Worried about an IRS audit? Prepare in advance

IRS audit rates are historically low, according to a recent Government Accountability Office (GAO) report, but that’s little consolation if your return is among those selected to be examined. Plus, the IRS recently received additional funding in the Inflation Reduction Act to improve customer service, upgrade technology and increase audits of high-income taxpayers. But with proper preparation and planning, you should fare well.

From tax years 2010 to 2019, audit rates of individual tax returns decreased for all income levels, according to the GAO. On average, the audit rate for all returns decreased from 0.9% to 0.25%. IRS officials attribute this to reduced staffing as a result of decreased funding. Businesses, large corporations and high-income individuals are more likely to be audited but, overall, all types of audits are being conducted less frequently than they were a decade ago.

There’s no 100% guarantee that you won’t be picked for an audit, because some tax returns are chosen randomly. However, the best way to survive an IRS audit is to prepare in advance. On an ongoing basis you should systematically maintain documentation — invoices, bills, cancelled checks, receipts, or other proof — for all items to be reported on your tax returns. Keep all records in one place.

Audit targets

It also helps to know what might catch the attention of the IRS. Certain types of tax-return entries are known to involve inaccuracies so they may lead to an audit. Here are a few examples:

• Significant inconsistencies between tax returns filed in the past and your most current return,
• Gross profit margin or expenses markedly different from those of other businesses in your industry, and
• Miscalculated or unusually high deductions.

Certain types of deductions may be questioned by the IRS because there are strict recordkeeping requirements for them — for example, auto and travel expense deductions. In addition, an owner-employee’s salary that’s much higher or lower than those at similar companies in his or her location may catch the IRS’s eye, especially if the business is structured as a corporation.

If you receive a letter

If you’re selected for an audit, you’ll be notified by letter. Generally, the IRS doesn’t make initial contact by phone. But if there’s no response to the letter, the agency may follow up with a call.

Many audits simply request that you mail in documentation to support certain deductions you’ve claimed. Only the strictest version, the field audit, requires meeting with one or more IRS auditors. (Note: Ignore unsolicited email or text messages about an audit. The IRS doesn’t contact people in this manner. These are scams.)

The tax agency doesn’t demand an immediate response to a mailed notice. You’ll be informed of the discrepancies in question and given time to prepare. Collect and organize all relevant income and expense records. If anything is missing, you’ll have to reconstruct the information as accurately as possible based on other documentation.

If you’re audited, our firm can help you:

• Understand what the IRS is disputing (it’s not always clear),
• Gather the specific documents and information needed, and
• Respond to the auditor’s inquiries in the most effective manner.

The IRS normally has three years within which to conduct an audit, and an audit probably won’t begin until a year or more after you file a return. Don’t panic if the IRS contacts you. Many audits are routine. By taking a meticulous, proactive approach to tracking, documenting and filing your company’s tax-related information, you’ll make an audit less painful and even decrease the chances you’ll be chosen in the first place.

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by Zak Barbagallo

Year-end tax planning ideas for individuals

Now that fall is officially here, it’s a good time to start taking steps that may lower your tax bill for this year and next.

One of the first planning steps is to ascertain whether you’ll take the standard deduction or itemize deductions for 2022. Many taxpayers won’t itemize because of the high 2022 standard deduction amounts ($25,900 for joint filers, $12,950 for singles and married couples filing separately and $19,400 for heads of household). Also, many itemized deductions have been reduced or abolished under current law.

If you do itemize, you can deduct medical expenses that exceed 7.5% of adjusted gross income (AGI), state and local taxes up to $10,000, charitable contributions, and mortgage interest on a restricted amount of debt, but these deductions won’t save taxes unless they’re more than your standard deduction.

Bunching, pushing, pulling

Some taxpayers may be able to work around these deduction restrictions by applying a “bunching” strategy to pull or push discretionary medical expenses and charitable contributions into the year where they’ll do some tax good. For example, if you’ll be able to itemize deductions this year but not next, you may want to make two years’ worth of charitable contributions this year.

Here are some other ideas to consider:

• Postpone income until 2023 and accelerate deductions into 2022 if doing so enables you to claim larger tax breaks for 2022 that are phased out over various levels of AGI. These include deductible IRA contributions, child tax credits, education tax credits and student loan interest deductions. Postponing income also is desirable for taxpayers who anticipate being in a lower tax bracket next year due to changed financial circumstances. However, in some cases, it may pay to accelerate income into 2022. For example, that may be the case if you expect to be in a higher tax bracket next year.
• If you’re eligible, consider converting a traditional IRA into a Roth IRA by year end. This is beneficial if your IRA invested in stocks (or mutual funds) that have lost value. Keep in mind that the conversion will increase your income for 2022, possibly reducing tax breaks subject to phaseout at higher AGI levels.
• High-income individuals must be careful of the 3.8% net investment income tax (NIIT) on certain unearned income. The surtax is 3.8% of the lesser of: 1) net investment income (NII), or 2) the excess of modified AGI (MAGI) over a threshold amount. That amount is $250,000 for joint filers or surviving spouses, $125,000 for married individuals filing separately and $200,000 for others. As year-end nears, the approach taken to minimize or eliminate the 3.8% surtax depends on your estimated MAGI and NII for the year. Keep in mind that NII doesn’t include distributions from IRAs or most retirement plans.
• It may be advantageous to arrange with your employer to defer, until early 2023, a bonus that may be coming your way.
• If you’re age 70½ or older by the end of 2022, consider making 2022 charitable donations via qualified charitable distributions from a traditional IRA — especially if you don’t itemize deductions. These distributions are made directly to charities from your IRA and the contribution amount isn’t included in your gross income or deductible on your return.
• Make gifts sheltered by the annual gift tax exclusion before year end. In 2022, the exclusion applies to gifts of up to $16,000 made to each recipient. These transfers may save your family taxes if income-earning property is given to relatives in lower income tax brackets who aren’t subject to the kiddie tax.

These are just some of the year-end steps that may save taxes. Contact us to tailor a plan that will work best for you.

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by Zak Barbagallo

Don’t forget income taxes when planning your estate

As a result of the current estate tax exemption amount ($12.06 million in 2022), many estates no longer need to be concerned with federal estate tax. Before 2011, a much smaller amount resulted in estate plans attempting to avoid it. But now, because many estates won’t be subject to estate tax, more planning can be devoted to saving income taxes for your heirs.

While saving both income and transfer taxes has always been a goal of estate planning, it was more difficult to succeed at both when the estate and gift tax exemption level was much lower. Here are three considerations.

Plan gifts that use the annual gift tax exclusion. One of the benefits of using the gift tax annual exclusion to make transfers during life is to save estate tax. This is because both the transferred assets and any post-transfer appreciation generated by those assets are removed from the donor’s estate.

As mentioned, estate tax savings may not be an issue because of the large estate exemption amount. Further, making an annual exclusion transfer of appreciated property carries a potential income tax cost because the recipient receives the donor’s basis upon transfer. Thus, the recipient could face income tax, in the form of capital gains tax, on the sale of the gifted property in the future. If there’s no concern that an estate will be subject to estate tax, even if the gifted property grows in value, then the decision to make a gift should be based on other factors.

For example, gifts may be made to help a relative buy a home or start a business. But a donor shouldn’t gift appreciated property because of the capital gain that could be realized on a future sale by the recipient. If the appreciated property is held until the donor’s death, under current law, the heir will get a step-up in basis that will wipe out the capital gain tax on any pre-death appreciation in the property’s value.

Take spouses’ estates into account. In the past, spouses often undertook complicated strategies to equalize their estates so that each could take advantage of the estate tax exemption amount. Generally, a two-trust plan was established to minimize estate tax. “Portability,” or the ability to apply the decedent’s unused exclusion amount to the surviving spouse’s transfers during life and at death, became effective for estates of decedents dying after 2010. As long as the election is made, portability allows the surviving spouse to apply the unused portion of a decedent’s applicable exclusion amount (the deceased spousal unused exclusion amount) as calculated in the year of the decedent’s death. The portability election gives married couples more flexibility in deciding how to use their exclusion amounts.

Be aware that some estate exclusion or valuation discount strategies to avoid inclusion of property in an estate may no longer be worth pursuing. It may be better to have the property included in the estate or not qualify for valuation discounts so that the property receives a step-up in basis. For example, the special use valuation — the valuation of qualified real property used for farming or in a business on the basis of the property’s actual use, rather than on its highest and best use — may not save enough, or any, estate tax to justify giving up the step-up in basis that would otherwise occur for the property.

If you’d like to discuss these strategies and how they relate to your estate plan, contact us.

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by Zak Barbagallo

The Inflation Reduction Act: what’s in it for you?

You may have heard that the Inflation Reduction Act (IRA) was signed into law recently. While experts have varying opinions about whether it will reduce inflation in the near future, it contains, extends and modifies many climate and energy-related tax credits that may be of interest to individuals.

Nonbusiness energy property

Before the IRA was enacted, you were allowed a personal tax credit for certain nonbusiness energy property expenses. The credit applied only to property placed in service before January 1, 2022. The credit is now extended for energy-efficient property placed in service before January 1, 2033.

The new law also increases the credit for a tax year to an amount equal to 30% of:

• The amount paid or incurred by you for qualified energy efficiency improvements installed during the year, and
• The amount of the residential energy property expenditures paid or incurred during that year.

The credit is further increased for amounts spent for a home energy audit (up to $150).

In addition, the IRA repeals the lifetime credit limitation, and instead limits the credit to $1,200 per taxpayer, per year. There are also annual limits of $600 for credits with respect to residential energy property expenditures, windows, and skylights, and $250 for any exterior door ($500 total for all exterior doors). A $2,000 annual limit applies with respect to amounts paid or incurred for specified heat pumps, heat pump water heaters and biomass stoves/boilers.

The residential clean-energy credit

Prior to the IRA being enacted, you were allowed a personal tax credit, known as the Residential Energy Efficient Property (REEP) Credit, for solar electric, solar hot water, fuel cell, small wind energy, geothermal heat pump and biomass fuel property installed in homes before 2024.

The new law makes the credit available for property installed before 2035. It also makes the credit available for qualified battery storage technology expenses.

New Clean Vehicle Credit

Before the enactment of the law, you could claim a credit for each new qualified plug-in electric drive motor vehicle placed in service during the tax year.

The law renames the credit the Clean Vehicle Credit and eliminates the limitation on the number of vehicles eligible for the credit. Also, final assembly of the vehicle must now take place in North America.

Beginning in 2023, there will be income limitations. No Clean Vehicle Credit is allowed if your modified adjusted gross income (MAGI) for the year of purchase or the preceding year exceeds $300,000 for a married couple filing jointly, $225,000 for a head of household, or $150,000 for others. In addition, no credit is allowed if the manufacturer’s suggested retail price for the vehicle is more than $55,000 ($80,000 for pickups, vans, or SUVs).

Finally, the way the credit is calculated is changing. The rules are complicated, but they place more emphasis on where the battery components (and critical minerals used in the battery) are sourced.

The IRS provides more information about the Clean Vehicle Credit here: https://www.irs.gov/businesses/plug-in-electric-vehicle-credit-irc-30-and-irc-30d

Credit for used clean vehicles

A qualified buyer who acquires and places in service a previously owned clean vehicle after 2022 is allowed a tax credit equal to the lesser of $4,000 or 30% of the vehicle’s sale price. No credit is allowed if your MAGI for the year of purchase or the preceding year exceeds $150,000 for married couples filing jointly, $112,500 for a head of household, or $75,000 for others. In addition, the maximum price per vehicle is $25,000.

We can answer your questions

Contact us if you have questions about taking advantage of these new and revised tax credits.

© 2022

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by Zak Barbagallo

Is your income high enough to owe two extra taxes?

High-income taxpayers face two special taxes — a 3.8% net investment income tax (NIIT) and a 0.9% additional Medicare tax on wage and self-employment income. Here’s an overview of the taxes and what they may mean for you.

3.8% NIIT

This tax applies, in addition to income tax, on your net investment income. The NIIT only affects taxpayers with adjusted gross income (AGI) exceeding $250,000 for joint filers, $200,000 for single taxpayers and heads of household, and $125,000 for married individuals filing separately.

If your AGI is above the threshold that applies ($250,000, $200,000 or $125,000), the NIIT applies to the lesser of 1) your net investment income for the tax year or 2) the excess of your AGI for the tax year over your threshold amount.

The “net investment income” that’s subject to the NIIT consists of interest, dividends, annuities, royalties, rents and net gains from property sales. Wage income and income from an active trade or business isn’t included. However, passive business income is subject to the NIIT.

Income that’s exempt from income tax, such as tax-exempt bond interest, is likewise exempt from the NIIT. Thus, switching some taxable investments to tax-exempt bonds can reduce your exposure. Of course, this should be done after taking your income needs and investment considerations into account.

How does the NIIT apply to home sales? If you sell your principal residence, you may be able to exclude up to $250,000 of gain ($500,000 for joint filers) when figuring your income tax. This excluded gain isn’t subject to the NIIT.

However, gain that exceeds the exclusion limit is subject to the tax. Gain from the sale of a vacation home or other second residence, which doesn’t qualify for the exclusion, is also subject to the NIIT.

Distributions from qualified retirement plans, such as pension plans and IRAs, aren’t subject to the NIIT. However, those distributions may push your AGI over the threshold that would cause other types of income to be subject to the tax.

Additional 0.9% Medicare tax

Some high-wage earners pay an extra 0.9% Medicare tax on part of their wage income, in addition to the 1.45% Medicare tax that all wage earners pay. The 0.9% tax applies to wages in excess of $250,000 for joint filers, $125,000 for a married individuals filing separately and $200,000 for all others. It applies only to employees, not to employers.

Once an employee’s wages reach $200,000 for the year, the employer must begin withholding the additional 0.9% tax. However, this withholding may prove insufficient if the employee has additional wage income from another job or if the employee’s spouse also has wage income. To avoid that result, an employee may request extra income tax withholding by filing a new Form W-4 with the employer.

An extra 0.9% Medicare tax also applies to self-employment income for the tax year in excess of the same amounts for wage earners. This is in addition to the regular 2.9% Medicare tax on all self-employment income. The $250,000, $125,000, and $200,000 thresholds are reduced by the taxpayer's wage income.

Reduce the impact

As you can see, these two taxes may have a significant effect on your tax bill. Contact us to discuss these taxes and how their impact could be reduced.

© 2022

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by Zak Barbagallo

Year-end tax planning ideas for your small business

Now that Labor Day has passed, it’s a good time to think about making moves that may help lower your small business taxes for this year and next. The standard year-end approach of deferring income and accelerating deductions to minimize taxes will likely produce the best results for most businesses, as will bunching deductible expenses into this year or next to maximize their tax value.

If you expect to be in a higher tax bracket next year, opposite strategies may produce better results. For example, you could pull income into 2022 to be taxed at lower rates and defer deductible expenses until 2023, when they can be claimed to offset higher-taxed income.

Here are some other ideas that may help you save tax dollars if you act before year-end.

QBI deduction

Taxpayers other than corporations may be entitled to a deduction of up to 20% of their qualified business income (QBI). For 2022, if taxable income exceeds $340,100 for married couples filing jointly (half that amount for others), the deduction may be limited based on: whether the taxpayer is engaged in a service-type business (such as law, health, or consulting), the amount of W-2 wages paid by the business, and/or the unadjusted basis of qualified property (such as machinery and equipment) held by the business. The limitations are phased in.

Taxpayers may be able to salvage some or all of the QBI deduction by deferring income or accelerating deductions to keep income under the dollar thresholds (or be subject to a smaller deduction phaseout). You also may be able to increase the deduction by increasing W-2 wages before year-end. The rules are complex, so consult us before acting.

Cash vs. accrual accounting

More small businesses are able to use the cash (rather than the accrual) method of accounting for federal tax purposes than were allowed to do so in previous years. To qualify as a small business under current law, a taxpayer must (among other requirements) satisfy a gross receipts test. For 2022, it’s satisfied if, during a three-year testing period, average annual gross receipts don’t exceed $27 million. Not that long ago, it was only $5 million. Cash method taxpayers may find it easier to defer income by holding off billings until next year, paying bills early or making certain prepayments.

Section 179 deduction

Consider making expenditures that qualify for the Section 179 expensing option. For 2022, the expensing limit is $1.08 million, and the investment ceiling limit is $2.7 million. Expensing is generally available for most depreciable property (other than buildings), including equipment, off-the-shelf computer software, interior improvements to a building, HVAC, and security systems.

The high dollar ceilings mean that many small- and medium-sized businesses will be able to currently deduct most or all of their outlays for machinery and equipment. What’s more, the deduction isn’t prorated for the time an asset is in service during the year. Just place the eligible property in service by the last days of 2022, and you can claim a full deduction for the year.

Bonus depreciation

Businesses also can generally claim a 100% bonus first-year depreciation deduction for qualified improvement property and machinery and equipment bought new or used, if purchased and placed in service this year. Again, the full write-off is available even if qualifying assets are in service for only a few days in 2022.

Consult with us for more ideas

These are just some year-end strategies that may help you save taxes. Contact us to tailor a plan that works for you.

© 2022

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by Zak Barbagallo