.naea.org. Some Certified Financial Planners (CFPs) also offer tax services. At a minimum, you want your CFP to be talking to whoever prepares your taxes. Another option is to use accredited tax accountants and tax-planning services. (I did say it was a whole other kettle of fish, right?) Getting a preparer who is recommended by someone you know and trust is good idea, too.
If you do plan to use tax software, make sure your password is strong to protect yourself from the fraudsters. The good news is that the software does all the math for you, making every calculation. The way the packages work is that they have you fill out the forms by asking you questions and prompting you for responses. For some of us, it comes down to comfort level. Do you want to handle your taxes on your own, or do you want a pro to do it for you? Either way you file, your return will go to the IRS electronically, and that will guarantee the quickest processing.
TAKING ALL THE DEDUCTIONS YOU ARE DUE
My advice is to leave no stone unturned when it comes to deductions. People write entire books about the thousands of obscure deductions that the tax code allows, and even the IRS expects you to take full advantage of all the deductions you can find to save on your tax bill. You’ll have to itemize your taxes and fill out the long form to claim them, but the benefits can be huge. In 2012, 97 million taxpayers claimed $1.18 trillion in write-offs. You can share in the wealth. Here are a handful of overlooked deductions that can bring your tax bill down. College loan interest is a critical deduction for parents and their children struggling with the high cost of education. You can deduct up to $2,500 of annual interest on loans to pay for college. Income phaseouts exist, naturally, and so high earners might want to consider taking out a home equity loan instead, which in most cases will allow you to deduct interest. For more on how to juggle college debt and deductions, check out Chapter 3. Private mortgage insurance. You already have learned all about the home mortgage interest deduction, and although that deduction is now on a phaseout schedule for high earners, others may benefit from it. PMI is an insurance policy that lenders require if you can’t make a 20 percent down payment on a home. This is a break that Congress reviews every year, and it will expire for 2015 unless Congress renews it. Make sure it has been renewed before claiming it. You’ll find the amount of PMI you paid on your bank’s Mortgage Interest Statement, Form 1098. The break is available to home owners who took out a mortgage after January 1, 2007. Like a lot of deductions, this one has income phaseouts. The sweet spot for this break is an adjusted gross income below $109,000. Caring for a dependent parent can save you money on taxes if you can claim a parent as a dependent. Your parent or parents must live with you and get more than half of their support from you. Keep in mind that the parent’s earnings must be less than the tax exemption level. The devil is in the details with this one, and you should consult a tax professional. But if you meet the requirements, you’ll be able to claim an added personal exemption on your income tax return. Another plus is that any medical expenses you pay for that parent can contribute to the threshold for deducting medical costs. To meet that threshold, you have to spend 10 percent or more of your adjusted gross income on medical expenses. If you or your spouse is age 65 or older, the 7.5 percent threshold is maintained through 2016. Home equity loan interest is deductible on loans of up to $100,000 no matter what you do with the money, as is, of course, qualified mortgage interest paid on up to $1 million of loans to purchase or improve your primary and secondary residence. (Again, phaseouts occur at higher income levels.) Job search expenditures are also deductible. If you were looking for a job last year, even if you were unsuccessful, those costs can be deducted as miscellaneous expenses. If you do land a new gig, you also can claim relocation expenses for a new job. A tax professional can help you with details. You also can write off worthless securities. Just keep in mind that the stocks, bonds, or notes you write off must be completely without value. You can look as far back as seven years to find investments that fit the bill. Don’t forget to write off any professional fees related to filing your taxes, securing alimony, or planning your estate.
There are many more deductions, but you should be aware that some of them are IRS audit bait. Deductions that may get a second look from the tax agency include home office deductions, which draw attention, especially if you claim a salaried income. Noncash charitable donations also are scrutinized, particularly if you contribute a car or another large noncash item. But even large cash contributions to charity can draw attention.
When it comes to deductions, one of the things IRS auditors keep in mind is how you stack up against other taxpayers. CCH calculated average deductions, and although you shouldn’t use them as a hard and fast guide to your own tax return, it makes sense to have a general idea of what people in your income bracket claim as deductions. For example, folks with an income range of $50,000 to $100,000 on average claim medical expenses of $7,312, interest of $9,320, and charitable contributions of $2,815. Claiming deductions far larger than the average in your income range may result in more scrutiny of your 1040 by the IRS because much of the heavy lifting of finding audit candidates is computerized.
BEING AWARE OF THE ALTERNATIVE MINIMUM TAX
As if the tax system weren’t enough of a burden, there is another tax system. The dreaded alternative minimum tax (AMT) is a second tax regime operated by the IRS that Congress set up to catch wealthy tax cheats way back in 1969. The idea is to get you to pay more under AMT, and to this day this alternative system is still boosting tax bills for Americans. Although the original AMT system ensnared only 19,000 people, in later years millions were forced to pay AMT, as brackets and exemptions were never indexed for inflation. Here’s how AMT works. Under regular IRS rules, you calculate your federal taxes, starting with gross income, and then subtract deductions. Under AMT, you start with gross income, but you can’t use many of the deductions you may be accustomed to. Key breaks such as the deductions for state and local income tax, property tax, and home equity loan interest disappear. Exemptions for children are gone. Even though the highest tax rate under AMT of 28 percent is lower than the highest rate under the regular tax system of 39.6 percent, people pay more in taxes under AMT because of the loss of these deductions. That’s the reason so many people fear the AMT. Fortunately, the American Taxpayer Relief Act of 2012 permanently patched the inflation issue, but AMT is still a threat to ordinary taxpayers, particularly in high-tax states that result in bigger tax deductions. Those who are likely to get caught in the crosshairs are people with high family income, generally $250,000 and higher; large state and local income and property taxes to deduct; and a spouse and several children. Large home equity mortgage interest also can play a role. In short, the more deductions you tend to take, the more likely you are to end up owing AMT, up to a point. At high earner levels of $750,000 and more, tax rates of 39.6 percent probably will result in higher tax payments without the AMT. But the sweet spot for capturing Americans in the AMT tax system is upper middle income with high deductions. A decent accountant will run your taxes both under AMT rules and under the regular system to make sure you don’t fall under AMT. The best-case scenario is that you run a mock calculation before the end of the year so that you can determine whether making a few adjustments to your gross income, such as making a contribution to your IRA, prepaying deductible business expenses, or selling losing investments in a taxable brokerage account, can keep you out of the clutches of the AMT.
THE BEST TIME TO PLAN IS THE YEAR BEFORE
The best time to lower your tax bill is the December before you file. Truth is, once you pop the champagne bottle, scream “Happy New Year,” and give your significant other a kiss at midnight, almost all of your tax-planning strategies are lost if you haven’t already implemented them. Before the end of the year, consider these strategies:
SELL YOUR LOSERS. If you invest in individual stocks outside a retirement plan and have enjoyed gains, analyze your portfolio to identify any losers you have. If you sell those losers, you can use the capital losses to offset your capital gains, plus you can take an additional $3,000 in losses against your other income. You can buy back those losers next year if you plan to hold them for the long term. Avoid tripping IRS wash-sale rules by buying back the same securities no less than 30 days after you sold them.
DELAY TAKING YOUR BONUS. One easy way to reduce your income is to get your boss to delay giving you your year-end bonus until after the first of the next year. That way your bonus won’t show up as income in the current tax year. If you are self-employed, delay invoices until after the first of the year.
SET ASIDE MORE FOR RETIREMENT. Most people don’t contribute the maximum they are eligible for to their workplace retirement fund. According to the IRS, contribution limits are $17,500 for 2014 and $18,000 for 2015. Catch-up limits for workers age 50 and older are $5,500 for 2014 and $6,000 for 2015. Check the rules for contributing to your 401(k) to make sure you can modify contributions at any time. Remember, the money you contribute to your 401(k) or an IRA comes out before you pay taxes (as long as you are within the contribution limits). Why not pay yourself before paying Uncle Sam?
GIVE TO CHARITY. If you are already planning to give money to your favorite charity, this is the time to do it. In addition to cash, you can give household goods, clothing, and even a car. But before you send that old junker off, talk to a tax professional to make sure you are doing it the right way. Vehicle contributions often are scrutinized by the IRS.
PAY YOUR TUITION BILL EARLY. If you’ve got a child in college, your spring semester bill isn’t likely to be due until January, but it may be worthwhile to pay it now. Early payers can claim the American Opportunity Tax Credit on their current-year returns. The credit is worth up to $2,500 and up to 40 percent of it is refundable, which means you could get back as much as $1,000 as a tax refund if you don’t owe taxes. You can claim tuition, fees, and course materials.
Finally, don’t leave any money on the table. Be sure to use any money you’ve set aside in your flexible spending account at work. Like a 401(k), FSA money goes into the account before taxes, but if you fail to use that money in the same year in which it is contributed, you could lose it.
AVOIDING AN AUDIT
The more you make, the more likely you are to get audited. Taxpayers earning $200,000 or more have an audit rate three times higher than that of the general population, and if you’re earning a million dollars, your chances jump to one in nine. Even if you aren’t in those brackets, you can find yourself face to face with an IRS audit. One way to escape the IRS’s notice is to fit in with the pack. I mentioned before that you want to keep your deductions near levels that Americans in your tax bracket claim, and there is a really good reason for that. The IRS conducts roboaudits, relying on automation and computer programs to flag returns that are out of step with the majority. Other items can get you a second look. If you submit a sloppy return with typos and bad math, watch out. One common reason people get audited is that the information they input into their forms is different from the information on their W-2s or 1099s. Double-check all your numbers and income sources when you file. Also, claim any new dependents on just one tax form. Claiming dependents who are claimed by someone else or have already filed a return and claimed themselves is a no-no. This is a big red flag to the IRS. I have mentioned that high-income filers attract attention, but so do people who claim to have zero income, especially people who run their own businesses. Don’t even consider setting up an unprofitable business just to reap the tax breaks. And for goodness’ sake, don’t forget to claim income. If you get income from various sources, you’ll need to report it even if a 1099 doesn’t reach your mailbox because the employer no doubt will report your pay to the IRS on its income tax form. It’s easy to lose track of these payments over the course of the year. Keep good records.
Finally, if the worst happens and you are contacted by the IRS, don’t panic. The IRS sends out millions of what it calls Automated Correspondence Exam notices each year that are generated by computer algorithms that catch something unusual. The best response is quick and accurate information to set the record straight.
MY LAST WORD ON TAXES
People often ask me how far they can go in claiming deductions such as unreimbursed employee business expenses. What happens if they forget to report a small source of income? Can they push the line, shade the truth, and get away with it? To be sure, in recent years the IRS has been down on its heels, preoccupied with scandal and burdened with additional responsibilities. But you couldn’t be more wrong in thinking this is the time to save a few dollars by cheating because the IRS in future years can go back and scrutinize previous tax year returns. According to its website, in extreme cases the IRS will look back at as many as six years of returns for errors. My advice is to stay within the law but exploit every advantage you can legally take.