The IRS has been decimated by budget cuts. Yet, despite its budget, the IRS has collected more in revenue. One reason for the increase in revenue was because the IRS focused on higher income earners. The other reason for the increase of revenue was the expanded utilization of correspondence audits. Correspondence audits occur by mail and focus on a specific schedule or line-item rather than the entire tax return. These IRS audits are cheaper than office and field audits and can target taxpayers of all income classes.
The issues that are addressed through the correspondence audit often involve Schedule A issues such as the deduction of medical expenditures, home mortgage interest, unreimbursed employee expenses and charitable donations. If you itemize your deductions, as opposed to taking the standard deduction, then you would file a Schedule A with your 2013 Form 1040. Therefore, you should be aware of IRS tax audits pertaining to Schedule A.
Itemized Deductions (Schedule A)
Medical and Dental expenses, Line 3
In 2013, the IRS revised its tax law with regard to medical and dental expenditures.
The new tax law states that if you were under 65 at the end of the 2013 tax year, then you may only itemize a deduction for unreimbursed medical expenses that exceed 10 percent of your adjusted gross income (AGI). In 2012, the threshold was 7.5 of AGI. However, if you are 65 or older at the end of 2013, then the lower 7.5 percent threshold applies. In 2017, however, the AGI threshold increases to 10 percent for all taxpayers. Therefore, to avoid any mistakes, make sure that the tax software you are utilizing requires you to impute your date of birth.
If you are deducting medical and dental expenditures, ensure that the expense is neither reimbursed by insurance nor part of a Section 125 cafeteria plan. Generally speaking, in order to deduct medical and dental expenditures, you must have paid out of pocket with no reimbursements and meet the aforementioned thresholds. I see this mistake by clients who self-prepare their tax returns. If its reimbursed or you receive a tax benefit, then it’s probably not deductible.
Home mortgage interest, Lines 10 and 11
In many other states and here in New Jersey, the cost of buying a home is high. This causes taxpayers to take out home acquisition loans that exceed $1 million. Many presume, including tax professionals, that all mortgage interest can be deducted no matter what the principal balance. This is not the case.
Under §163 taxpayers can deduct either home acquisition debt or home equity debt secured by their residence. Acquisition indebtedness is indebtedness to acquire, construct, or substantially improve a residence, but IRC 163 limits acquisition indebtedness to $1 million. Home equity indebtedness is indebtedness other than acquisition indebtedness. IRC 163 limits home equity indebtedness to $100,000.
The IRS issued a Memorandum (CCA 200940030) in which they reinterpreted the definition of “acquisition indebtedness” to permit the taxpayer to deduct interest on the first $1.1 million of his or her mortgage instead of the usual $1 million limit.
If your debt exceeds $1.1 million, then you must utilize the worksheet Form 886-A to determine the qualified loan and deductible home mortgage interest limit. Many CPAs, EAs, tax attorneys, and people that self-prepare their returns miss this phase out. It’s a slam dunk for an IRS audit.
If you’re self-employed and file the Schedule C or have rental properties and file the Schedule E, then you have tremendous audit exposure. By missing the interest deduction rule in 2014, you can expose yourself to an intrusive office or field audit.
Gifts to charity made by cash or check, Line 16.
On Line 16 of Schedule A, there is a distinction between gifts of cash and checks less than $250 and $250 or more. If your gifts were greater than $250, then Schedule A instructs you to review the Schedule A instructions.
Within the Schedule A instructions, the IRS states that for any cash or property contribution of $250 or more, you must retain a contemporaneous, written acknowledgment from the qualified organization indicating the amount of the donation, a description of any property contributed, and a statement reporting any goods or services received as a result of the contribution. If no goods or services were received, then the statement must say as much.
The distinction between gifts greater than or less than $250 causes many to think that gifts for less than $250 do not require substantiation. This is not true. Cash contributions under $250 must be substantiated by a bank record, receipt or other written communication from the qualified donee organization that verifies the transaction took place. Meaning, if you threw change in a collection bowl at the church or temple without a contemporaneous record, then the IRS would disallow the charitable deduction upon audit.
Even worse, the IRS will not permit circumstantial evidence for charitable deductions in a tax audit. You may recall, in an early blog about tax audits and missing receipts, I discussed the Cohan rule. Under the Cohan rule, the Tax Court will allow the taxpayer to estimate the amount of expenses where it is clear the taxpayer is entitled to a deduction but cannot establish the exact amount of the deduction.
Congress limited the Cohan rule to exclude charitable deductions. Congress stated in IRC 170 that no charitable contribution deduction is allowed unless the taxpayer has: (a) bank records, such as a cancelled check or bank statement; or (b) a written acknowledgment from the charity documenting the donation’s amount and date.
Therefore, when filing in the 2014 tax season, you should take particular care to ensure that the acknowledgment from the qualified organization is contemporaneous, meaning the receipt was obtained prior to filing the tax return. If you’re a CPA, enrolled agent, or tax preparer take extra care to ensure that your client has the appropriate documentation before claiming the deduction.
If you are under audit by the IRS and cannot produce the documentation to the IRS auditor, then you must have the charity reproduce the original copy of the contemporaneous written acknowledgment. The IRS agent would disallow the deduction if the qualified organization had to reproduce a new receipt.
Unreimbursed Employee Expenses, Line 21.
Another common area for the IRS to audit is unreimbursed employee expenditures. Generally speaking the tax code permits a deduction of ordinary and necessary expenses paid or incurred during the taxable year in carrying on a trade or business. The term “trade or business” includes the trade or business of being an employee.
As a cash basis taxpayer, you must ensure that the expenditure was paid or incurred in the 2013 tax year. Most taxpayers win on this issue as they will provide the auditor with bank or credit card statements. The problem is that in a tax audit, the expenditures are often commingled with personal expenditures and not clarified as to how the expense was ordinary and necessary. Therefore, providing the auditor with bank and credit card statements is not enough. All you proved to the IRS was that the expense was incurred. You must also prove that the expenditure was ordinary and necessary in carrying on your employment.
Accordingly, when preparing your 2013 tax return, you must review all of your yearly credit card and bank statements. Upon review, you should notate the type of expense and retain the receipts for those expenses. If you’re self-preparing your return and are having a problem determining what is ordinary and necessary versus personal, then either research online or contact a CPA or tax attorney.
Finally, as an employee you must not have been reimbursed or had the right to obtain reimbursement from your employer. Therefore, you should maintain a copy of your employee handbook that shows the employer’s policy with regard to reimbursements. Employment policies showing non-reimbursements is powerful in defending a tax audit.
IRC 6001 requires every taxpayer to maintain adequate tax records, and to make those records available to the IRS during a tax examination. When it comes to deducting medical expenditures, home mortgage interest, unreimbursed employee expenses and charitable deductions, you must keep those documents for a minimum of seven years. Seven is not an arbitrary number.
Generally speaking, the IRS has three years to audit a tax return from the date of filing. The 3 year audit statute can increase to 6 years if there is a substantial understatement defined as an omission of 25% or more of your gross income. The IRS would have an unlimited amount of time to audit a tax return if you intended to commit tax fraud upon filing your return. I like to retain records for seven years because it is after the six year statute.
IRS and state tax audits are tough because they usually occur years after you filed your tax return. With charitable deductions, it’s show me the contemporaneous records or lose the deduction. As discussed above, record reproduction of charitable deductions is not successful as a tax audit defense. Therefore, you must keep physical receipts and scan the documentation on your computer and upload them to a server.
With unreimbursed employee expenditures, it is hard to characterize the type of expense incurred years after the deduction. Therefore, make notes on your bank, credit card statements, and receipts. Notate the type of expense, cost of expense, and retain an employee handbook. Be careful on whether the expenditure is ordinary and necessary as the law is confusing. For example, new suits are not ordinary and necessary because they are suitable for ordinary wear. You should research the expenditure claimed or contact a CPA or tax attorney to clarify the deductibility thereof.
Many banks go out of business or merge. This causes difficulty determining the amount of home acquisition debt and home equity debt if you lost your documentation. Form 1098s, which report interest, don’t always include the beginning and ending principal debt balance. Therefore, if you don’t have the principal balance information, contact your bank to obtain an accounting of beginning and ending balance 2013 documents and scan on to your computer and server. Keep a copy of the physical documents with your 2013 return. Remember, this is important if your debt exceeds 1-1.1 million.
If you are undergoing an IRS audit or require assistance in preparing your 2013 tax return, then contact the Law Offices of Todd S. Unger, Esq. today. An IRS correspondence audit can be difficult and tax attorney, Todd Unger is here to help you defend against the IRS examiner. If you do not like your audit results, then Todd Unger can advocate for you in the IRS office of appeals, US Tax Court or other judicial forum to resolve the tax controversy.