Royal Financial

⏱ Estimated reading time: 10 min read

Due to the CARES Act signed into law on March 27, 2020 the federal and state governments have extended tax deadlines to July 15, 2020. As such, this post will discuss a list of things you, and your tax preparer, should consider when filing your 2020 tax returns. The list isn’t meant to be exhaustive but meant to hit some IRS focus areas.

1. Failing to Report All Taxable Income
   1. The IRS gets a copy of 1099s and W-2s, which can create an automatic (and frankly unnecessary) audit. Note, if you believe the figures are incorrect, you need to tell those who sent them to you and have a corrected version sent out.
2. You are a Rainmaker (Make a lot of money)
   1. Odds of an audit increase as income goes up (partly because you probably have the money to actually pay)
   2. If you make $1mm+ your audit rate goes up to a 1/31 chance (~3.2%). 
3. Being a Cowboy (Higher-than-average deductions or credits)
   1. Disproportionate deductions when comparing to income. Note, if you have the proper documentation for your deduction or credit, don’t be afraid to claim it. Don’t ever feel like you should pay more tax than you owe.
4. Large Charitable Giving
   1. Again, if you have the documentation by all means take it, BUT know the IRS has an idea of the average charitable donation at various income levels. “They”, being the IRS, have a view of millions of returns, while you are only focused on yours.
   2. Best practice: Keep your receipts or email confirmations, as applicable.
   3. If donating non-cash items, have documentation and make sure you are filing Form 8283 as necessary.
5. El Jefe (Schedule C because you are your own boss)
   1. Schedule C is a hot spot (think Covid in NYC) for tax deduction for people who are self-employed. As a result, it is also a gold mine for IRS Agents to pick things apart (think Thanksgiving and the cops waiting at the corner for drunk drivers). 
   2. The IRS looks at high and low earners here. Cash and non-cash. If you are making a lot and showing big losses, consider yourself next on the “IRS Agent May be Right”. 
   3. Think about it. If you are filing Schedule C you are funding the business. So if you are taking losses, that is a direct line to a reduction in your personal wealth. Again, if you have the proper documentation for your deduction or credit, don’t be afraid to claim the deductions.
6. Rental LOSSES (LARGE ones)
   1. There are rules that generally prohibit landlords from deducting rental losses, with some exceptions (Active Participation or considered a Real Estate Professional). 
   2. The IRS scrutinizes these because (1) the general idea is to have passive income not a loss when you are renting property and (2) if you are a Real Estate professional or Actively Participating, taking large losses is sort of not great for your real estate reputation.
7. About that hobby of yours
   1. If you are consecutively reporting losses on Schedule C for arts and crafts, or whatever, the IRS may consider this a hobby. 
   2. The idea is you are showing wage income and you are using a year of Schedule C losses to offset income. 
8. Business Meals & Entertainment (M&E)
   1. Auditors will look at large M&E charges taken on Schedule C. Agents are looking for personal meals disguised as business meals.
   2. Must keep receipts for expenditures over $75
   3. Further, TJCA removed the ability to deduct any entertainment expenses (golf fees and sports tickets).
9. 100% business use of vehicle
   1. Agents know it is rare, in some cases, for a vehicle to be used for business 100% of the time, especially if you have kids or are married.
   2. Auditors will take eye at heavy truck or SUV purchases, especially purchased late in the year. Make sure to keep detailed logs and precise entries for every road trip. Sloppy recordkeeping makes it easy for the IRS to disallow deduction.
10. Claiming the American Opportunity Tax Credit
    1. Student must be in school at least half-time
       1. Worth up to $2,500 for each of the first four years of college
       2. Based on 100% of the first $2,000 spent on qualifying college expenses and 25% of the next $2,000
       3. 40% of credit is refundable (you get it even if you don’t owe tax)
       4. Phase-out begins at $80,000 and $160,000 for single and MFJ filers, respectively
    2. The IRS focuses on people trying to take the credit for more than 4 years.
11. Health Premium Tax Credit
    1. Helps individuals, with household income between 100% to 400% of  federal poverty level, purchase health insurance purchased through marketplace
    2. Not for those who receive Medicare, Medicaid, other federal insurance, or  able to get affordable health coverage through their employer.
    3. Credit is calculated through Marketplace (healthcare.gov) and credit can be applied in advance.
    4. The IRS looks for people who receive the advance and don’t file returns or mistakenly report the credit.
12. IRA and 401k EARLY withdrawals
    1. Payouts before age 59 ½ are subject to a 10% penalty and regular income tax, unless an exception applies.
    2. Click here for the list of exceptions.
    3. IRS study showed that 40% of these audits resulted in the taxpayer making an error. In other words the cost-benefit here is worth it to the IRS.
13. Alimony Deductions
    1. TCJA enacted by Congress in 2017 permanently eliminates the deduction for alimony for those who get divorced in 2019 and going forward
    2. On the flip side, the recipient doesn’t pick up the payment as income.
    3. Two key items here (1) agreement can’t say that payment is NOT alimony and (2) payments must end when the former spouse dies. 
    4. The IRS knows the rules are complicated so they know that some filers that claim the write-off don’t satisfy the requirements. Further the IRS is changing Schedule 1 to require the date of the divorce separation agreement.
14. Letting it Ride! (Gambling Losses & the Risks)
    1. Gambling winnings are taxable to the taxpayer (in some cases, the winnings are reported to the IRS on form W-2 by the gambling institution/site)
    2. Losses are deductible on Schedule A, which means you have to itemize. 
    3. The key here is losses can only be written off to the extent of winnings for BOTH (1) recreational and (2) professional gamblers. Further, losses not utilized in one year CANNOT be carried forward.
    4. The IRS is looking at returns of filers who report large losses on Schedule A from recreational gambling, but aren’t including all winnings income. Further “Professional gamblers” reporting large losses on Schedule C will receive extra scrutiny. 
    5. To clarify, neither recreational or professional gamblers can report a net loss for the year. The losses can only be taken to the extent of winnings.
    6. States may not let you offset your income with losses.
15. Chich-and-Chong and the Marijuana Business
    1. Weed is still federally illegal, which poses a lot of problems including taxes and holding bank accounts.
    2. Federal statute prohibits weed businesses for deducting anything but the cost of marijuana, even in states where it’s legal to sell, grow and use pot.
    3. If the IRS sees any deduction for anything but the deduction for the cost of weed, the IRS can disallow the deduction.
16. Rogue Traders
    1. Day Traders and Professional traders have the benefit of (1) fully deducting expenses on Schedule C pertaining to the taxpayer (not the investor) and (2) profits are exempt from Self-Employment tax (15.3%). 
    2. Traders can make a special 475(f) election deductible as ordinary losses that aren’t subject to $3,000 cap on capital losses. 
    3. The IRS is looking for people who claim they are a trader, but are really an investor. To be a trader, you must buy and sell securities frequently and look to make money on short term swings in prices. Further, this needs to be continuous. 
    4. If you aren’t a day trader click here for information how the TCJA impacted your expenses.
17. Cryptocurrency Trading
    1. The key here is reporting. This crypto thing really blew up over the last years with no real way for the IRS to track the large sums of income made on the bubbles (or high’s if you are optimistic). 
    2. This has to be reported on Schedule 1 now. 
18. “We only take cash!”
    1. The IRS gets reports of cash transactions in excess of $10,000 from banks, card dealers, casinos, and other businesses. Banks can also provide any suspicious activity such as transfer from or to foreign accounts OR transactions that are just under the $10,000 threshold.  
    2. Further, PayPal (including Venmo) have reported certain transactions to the IRS when there are 200+ transactions or more than $20k moving around. 
19. That Swiss Bank Account
    1. The IRS is a watchdog and they want to know where you have money, in or out of the country. This can help the IRS identify transactions that may be hidden for (1) income tax purposes or (2) other purposes (illegal activity or dealings with not so desirable people and/or institutions). There is even more pressure applied on US banks for Anti Money Laundering (AML) and Know Your Customer (KYC) laws set in place.
    2. Failure to report foreign bank accounts will result in penalties. 
    3. Reporting is done electronically using FinCen Report 114 (FBAR) by April 15th (there is an automatic 6-month extension if you miss the initial deadline) for any taxpayer who has had $10,000 in total combined foreign accounts at ANY time during the tax year.
20. Foreign Earned Income Exclusion
    1. US Citizens who work overseas can exclude up to $105,900 in 2019 for income earned abroad if they are (1) bona fide resident of another country for the entire year OR (2) the taxpayer was outside the US for at least 330 complete days over 12-months AND (3) the taxpayer has a tax home in the foreign country. One caveat is if your firm is paying for housing, this doesn’t apply.
    2. The IRS is looking for people who are erroneously claiming this break. The IRS can look at bank activity to identify where money is being spent. To be honest, with technology now they can probably use things like social media. 

Summary

If you are a taxpayer filing your own return, a tax preparer, or a friend just helping another friend out it is worth your time to skim through this list. It can identify potential issues that you didn’t previously consider. At the very least it gives you an idea of the defense (IRS) and what they are looking to do. 

Disclaimer: The information provided herein is intended solely for informational purposes and no person(s) or other third-party may rely upon it as financial, tax, or legal advice or use it for any other purposes. As a result, Royal Financial, and any affiliates, assume no responsibility whatsoever to readers, or any other persons for that matter, as a result of the information contained herein.