As stated previously in part one, IRS audits can cause painful tax problems if you don’t look out for specific details that set them off. With five down and just seven more to go, we’re rounding up our series on stressful tax triggers to avoid:
An Unverified Earned Income Tax Credit (EITC)
An EITC is another refundable tax credit (like charity donations) that allows citizens to add child dependents under their name. While there are income limits to qualify, the IRS sends taxpayers a check with the difference if they are eligible and their credit amount is higher than the tax owed.
However, the IRS holds off on doing this until they are sure a citizen is qualified and their income is reported accurately. If not, the DIF will notify agents of the anomaly and conduct an audit, especially if one or more of the same dependents appear on another taxpayer’s EITC.
Missed Interest or Investment Tax Payments
Remember that the IRS taxes all sources of income, whether an employee, freelancer, or even an investor! Yes, even revenue generated from interest or dividends must also be reported to them and are subject to taxation!
If your earnings from dividends and interest are not on your tax return, Washington will send you a letter asking why you didn’t notify them. But, you can avoid an audit if you simply adjust your income and pay the necessary taxes.
Undeclared International Assets
The IRS doesn’t just tax your local income sources, but even your assets and finances stored abroad, especially in countries with lighter tax laws! They can access your accounts from foreign banks, especially when you don’t declare your assets, as they get a percentage from that too!
To stress this point even further, American citizens with foreign bank accounts totaling more than $10,000 must declare it to the IRS and U.S. Treasury or suffer debilitating tax problems and even criminal charges!
If you have a balance of $10,000 stored abroad, duly report them through a FinCen Form 114. If you have $50,000 or more, you need IRS Form 8938.
Reporting Your Business as a Hobby
To the IRS, businesses are legally defined as entities that generate profit over a year. That means it must show positive income in at least three of the last five tax years (it’s two out of seven years for horse breeders).
Businesses that start from a hobby (like breeding dogs or giving musical lessons) can file a Form 5213 to provide them with more time to generate income before getting taxed. Be careful with this, though, as it might cause an IRS audit too.
Conversely, a business that fulfills the IRS’ legal definition but still reports itself as a hobby to exempt them from paying taxes will trigger an audit.
Owning a Cash Business
Cash businesses are those where the exchange of money occurs for goods and services, as defined by the IRS. That means the IRS gets a cut from each financial transaction—which has to be declared—whether it’s $10 or $100!
In these cases, an audit occurs when your reported income does not justify your lifestyle—owning a 200-sqm mansion in Beverly Hills on a $100,000 salary signals to the IRS you haven’t been truthful about your income at all.
Declaring Your Business as Home-Based
Like charity donations and EITCs, declaring your home as a business area awards taxpayers with deductibles, particularly concerning items used for work. However, IRS Publication 587 states that declaring your house as an office means you can only use it for work and nothing more.
This is because taxpayers can combine their home and office overhead to cut expenses and avoid paying more taxes from their gross annual income. Under no circumstances should you do this to avoid even more tax problems.
As we bring this series about tax triggers to a close, keep in mind that consistency and transparency are values that will keep you free from audits and other financial headaches. Always declare and pay what is due to the government from local and foreign assets, declare the right business category, and obey the law since taxes lead to better public services and utilities!
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