Avoid Tax Problems
Tax issues can cause major problems in your life. No one wants an audit, and no one wants to be fighting tax bills for years--and those consequences are relatively mild. More severe consequences include wage garnishment, civil liability, and even prison. In order to avoid the pitfalls, you have to know about good habits to get yourself into, and the red flags that they look for when they decide to investigate you.
Filing Your Taxes Correctly
- Pick the correct filing status. A person’s filing status has a huge effect on their taxes, influencing numerous deductions and tax credits. Therefore, you should determine which filing status you fall under before you do anything else.
- Single. A single filer is an unmarried filer. Although a single filer can claim dependents, other designations are usually more advantageous.
- Married filing separately. Married taxpayers who file separately tend to have two characteristics: a high income and a large amount of itemized deductions. In fact, if one spouse itemizes deductions, the other spouse cannot take the standard deduction. Under most circumstances, it is more advantageous for a married couple to file jointly, so even if separate filings are best in one year, don’t assume they will be for every year.
- Married filing jointly. Most spouses file jointly under most years. That means the couple turns in one tax return for both spouses. This tends to result in lower tax liability and access to more deductions and credits.
- Head of household. The head of household designation is reserved for unmarried caretakers of a dependent—usually a single parent. The head of household must pay more than 50% of the expenses for the dependent.
- Figure out whether you need to file. The vast majority of adults in the United States will need to file a tax return, but a minority won’t. If a person’s yearly income isn’t equal to the standard deduction plus one exemption per person, they are tax exempt. While the amount of the personal exemption is the same regardless of filing status ($4,050), the standard deduction changes.
- Single tax filers get a standard deduction of $6,300, meaning a single person making $10,350 or below is tax exempt.
- A married couple filing jointly gets a deduction of $12,600, meaning a married couple making $20,700 or less is tax exempt.
- If a filer is designated as a head of household, they can claim a deduction of $9,300, making them tax exempt at $13,350 or below.
- Choose the right type of 1040. The 1040 is the form used to file personal income taxes. The three types of 1040 are used for different types of tax situations, with 1040EZ being the simplest to file, and the regular 1040 being the most complicated.
- The 1040EZ is reserved for filers who make less than $100,000 per year, and/or have no dependents, and make less than $1,500 per year in interest income. In addition, they must be single, married filing jointly, and under 65.
- The 1040A works best for filers who make less than $100,000 per year, and/or receive income from capital gains, and adjust your income according to contributions to an IRA and student loan interest.
- You should use the 1040 if you make more than $100,000 per year, and/or claim itemized deductions, are self-employed, or claim income from the sale of property.
- Those who claim head of household status can file either the 1040A or the 1040, but not the 1040EZ.
- Figure your deductions, exemptions and tax credits. A deduction is a type of expense the IRS agrees not to count towards your income. An exemption is a type of deduction available for yourself and any dependents you may have. A tax credit is money the government gives to you. So instead of you subtracting an amount from your income as you would with a deduction, you simply get a fixed dollar amount for the tax credit. Once you have figured which deductions to claim and which credits apply to you, you will have your tax liability for the year.
- In 2016, the value of an exemption stood at $4,050 per person.
- The list of deductions are far too numerous to count here. Although most people are better off using the standard deduction of $6,300, there are people who can further reduce their tax liability by claiming an itemized list of deductions.
- Although you can find a list of deductions and tax credits at https://www.irs.gov/publications/p17/pt06.html, you’re probably better off using an electronic filing program, like TurboTax (especially if your income is from wages and you are single), and using the services of a tax preparer if your taxes are more complicated. If you make less than $54,000 a year, you can get free help from the IRS. Go to https://www.irs.gov/individuals/free-tax-return-preparation-for-you-by-volunteers to find a tax preparer near you.
- File your taxes. Once you’ve finished figuring your tax liability for the year, you only have to file the 1040 with the IRS. By far, the most popular method of filing taxes is by using the IRS’ efile system. You can efile at https://www.irs.gov/filing/e-file-options. If you feel like sending in a paper form, you can do that as well. Just print out a paper 1040.
Avoiding the IRS’ Red Flags
- Keep your home office in good working order. The home office deduction is one of the most common deductions for a filer to claim. It allows the filer to take the proportion of the house devoted to the office, subtract that portion from rent or mortgage payment, and deduct that from their income. So if your office took up half of your house, you could deduct half of your house payment from your income. But it easily raises suspicion, because it can call into question and cast doubt on many other aspects of a return.
- For example, say the house payment is $500/month and the filer has claimed four dependent children. In addition to his children, he claims half of the house as an office. Since $500/month is a really low amount for a mortgage, an IRS agent will assume it’s a small house, and if it’s a small house, then where are all these kids staying—in the office? But then it isn’t an office, it’s a bedroom with file cabinets. If the filer needs that much office space, and he doesn’t he seem to make much money from office-related work, he could be underreporting that income.
- Buy a mileage log and keep it in your car. It’s also common for people to claim mileage in a car as a business expense. It’s a permissible deduction, but also one that’s easily open to abuse, so it’s scrutinized pretty carefully. To satisfy any suspicions, put a mileage log in the car and update it every time you take a trip.
- For instance, if the “business vehicle” is the person’s only vehicle, it’s really hard to tell when business stops and pleasure begins, so they’ll want to investigate it—which can trigger an audit.
- Be conservative about meal and entertainment deductions. When travel, entertainment, and meals are for business purposes, they are deductible, but this is another area which is open to abuse, and therefore scrutinized heavily. If you claim more than $1000 per year in entertainment, you need to be very diligent about keeping track of the receipts and records.
- Make your charitable contributions by check. The IRS actually has statistical models of charitable giving divided up into income brackets, so they would know about how much a typical single man making $40,000 per year would donate to charity. So if you donate much more than your usual amount, or much more than the amount a typical person of your situation would give, that’s going to invite a closer look.
- In order to protect yourself, make sure you make your charitable contributions via check and not cash.
- Don’t go overboard with itemized deductions. If you claim more than a third of your income in itemized deductions, be prepared for an audit. It's an IRS red flag. Very few people could legitimately claim that amount of deductions, but even if they were all legitimate, it indicates a great degree of calculation on the part of the tax preparer. The level of calculation that allows a person to claim half of their income in itemized deductions invites suspicion.
Keeping Good Habits
- Make sure you file on time. Filing late opens you up to trouble in two ways. For one, you might be charged late fees and penalties. Since taxes are due on the same day every year, that makes being late bad enough. Another thing it opens a person up to is uncovering a hidden tax liability.
- For example, if a person makes a good living but files for an extension every other year, it makes them seem sloppy. Sloppy people make mistakes, and people who make mistakes get audited.
- Report all of your income. It should go without saying, but reporting all of your income is the best financial habit to get into. A lot of people think they only have to claim income from a job where they get a W-2, but that’s not the case. If you fail to declare income from a 1099 job, the IRS most likely knows about it anyway, because there’s no reason for the employer to conceal it.
- You also need to report income from odd jobs or under-the-table ventures, especially if you’re the type to make a lot of itemized deductions anyway. If there’s any discrepancy between lifestyle and tax liability, it will be pursued.
- Double check your math and your paperwork. If there’s paperwork that’s missing or mathematical errors (that come off in the filer’s favor), it makes your taxes an immediate candidate to get flagged for review by the IRS. That’s not necessarily an audit, but it’s a step on the way to an audit.
- Keep methodical financial records. Almost any issue that can trigger an audit can be explained if there are legitimate records to back it up. There’s not an option to avoid paying taxes, but it is an option to avoid tax problems, and recordkeeping does that. It shows you did what you said on your tax records. You can reduce your preparation time significantly if you organize your records and receipts. Good organization can also help you monitor the progress of your business, prepare your financial statements, identify the source of receipts, keep track of deductible expenses and support items reported on your return.
- Don’t wait until the last minute to prepare your tax returns. Procrastination can be a killer. If you wait, you may get in a rush and make some mistakes you wouldn’t normally make. If you think your return is going to be complicated, get help along the way.
- Get some help if you need it. If your taxes are too complicated, enlist the help of a tax preparer or CPA. Give this special consideration if you have a lot of complicated declarations or deductions, or if you are filing on behalf of a business or organization.
- The IRS also offers free help if you get stuck on any given point. The Volunteer Income Tax Assistance (VITA) program is available to filers who make less than $54,000 per year. If you are eligible, the IRS' volunteer tax preparers will complete your taxes free of charge. Find a VITA site near you at http://irs.treasury.gov/freetaxprep/.
- In addition, the IRS offers a tool called the Interactive Tax Assistant that can answer most questions you have. Access it at https://www.irs.gov/uac/interactive-tax-assistant-ita-1.