In late 2020, the IRS announced that it will increase tax audits of small businesses by 50 percent in 2021. Here are several mistakes to avoid if you do get audited by Uncle Sam.
- Mistake: Missing income. A long history of investigating has led IRS auditors to focus on under-reported income. If you’re a business that handles cash, expect greater scrutiny from the IRS. The same is true if you generate miscellaneous income that’s reported to the IRS on 1099 forms. Be proactive by tracking and documenting all income from whatever source. Invoices, sales receipts, profit and loss statements, bank records—all can be used to substantiate income amounts.
- Mistake: Higher than normal business losses. Some small businesses struggle in the early years before becoming profitable. If your company’s bottom line never improves, the IRS may view your enterprise as a hobby and subsequently disallow certain deductions. As a general rule, you must earn a profit in three of the past five years to be considered a legitimate business.
Mistake: Deductions lacking substantiation. Do you really use your home office exclusively for business? Does your company earn only $50,000 a year but claim charitable donations of $10,000? Do you write off auto expenses for your only car? The key to satisfying auditors is having clear and unequivocal documentation. They want source documents such as mileage logs that match the amount claimed on your tax return and clearly show a business purpose. If you can’t locate a specific record, look for alternative ways to support your tax return filings. In some cases, a vendor or landlord might have copies of pertinent records.- Mistake: No expense reports. If you use your credit card for business, create an expense report with account numbers and attach it to each statement. Then attach copies of the bills that support the charges. This is an easy place to blend in personal expenses with business expenses and auditors know it.
- Mistake: No separate books, bank accounts or statements. Never run personal expenses through business accounts and vice versa. Have separate bank accounts and credit cards. A sure sign of asking for trouble is not keeping the business separate from personal accounts and activities.
- Mistake: Treat the auditor as an enemy. Auditors have a job to do, and it’s in your best interest to make their task as painless as possible. Try to maintain an attitude of professional courtesy. If you’re called to their office, show up on time and dress professionally. If they come to your place of business, instruct staff to answer questions honestly and completely.
Here are several new tax laws passed this year to consider as you start planning your 2020 tax obligation.
Make up to $300 of charitable contributions. For the 2020 tax year only, an above-the-line deduction of $300 is available to all Americans who want to make a charitable contribution. You can donate to more than one charity, but the total amount of contributions must be $300 or less to be able to take an above-the-line deduction. While you will still need to itemize your deductions if you want a tax break for donations greater than $300, this above-the-line deduction for $300 or less helps alleviate the elimination of the charitable deduction for most taxpayers. (NOTE: $300 is the maximum above-the-line deduction per tax return, regardless of filing status.)
What you need to do. Donate $300 to your favorite charitable organization(s) by December 31, 2020. You must receive a written acknowledgment from the charitable organization(s) to which you made the $300 contribution before filing your 2020 tax return.
- Donate up to 100% of your income. The normal contribution limit of 60% of your income is suspended for 2020, allowing you to contribute as much of your income as you want to various charities.
What you need to do. While only a tax break for a few taxpayers, this initiative is meant to help struggling charities during the pandemic. If you are considering additional giving, you must make your charitable contributions by December 31, 2020. Remember to obtain written acknowledgment from each charity you made a donation to before filing your 2020 tax return.
- Use retirement savings to pay for birth or adoption expenses. Adding a child to your family is very expensive. To help with these costs, you can now cash out up to $5,000 per parent from your retirement accounts to pay for birth and/or adoption expenses. While the withdrawal won’t be hit with the 10% early withdrawal penalty, you’ll still have to pay income taxes.
What you need to do. Consult your financial advisor or benefits coordinator to find out how to withdraw the funds from your retirement accounts. Since this withdrawal will deplete your retirement savings, first consider whether you have other sources of cash to cover expenses.
- No age limit for contributing to IRAs. You can now contribute to an IRA regardless of your age as long as you have earned income. The old rule prevented you from contributing to an IRA past age 70½. The IRA contribution limit for 2020 is $6,000 if you’re under age 50 and $7,000 if you’re over age 50.
What you need to do. Consider getting a part-time job or doing some consulting work if you project that you won’t have earned income by the end of 2020. You can then use this earned income to fund your traditional or Roth IRA.
You’ve probably already received several letters and phone calls from charities asking for donations. Most requests are from legitimate organizations. Some, however, are bogus charities set up by con artists who use the holiday spirit to their financial advantage.
Last year, Americans gave nearly $428 billion to charities, according to Giving USA 2019: The Annual Report on Philanthropy for the Year 2018. That’s a huge incentive for fraud.
If you’re planning to donate, take some time to learn how to spot a charity scam. Here are a few big red flags:
- Popup charities. Every legitimate charitable association started sometime, and some are still being formed. But natural disasters, endemics and calamities of every type — from Hurricane Dorian to the Ebola virus — seem to spawn an inordinate share of fake charities. You can avoid these popup scams by donating to charities that you trust, which generally means those with a proven track record. If you’re unsure, check out the organization with the Better Business Bureau, Charity Navigator, GuideStar or similar watchdog group.
- Evasive answers to fundraising questions. A legitimate caller should be upfront about their charity, the percentage of funds allocated to administration and marketing, and what target groups will be aided by your donation. Whether you’re giving to provide medical supplies, support research or some other worthy cause, don’t be afraid to ask direct questions and expect direct answers. If the fundraiser seems to hedge their responses or knows little about the supposed cause to which you’re contributing, consider a different charity. Beware of vague claims like “educating the public” or “promoting awareness.”
- Urgent email requests. Websites made to mimic legitimate charities have conned many otherwise careful contributors. Emails asking for money on a deadline may originate from the backroom computer of a scam artist. Never divulge your financial information via email. Call the charity directly and find out if it’s registered in your state (if required). Ask for written information. When in doubt, check it out.
Many charitable organizations are seeking your aid to address genuine hardships. Avoid the schemes of unethical scammers, and your donations will provide help where it’s needed most.
If you think you’ve been contacted by a bogus charity, let the Federal Trade Commission know by filing a complaint.
Now is the ideal time to schedule a tax planning session. Your 2017 tax return outcome is still fresh, and it’s early enough in the year to take advantage of the numerous tax law changes taking place in 2018. Here’s a brief overview of some of the new tax issues that you need to plan for now.
Income – Tax rates for both individuals and small businesses have changed substantially. Income tax deductions have also changed drastically, including a nearly doubling of the standard deduction and elimination of personal exemptions and miscellaneous itemized deductions.
It’s important to review your income tax withholding schedule to see where you fall in the new income tax bracket structure. Small adjustments here could save you hundreds.
Bunching – Because of the changes to the deductions structure, using itemized deductions may now require bunching two or even three years of expenses into one tax year. Things like donations to charity and medical expenses that you may have spread across several years are now better bunched into a single year to maximize your tax savings.
If you typically take care of medical expenses or charitable donations at a regular time every year, hold off this year until you have a new tax-efficient plan.
SALT (State and local taxes) – There’s now a $10,000 combined total cap on deductions of state and local income, sales and property taxes, which is going to impact a lot of people, especially in high-tax states. This may be a big factor to account for if you’ve relied on this deduction in the past.
Get an analysis done to see how much larger your tax bill is going to be because of the cap on SALT taxes. There may not be much you can do about it, other than changing where you live and own property, but you’ll need to have a clear picture of how it will impact your tax return in 2018.
Mortgage interest changes – There are several new rules changing how mortgage interest is deducted. You can no longer deduct the interest on mortgage indebtedness greater than $750,000. And you can no longer deduct interest on mortgage indebtedness that wasn’t spent directly on buying, building or substantially improving your home.
If you have previously claimed a home equity loan interest deduction, you’ll need to review how this will affect your itemized deductions.
These are just a few examples of things that you’ll need to review in the wake of the largest tax law change in more than 30 years. Take some time this summer to make sure you have a plan in place.