Tax returns could be very complicated for taxpayers. Regardless of the level of complication, all taxpayers could tremendously benefit by reviewing their tax return, knowing their tax return, and by asking questions.
Hiring a tax preparer to prepare a tax return does not confer an immunity from liability to the taxpayer. A taxpayer cannot necessarily switch all the liability to the tax preparer in an audit by the Internal Revenue Service. The IRS will not process a return until the taxpayer declares and signs that “Under penalties of perjury, I declare that I have examined this return and accompanying schedules and statements, and to the best of my knowledge and belief, they are true, correct, and complete. Declaration of preparer (other than taxpayer) is based on all information of which preparer has knowledge.”
The tax return could have many pages. Many items are difficult to understand. However, there are some steps that taxpayers could take to ensure that their return is accurate by reviewing and asking questions relating to certain items.
Taxpayers who received two W2s or more may not have all W2s accounted for because some preparers would not report the correct income to affect the earned income tax credit and other credits. Meanwhile, the IRS received all of them. They could have a fraudulent Schedule A, Schedule C on their returns. It is easy to discover inflated expenses on the Schedule A and the Schedule C. Self-employed taxpayers (Schedule C) might not have the correct income reported. When the total gross income does not match that from the 1099-Ks or other 1099s, it is a red flag for audit. If you reported gross income without expenses, it is also a red flag because the income reported affects the earned income tax credit amount.
In Memorandum 200022051, the Internal Revenue Service Office of the Chief Counsel advised tax professionals that they should know that all expenses must be deducted.
Taxpayers who claimed to be real estate professionals must pass the three-parts test for losses to be fully deductible: 1) spending more than half personal service in real property trades or businesses- log of business activities is key, 2) 750 Hour Rule – must perform at least 750 hours annually, and 3) material participation– taxpayers could meet this test in several ways as described by the code and regulations. A taxpayer would not pass the active participation test when he or she owns less than 10% of the real estate business. Grouping of activities under IRC section 469 and relevant regulations provide a remedy.
Partners and shareholders should keep track of their basis in their partnership or S corporation. Amount of Paycheck Protection Program loans (PPP) that are forgiven are classified as tax exempt income and it increases the basis of the partners or shareholders. They should inquire about the classification of any income received, whether it is distribution of capital (basis) which is not taxable or net income from the profit, a taxable event. Reasonable compensation is another audit target because shareholders would take a lower salary to minimize their FICA taxes and employment taxes. In these cases, the IRS could determine a reasonable salary and penalize the shareholders. The IRS could also reclassify income when it could be concluded that income is disguised as distribution. Partners and shareholders should review their schedule K-1 for accuracy.
Taxpayers must be able to substantiate their income and expenses. Expenses that could not be substantiated are usually disallowed. Most financial transactions have some tax implications. Careful tax planning strategies help to save in taxes. Tax laws and regulations constantly change. As a result, a tax planning strategy should be constantly revised to adapt to the changes in tax laws and regulations.
The Internal Revenue Code in Section 6662(a) and (b)(1) imposes an accuracy-related penalty equal to 20% of the amount of any underpayment of tax that is due to the taxpayer’s negligence or disregard of rules or regulations. An underpayment is generally defined as the difference between the tax imposed on the taxpayer and the tax reported on the tax return. Section 6662(a) imposes an accuracy-related penalty on taxpayers on the theory that the petitioners’ underpayment of tax was due to negligence.
The Internal Revenue Code provides an exception in Section 6664(c)(1) to the imposition of a penalty, if it is shown that there was reasonable cause for the underpayment and the taxpayer acted in good faith.
The IRS and the Courts apply a three-parts test established by the Third Circuit Court of Appeals in Neonatology Assocs. P.A. v. Commissioner to prove reasonable cause and good faith. For reliance on the advice of a professional tax adviser to constitute reasonable cause and good faith, a taxpayer must prove that:
- The adviser was a competent professional who had sufficient expertise to justify reliance,
- The taxpayer gave the adviser the necessary and accurate information, and
- The taxpayer actually relied in good faith on the adviser’s judgment.
- Internal Revenue Code Section 469.
- Treas. Regs. section 1.469.
- Revenue Ruling 56-407, 1956-2 C.B. 564
- Publication 4717- Help Your Tax Preparer
- Internal Revenue Code Section 6662(c)
- Treas. Regs. section 1.6662-3(b)(1)
- Neonatology Assocs. P.A. v. Commissioner, 115 T.C. 43, 99 (2000).
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