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Dear Harley the Dawg,

I just got a divorce and my ex-husband is giving me $50,000 from a CD we had together. Do I have to pay taxes on that? If I do, I’m gonna be hella mad.

Judy

This article has been excerpted from Taxpertise: The Complete Book of Dirty Little Secrets and Tax Deductions for Small Business the IRS Doesn’t Want You To Know, available from Entrepreneurpress.com.

Dan, a new client, arrived at my office for his tax appointment. He had dutifully filled out the tax organizer I had mailed to him. His penmanship was like a draftsman’s–perfectly aligned, square, and consistent.

I flipped to the first page of data. Dan had copied every figure from every box of his W-2 onto the organizer despite my telling him he needn’t do that. Just give me the W-2; no need to do any copy work. And, like most tax pros, I prefer to work from the document itself. The numbers written onto an organizer could possibly be transposed or illegible. Hey, no problem. Lots of folks like to mark up the organizer; I just hate to see them go to all that extra work.

I flipped a few more pages and found that Dan has a side business as a computer consultant. He has a home office and travels quite a bit to his clients’ places of business. I turned to the home office worksheet, and lo and behold, Dan had actually prorated his mortgage interest, insurance, property taxes, and utilities between personal and business use of the home. Poor guy. Another waste of time since the tax software does that for me automatically.

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When I turned to the section regarding business use of the automobile, my eyes bugged out. You’d think I’d found a black widow squashed onto the page. What I saw was something I had never seen before and have not seen since: A complete six-page mileage log detailing to the tenth of a mile every destination by date for the entire year. Beside it was listed Dan’s actual expenses, including gas, vehicle registration, repairs, insurance, and auto loan interest. He listed his grand total mileage, his commuting mileage, his personal mileage, and his business mileage.

Absolutely amazing.

It is rare for a client to list his automobile expenses because most clients don’t track their costs during the year. Rare for a client to even know his total mileage. But to show every expense plus attach a mileage log with so much detail wasn’t just rare–it was a once-in-a-lifetime event. With any other client, even the most anal retentive of the lot, the page is usually blank. And it’s typically accompanied by this conversation:

Me: So, Bob, did you use the van this past year in your mobile repair business?

Bob: Yep.

Me: So how many miles did you drive, Bob?

Bob [His head rears back and his eyes dart skyward as though the answer were inscribed on the ceiling. In fact, I think it would be great fun to take a marker and write “19,497” right up there above the client chairs.]: Uh, I don’t know. Probably about the same as I did the year before. How many miles did I drive then? Whatever it was, add another thousand.

As if mileage inflation ran side by side with economic inflation. Dan was the client from heaven by comparison. All I could do was stare at the mileage log. Dan shifted in his seat and cleared his throat.

I finally picked up my jaw from the desktop and closed my mouth. Where did I put that box of gold stars? I wanted to offer Dan a job. What else do you do with someone like that? I mean, there would be no lost files, ever. Every client conversation would be documented in great detail. Every figure on a tax return would be backed up by tapes and logic and citations of tax code and photographs and schematics. He would be the perfect employee. I wouldn’t have to spend years carrying on about the importance of documentation. He already got it.

It was either that or ask him what the hell is wrong with him. Find out if he was being treated for obsessive-compulsive disorder and, if so, did he remember to include a deduction for his meds?

I didn’t do either. I simply prepared Dan’s taxes and have enjoyed a smooth and steady business relationship with him ever since.

Naturally, Dan never got audited. So I never had the pleasure of making an IRS agent’s eyes bug out the way mine did.

The funny thing is that what Dan brought me is exactly what the IRS wants. Or so then say. IRS regulations dictate that if you are using a vehicle for business purposes, you must keep a contemporaneous mileage log, which means you’re supposed to mark down your mileage as it occurs. That’s what Dan did. Dan and Dan alone in the entire country, in the entire universe, if in fact they have taxes on other planets.

The IRS can require us to keep logs all it wants. Just like our parents required us to make our beds and be home by ten and not hit our siblings. But let’s get real. Dan is the only guy out there who does this. The rest of us don’t have the time or inclination for this busywork. Like we’re really going to stare at our odometers and mark down “.8” every time we have to run over to the office supply store. As small-business owners, we’re spending our time changing hats and putting out fires. No time for crayons and clipboards. Sorry.

For that reason I will not lecture you about keeping a log. I know you won’t do it. Even if you make it a New Year’s resolution and you’re gung ho, I’d bet you dollars to martinis that by January 15, you’ll be off the wagon.

It’s damn near impossible to keep up that good habit. Well, guess what? IRS agents are reasonable human beings and most of them agree with me—no one’s going to keep a damn log. Every IRS agent I’ve dealt with over the past 25 years, even the most hard-boiled of the lot, the ones who have the look of disdain down pat, the perfected eye roll, the smug eyebrow raise, even they have agreed to allow reconstructed logs.

Unless you’re Dan, here’s what you should do: First off, even a reconstructed log needs a starting point. It’s very simple. Write your beginning odometer reading in your appointment book on January 1, and in bright red, mark “odometer:” on the December 31 page so you remember to record the ending reading at year-end. Now subtract one number from the other to find out your total mileage. It looks so much more believable and accurate to see 14,823 on the tax return under total mileage than it does to see 15,000, which is a dead giveaway that the student hasn’t done her homework.

Try as much as possible to note all business meetings, errands, and other business vehicle travel in your appointment book. In fact, if you can do it, track both business and personal miles for a two-week period every quarter. Keep the info in your tax file for use at year-end to determine the ratio of business versus personal use.

Provide the total mileage figure and business mileage to your tax pro.

Some people think they can get away with writing off 100 percent of their only vehicle for business. All they are doing is tempting fate. Bob is one of those. Remember him from a couple of pages ago? He’s such a bad boy; he keeps no records. Here’s the rest of our conversation:

Me: OK, Bob. So how much of the mileage would you say is personal?

Bob: Oh, I don’t have any personal mileage at all.

Me: But Bob, you don’t have another vehicle.

Bob: Oh I know. But all my miles are all business.

Me [Heavy sigh.] We go through this every year.]: But Bob, you certainly must go to the grocery store or have a girlfriend somewhere.

Bob: I do grocery shopping on the way home. And my girlfriend Susie? She does all the estimates and paperwork.

Me [eye roll]: Right. What about weekends? Don’t you have 49ers season tickets?

Bob: Yep, but that’s a business expense, too.

Me: OK, Bob, whatever. Fine.

Bob thinks I’m going to give him 100 percent. But he’s wrong. I know that old van is not 100 percent business use. So I knock off some points when he isn’t looking and figure we’re pretty square with the IRS.

So what is business mileage? First of all, you cannot deduct commuting. So forget about driving from home to your primary business location or from home to your first client. An exception is if you are self-employed and have a qualified home office. Your commute would be defined as travel down the hall or through the yard to the space that serves as your office. Once you are in the office, then every destination to which you travel to carry on business is considered business mileage.

See the logic? After all, if you have a regular job, you never deduct your commuting mileage against your W-2 wages. Once you get to work, if your boss requires that you use your vehicle for business travel, mileage for which you are not reimbursed is deductible.

You may also deduct travel between jobs. If you have two employers, you can deduct the mileage for travel from job No. 1 to job No. 2. Just don’t stop at home first. That will blow the deduction out of the water.

I often walk from my home office to the post office and sometimes to nearby client offices. On one such walk, I wondered how audacious it would be to write off my shoes. Maybe I’d have to keep pedometer readings in my appointment book to substantiate business use. Hey, why not? I bet, however, that my Manolo Blahniks wouldn’t be considered an ordinary and necessary business expense. The IRS would likely reduce that write-off to what one would spend for a pair of hiking boots, if they allowed the deduction at all. I can hear the auditor now: “You of all people should know better.”

If your vehicle is used 100 percent for business–say it’s a utility truck, a dump truck, a delivery vehicle, or a second vehicle devoted to business–and there’s no personal use, you must still keep a mileage log.

To determine the business-use percentage for a mixed-use vehicle, divide the business miles by the total miles driven, for example, 7,000 (business miles)/10,000 (total miles) = .70, or 70 percent.

Now that we’ve established the percentage of business use and the total miles and business miles driven, let’s put them to use. You need to determine if you are going to use the IRS standard mileage rate or actual costs.

You cannot use the standard mileage rate if:

your business provides cars for hire (limo service, taxi, etc.);

you have a business that has five or more vehicles being operated at the same time;

you are a rural mail carrier who has a qualified reimbursement plan; or

you are using an employer-provided vehicle.

If you wish to claim actual expenses, you can deduct gasoline, repairs, and maintenance (don’t forget car washes), vehicle registration fees, insurance, tires, car loan interest, lease payments, garage rent, parking, tolls, and of course depreciation, including the Section 179 deduction. Don’t forget to deduct the cost of those scented Christmas trees you hang from the rearview mirror.

Fill in the proper boxes on Form 2106 or on page 2 of Schedule C to take the deduction. If you are depreciating your vehicle, include Form 4562, Depreciation. Make sure you keep all documentation concerning this deduction in your tax file in case of audit.

And if you are audited and don’t have your paperwork together, don’t panic. Let me show you how understanding the folks at the IRS can be. A couple of years ago a new client, Spencer, came to see me. The IRS was in the middle of auditing three years of tax returns and was considering throwing Spencer in jail for tax fraud. And believe me it had a case; the tax returns he filed were as phony as Monopoly money. My firm compiled his books and created proper tax returns and a stay-out-of-jail card.

The auditor disallowed the vehicle deduction because Spencer hadn’t maintained a mileage log. I got to work and reconstructed a mileage log based on Spencer’s job files and a little help from Mapquest. The results proved his vehicle expense actually exceeded the amount he had claimed. He had likely paid cash for many of his gasoline purchases but had no receipts. I was excited!

But the auditor would not acquiesce. She had the right to deny the deduction because he did not keep a contemporaneous record. I argued that most auditors understand and accept reconstructed records, even reasonable estimates. “Oh c’mon,” I said, “He’s a contractor. He’s got a truck. I mean, duh, he’s got vehicle expense. You should allow something. It’s only fair.”

Finally, the reason for her stubbornness was revealed. The auditor uses her own vehicle and is forced to keep a mileage log so the IRS will reimburse her. And by golly, if she has to keep a log, then everybody else has to. Well, I finally wore her down and she accepted the reconstructed log and 100 percent of the deduction.

I know I have just relieved your mind. However, I’m not going to let you rest easy. Even though my clients and I have had good experiences dealing with the IRS when it comes to vehicle expense, bear in mind that the IRS does not have to accept reconstructed logs. And in our current political climate, when more tax revenues are required to pay for ever increasing government spending, economic bailouts, wars, and such, the IRS may decide to become stricter. You may find yourself walking out of an audit with a big tax bill because you didn’t keep a mileage log.

So go clean your room, quit hitting your sister, and at least mark your annual beginning and ending odometer readings in your appointment book.

Bonnie Lee is an Enrolled Agent (E.A.) admitted to practice at all levels within the IRS representing tax payers in all 50 states. She founded Symmetry Business Services to represent taxpayers in audits, offers in compromise, tax problem resolution and to help non-filers safely reenter the system. She has served as a champion to taxpayers for more than 25 years. She is the author of Taxpertise: The Complete Book of Dirty Little Secrets and Tax Deductions for Small Business the IRS Doesn’t Want You To Know, available from Entrepreneurpress.com

Whether your business is small or large, incorporating is a worthy consideration under Obama’s new administration. Many think of Obama’s administration as small business friendly, however, there is a new mandate to close the $400 billion tax gap and empower the IRS to get every penny it is entitled. Now, more than ever, small business owners need to consider the concept of adding, “Inc.” to their name.

I often advise clients to consider incorporating their business once profits reach a steady $100,000 plus per year. Beyond the tax consequences, the legal aspects of incorporating should be discussed with one’s attorney. The tax consequences, as well as the ability to function within a more restricted structure, should be discussed with one’s tax pro. Employee benefit packages and retirement plans should also be studied for comparison with existing strategies.

Income Splitting

When it comes to the income tax picture, income splitting is the primary reason to incorporate as a C Corporation. As a sole proprietor, you are the business. You declare your sales and subtract business expenses on Schedule C of your individual income tax return. Then you pay both income taxes and self-employment tax (15.3 percent) at the individual level.

By incorporating as a “Sub S Corporation,” no tax is paid at the corporate level and all income flows through to your personal income tax return. Since the self-employment tax does not apply to dividends, you will also enjoy some tax savings.

Incorporating gives birth to a legal entity which will exist at arm’s length from your personal finances. If structured as a C corporation, this entity files its own tax returns and pays its own taxes.

Americans enjoy–using the term loosely–a progressive tax system, in which the more you make, the higher your rate and the more you pay. So if your income is cut in half and allocated between your C Corporation and your individual income tax return, you are likely to save a lot of money. You pay taxes on this income at the individual level when you draw income from the corporation in the form of wages, dividends, rents, etc. There may be other non-taxable forms of income, such as employee benefits and expense account reimbursements.

For example, the net profit after paying yourself a reasonable wage, is $100,000. You take a qualified dividend of $50,000 which is subject to a tax rate of 15 percent through 2010. The C Corporation pays corporate tax on the remaining $50,000 at a rate of 15 percent and you have no self-employment tax to worry about. The overall tax rate is 15 percent.

Same scenario but the business is set up as a sole proprietorship: Your tax liability would be about 25 percent on a profit of $100,000 plus an additional 15.3 percent for self-employment tax to fund your social security. Ouch!

Since you are taking wages from the corporation, the 15.3 percent self-employment tax rate will be built in to your withholdings and the employer’s matching share, all classed as payroll taxes, which is a write off at the corporate level. When a sole proprietor pays the self-employment tax, she cannot write it off as a business deduction.

Obama’s tax plan and new tax rates on those making more than $250,000 per year will be affective in 2011. Using income-splitting techniques these higher tax rates can be minimized.

Protection from the IRS

If a C Corporation gets in income tax trouble, the IRS can only go after corporate assets. Like any litigator, they may attempt to pierce the corporate veil, and tap into your personal assets. So make sure you follow the rules.

“There is no personal liability for corporate income taxes unless there is a liquidating dividend or the shareholders fail to maintain clear delineation between corporate finances and personal finances,” says Robert McKenzie, tax attorney for Arnstein & Lehr LLP. He added that if the company is operated properly and not a single member LLC treated as a C Corporation for income tax purposes, there is no personal liability for corporate income taxes.

But look out! If the C Corporation has an unpaid payroll tax liability, the IRS can hold you personally liable.

Why is this so important? Because the “newer and friendlier IRS” has left the building. Obama sees the $400 billion tax gap–unpaid tax liabilities, projected lost tax revenue due to nonfilers, cheaters, and the underground economy–as a potential source of revenue. His mandate to IRS Commissioner Doug Shulman is to “Sic ‘em!” So the IRS is retraining their keypunch staff (don’t need all those clerk typists now that more than 70 percent of the nation is filing electronically) for enforcement positions. The IRS is also adding an additional 3,500 positions in all areas of enforcement from audit personnel to special agents.

With this rocky economy, it might be wise to have a suit of armor to protect your personal wealth.

Consider these factors along with all the issues that pertain to your individual situation. Then sit down with your tax pro and your attorney to determine if incorporating your business is a logical next step.

Bonnie Lee is an Enrolled Agent admitted to practice and representing taxpayers in all fifty states at all levels within the Internal Revenue Service. She is also the author of Taxpertise: The Complete Book of Dirty Little Secrets and Hidden Deductions for Small Business that the IRS Doesn’t Want You to Know, from Entrepreneur Press. Follow Bonnie Lee on Twitter @BLTaxpertise or email her at bonnie@taxpertise.com. Live stream her radio show every Tuesday at 1:00 PST by going to KSVY.org and clicking on Listen Now.

This article has been excerpted from Taxpertise: The Complete Book of Dirty Little Secrets and Tax Deductions for Small Business the IRS Doesn’t Want You To Know, available from Entrepreneurpress.com.

The IRS will never tell you why a particular tax return is under audit. However, there are certain factors that make it obvious why a tax return was selected.

What Triggers an Audit?

Following is a comprehensive list of things that can trigger an IRS audit:

Failure to include income that has been reported to the Internal Revenue Service

During the month of January, you receive tax documents in the mail declaring income and certain expenses that relate to your tax return. For example:

1099-INT declaring the amount of interest income you’ve received from various sources including banks and investment companies

1099-DIV declaring the amount of dividends you have been paid on your investments

1099-MISC for work as an independent contractor and for rental income from tenants of your commercial properties

W-2s and K-1s

The Internal Revenue Service receives this same information. When you file your tax return, the IRS plays a matching game to ensure that you have declared all of this income on your tax return. If you have not, the IRS will recalculate your tax liability and bill you accordingly. Also considered an audit, it’s basically a by-mail correction notice that is open to dispute.

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Severe departure from the national standards

The IRS has a construction of tables, available on its website at irs.gov, that indicate by income level and if self-employed, by industry, an average of deductions taken in any given tax year. If your numbers are significantly different than the national averages, you may find your tax return up for scrutiny. Red flags include vehicle expense; charitable contributions, especially noncash ones; meals, entertainment, and travel; and excessively high cost of goods sold.

Dramatic change in income and expenses from one year to the next

You may experience a financial downturn that throws you into a loss situation. The IRS may audit just because it is interested in what happened and whether or not you are hiding income. Or if your income suddenly increases, the IRS may be suspicious that you cheated in the past and are now coming clean.

Lifestyle

Lifestyle audits are supposedly a thing of the past. But come on, you know that lifestyle comes into play. I mean, if you are living in a Beverly Hills mansion, with mortgage interest of $200,000 per year, paying DMV fees on a Ferrari, and making charitable contributions of $50,000 each year, then your tax return had better show more than $36,000 of wages from Oil Changers, right? These incongruities will flag your tax return for audit.

Industry

Specific industry audits are a continuing IRS project. Every year the IRS selects a particular industry to audit. In recent history it has selected wage earners with a small Schedule C business (looking to blow hobby losses out of the water), attorneys incorporated as S corporations (looking at unreasonable compensation in order to add payroll tax liabilities), and trusts with offshore holdings (looking for tax fraud and unreported income).

Bonnie Lee is an Enrolled Agent (E.A.) admitted to practice at all levels within the IRS representing tax payers in all 50 states. She founded Symmetry Business Services to represent taxpayers in audits, offers in compromise, tax problem resolution and to help non-filers safely reenter the system. She has served as a champion to taxpayers for more than 25 years. She is the author of Taxpertise: The Complete Book of Dirty Little Secrets and Tax Deductions for Small Business the IRS Doesn’t Want You To Know, available from Entrepreneurpress.com

When you’re self-employed filing a Schedule C with your tax return, your chances of being audited are greater than if you were a wage earner. Why? Because the IRS suspects that you will attempt to either hide income or write off personal expenses as business deductions. So when they select tax returns to audit, they cast the net wider and rake in 1.5% of self-employed folks versus 1% of W2 employees.

Here’s how you can keep them off your back:

Use a professional software accounting system. Your credibility increases in the eyes of an IRS agent if your tax return is based on professionally prepared financial statements, especially if maintained by an outside firm. You can use the same software to track your personal income and expenses as well.

Document sources of all income. If you are audited, the first thing the IRS agent will do is add up all of the deposits from your personal and business bank accounts. If more money went into the bank than was declared on your tax return, the IRS will want to know where the money came from and whether or not the income is taxable. If you use QuickBooks for your personal and business books, you will automatically tie out this income. But you still need proof. If the income you record is not taxable, e.g. gifts, inheritances, loans, transfers from personal funds, then keep a copy of the check or document that accompanies the income.

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Let a professional prepare your income tax return. Self-prepared returns are more likely to be audited because the IRS believes that a nonprofessional has limited knowledge. Besides, you may find that the fee charged by an Enrolled Agent or CPA might be wiped out by the added deductions they spot for you. Tax law is complex. There are more than 14,000 pages of tax code. And if you are self-employed, no matter how small your business, your tax return is now a complex creature.

Rethink your legal form. Corporations, LLCs, and partnerships are less likely to be audited. But that should not be the sole reason to incorporate. Discuss this option with a tax professional and your attorney before deciding.

Document red flags. You are allowed to deduct all ordinary and necessary business expenses. Would you make this purchase if you didn’t have this business? If the answer is no, you probably have a deductible business expense. But it’s important to know the rules and to have proper documentation to justify the deduction. Some expenses receive considerably more scrutiny than others.

Automobile expense is a favorite area the IRS explores. Taxpayers are required to keep a mileage log, however, I have met only one client who ever did. There are ways to substantiate mileage deductions without presenting an auditor with a mileage log. Be sure to record your beginning and ending odometer reading in your appointment book on Jan 1 and again on Dec 31. If you use an appointment book or calendar, a mileage log can be reconstructed from those pages and total mileage for the year can be extrapolated from odometer readings recorded on vehicle repair receipts.

Travel, meals and entertainment are close runners up to automobile expense when it comes to scrutiny. Go to www.irs.gov and read publication 463 to determine what you can and can’t deduct. Then document the hell out of it.

Vacation destinations like Las Vegas or Hawaii should be documented with more than purchase receipts to prove business intent. Keep flyers advertising the trade show, the seminar or letters from prospective clients at that location on file to prove the validity of the deduction. If entertaining, make sure to make notes on receipts for meals and entertainment mark with name of the person entertained and a brief description of the business purpose.

More people telecommute and work from home offices than ever before. So while it has become the norm, the IRS still likes to pick this deduction apart. Take photographs of the house and the office area. This will serve two purposes: It will show the proportion of the business area versus the personal living area to substantiate the amount of space claimed and it will show that there is in fact a business area. The rule is that your home office must be your principal place of business, used exclusively and on a regular basis for business purposes.

Bonnie Lee is an Enrolled Agent admitted to practice and representing taxpayers in all fifty states at all levels within the Internal Revenue Service. Lee founded Symmetry Business Services in 1982 to represent taxpayers in audits, offers in compromise, tax problem resolution, tax preparation, tax planning, and to help non-filers safely re-enter the tax system. As an outgrowth of her work with her growing clientele and her dedication to demystifying taxes for real people everywhere, Lee launched the Taxpertise ™ seminar program, her Taxpertise ™ radio show on KSVY radio in Sonoma County, California and her upcoming (July, 2009) Entrepreneur Press book, Taxpertise, The Complete Book of Dirty Little Secrets and Hidden Deductions for Small Business that the IRS Doesn’t Want You to Know. Follow Bonnie Lee on Twitter @BLTaxpertise or email her at bonnie@taxpertise.com . Live stream her radio show every Tuesday at 1:00 PST by going to KSVY.org and clicking on Listen Now.

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©2017 Taxpertise | Bonnie Lee, E.A. | Ph: 707.935.1755 Fax: 707.938.1891 | 453 2nd Street West, Sonoma, CA 95476