During An IRS Audit, What Do The Auditors Look For?

There’s nothing more stressful than getting that audit letter in your mailbox. IRS audit is time-consuming and could be nerve-wrecking as well. Over my career, I’ve taken multiple business and individual clients through IRS audits with no adjustments made to books or tax returns. I’d like to share a few pointers from my own experience:

I got audited, but why me?

Almost all IRS agents told me the same thing: IRS has a complex algorithm that compares your tax return data with the “curve” or “pattern” they have in their system (information gathered from “big data”) and checks for reasonableness. However, I have noticed that you are more likely to get audited if you check one or more boxes from below:

• Choppy trend: Hitting a great year, followed by a terrible one, and then hitting it out of the ballpark again - This won’t put you on the board 100% but certainly raises a red flag. Presenting a healthy and stable trend is generally recommended, unless there is genuinely an extraordinary event, for example, natural disasters, pandemics like COVID-19, etc.

• Big top line but running a loss: Sounds suspicious already, right? Be prepared to have reasonable explanations and documentations in line to pass this one.

• Making too much: Net income over $1mm is typically a good indicator that you’re “making too much money”. Simply put, IRS hopes there’s something in it for them to spend the time and resources on an audit. It’s just more likely for them to get something out of it if they know you have the $$$.

What do auditors look for?

• Process walkthrough - IRS agents ask a lot of questions, which can be intimidating. What they’re trying to do here is to understand your business process - how do you get new customers? How does a lead become cash in your bank? Based on what you said, is it possible for you to miss or under-report your income? These are all important assessments being made in this part of the audit.

• Bank activities - Does your income match all the deposits? Did all the activities foot? Was there commingling of funds between business and personal? I always advise my clients - if you don’t want IRS to open additional audits based on results from one initial audit, keep your business and personal expenses separate, and always keep a clean paper trail.

• Major spendings - Be prepared to present documentation for major spendings and provide comments. My clients always ask me: if I don’t have the receipts, does it mean IRS won’t let me take the deduction whatsoever? The answer is, it depends. For example, if you didn’t have the receipts for $30 charged by Uber, but you have documented on your credit card statement, that this is the trip when you went to LA for a conference, accompanied with conference related plane tickets and lodging details, there’s a good chance the IRS will allow it. However, you don’t want to push the rules - we all know that Nintendo you bought serves no purpose in your jewelry crafting business.

• Contractor payments - Definitely a big area. IRS agents typically ask for agreements with specific service terms, work reports and related documentation to help determine the legitimacy and compliance of the contractor payments. Were W9 and/or W8-BEN collected? Were Forms 1099 filed?

• Sample tests - If your business is on the larger scale, instead of going through all transactions, it is not uncommon for the IRS agent to sample a few transactions deemed significant or representative to form an opinion on overall financial integrity. For example, they may ask you to provide PO records from key customers, POD (proof of delivery) if you sell goods, etc.

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Capital Gains Tax on a House Sold From a Trust

Source: The Motley Fool

Figuring your tax liability is more complicated when you don't own a home in your own name. Most people don't think much about capital gains tax on the sale of a home, because the tax laws offer a capital gains exclusion of $250,000 to single filers and $500,000 to joint filers when they sell their main home. However, some people use estate planning strategies involving trusts to own their homes, and understanding the effect of having a home within a trust is crucial to make sure that you don't miss out on this key tax break. Below, we'll go into more detail about how to calculate capital gains tax on a house sold from a trust.

The key question: What kind of trust owns the home?

The tax laws treat various types of trusts differently. One key distinction is between revocable trusts and irrevocable trusts. If you have a revocable trust, then the tax laws treat that trust as what is known as a grantor trust. What that means is that even though the trust owns legal title to property contributed to the trust, including real estate, the trust assets are treated for tax purposes as if they still belong to the grantor, or the person who put the assets into the trust in the first place.

As a result, if you meet the tests for the capital gains exclusion, then you can claim the exclusion even if you own the home through a revocable trust. In general, to get the benefits of the exclusion, you need to have owned your home for at least two out of the five years prior to the date of sale, and you have to have lived in the property as your main home for at least two out of the past five years.

By contrast, the rules are much different for an irrevocable trust. Irrevocable trusts are separate legal entities, and so transferring your home to an irrevocable trust makes it impossible for you to claim the exclusion on capital gains. The proceeds from the sale of a home within an irrevocable trust typically stay within the trust, and the trust itself owes the resulting capital gains tax on the profit. Because tax brackets covering trusts are much smaller than those for individuals, you can quickly rise to the maximum 20% long-term capital gains rate with even modest profits on the sale of a home.

However, there is one aspect of an irrevocable trust that you should keep in mind. Often, revocable trusts become irrevocable after the person who created the trust dies. If the home was included in the estate of the deceased owner, then the property will get a step-up in tax basis. That means that even if the trust becomes irrevocable after the deceased owner's death, the trust won't have capital gain if it immediately sells the home. Only if the trust holds onto the property for a time after death will new gains have a chance to start accruing.

Trusts can be complicated, so it's important to know exactly what trust you're working with in a home-sale situation. With the right planning, you can often reach a tax result that will be advantageous to you.

When in doubt, consult a trustworthy CPA! Zhong and Sanchez is dedicated to provide high-quality tax and financial reporting services to privately-held entities and small business owners. Our expertise ranges from income tax filing and accounting services to international compliance and financial analysis. Located in the Silicon Valley, you can reach us at 510-458-4451 or schedule your first free consultation today at https://calendly.com/zhongsanchez

5 Ways the New Tax Law Affects Paying for College

The final version of the GOP tax bill that passed last month rewrites the tax code in many ways, eliminating deductions and adding new benefits. Some of these new provisions affect those paying for college.

After public outcry on several provisions proposed in the House's tax bill, the Senate version that passed last month left many tax credits related to higher education untouched.

The new tax bill keeps the deduction for student loan interest. Additionally, the tuition waivers that graduate students receive will stay tax free, and other tax credits – such as the Lifetime Learning Credit and the American Opportunity Tax Credit – remain unscathed.

"A lot of things didn’t change that we were worried about changing – the taxation of the tuition waiver, the taxation of employer tuition assistance. We worried about that happening, but it didn’t end up happening," says Shannon Vasconcelos, director of college finance at College Coach, an admissions consulting firm.

But a few key changes will affect families and students who are financing higher education. Here are five new tax codes that may change a family's finances.

1. Deductions for interest on home equity loans and lines of credit are eliminated. Under the new tax legislation, the ability to deduct interest on home equity loans is suspended from 2018 to 2025.

"This one is a real big one that is a bummer for families," says Vasconcelos. "For a lot of families, it's the best interest rate – it's better than a lot of the education loan rates. A lot of families do tap their home equity to pay for college, so losing the deduction is going to cost them fairly significant money."

The new restrictive mortgage rules that cap interest on new loans to $750,000 will also "prevent many middle-income taxpayers from using home-equity loans in the future to fund college tuition, while generating tax-deductible interest," says Blake Christian, a CPA at Holthouse, Carlin, Van Trigt, a Southern California accounting firm.

2. Families can use 529 plans to pay for K-12 education. Families can now use qualified education expenses in a tax-advantaged 529 savings account to pay for elementary or secondary school tuition. The new tax code allows taxpayers to pay up to $10,000 per student per year in K-12 tuition.

But college experts caution some families against using this new flexibility with 529 accounts. Sean Moore, founder of SMART College Funding, worries that parents who redirect these funds to cover private school education may use the money too quickly and come up short for college.

Christian from HCVT says this benefit will largely help families with a high net worth.

3. Colleges and universities will pay a new excise tax on endowments. A new excise tax levies a 1.4 percent on a private educational institution's endowments that amount to more than $500,000 per student.

The new provision affects scores of private universities with large endowments, such as Harvard University in Massachusetts, the University of Notre Dame in Indiana and Stanford University in California, to name a few.

"It's going to cost these colleges money. How much is going to be passed on to students and parents – we don't know yet. The colleges are just now figuring out how to deal with this new tax," says Vasconcelos from College Coach.

4. Student loans discharged for death or disability are now tax-exempt. The new tax code makes death and disability discharges of federal and private education loans tax-free.

Previously, the debt cancellation would be added as income on to the taxpayer's bill. Now the cancellation of the student debt is tax-free. But the new tax code only applies to discharges that occur during 2018 to 2025.

"It's great for those families who suffer from those devastating effects. But the reality is the people that it helps are hopefully very small," says Moore from SMART College Funding.

5. Alimony for recipients is no longer taxable. College consulting experts say this provision should make it easier for custodial parents to qualify for need-based aid when filling out the Free Application for Federal Student Aid, commonly known as the FAFSA. For the most part, the FAFSA for college-bound students relies on parental information, such as tax records.

"Without alimony showing up on their tax returns, divorced custodial parents should be eligible for financial aid," says Joe Orsolini, president of College Aid Planners, a consulting organization in Illinois that helps families navigate paying for college. "This change will make is easier for them to qualify."

Even with this provision, the FAFSA uses tax records from the prior prior year – so there is a time gap to when this new tax code would benefit a custodial parent. But Orsolini says this should benefit these parents "unless the Department of Education catches on to this and changes the FAFSA."

Source: https://www.usnews.com/education