Understanding An IRS Letter Questioning A Deduction And What To Do If You Receive One
Tax Deductions Are Important And Often Legitimate Ways To Reduce The Amount Of Taxes You Owe To The IRS
Any letter from the IRS can be a major source of stress if you’re the one receiving it, even if you thought your tax return was accurate. It is critical to read the letter carefully and respond accordingly.
An experienced tax lawyer like Attorney Sammy Kim can help ensure you reply effectively and in a timely manner.
One of the key things that triggers an IRS letter is questioning a deduction. While deductions are a common practice to reduce your income before your taxes are calculated, certain deductions are considered red flags by the IRS — either because of the type of deduction or the amount in relation to your income.
What Do You Do If The IRS Sends You A Letter Questioning One Of Your Deductions?
As a general rule, the IRS tends to take notice if your deductions are disproportionately higher than your income. However, the fear that your tax return could be flagged is not a good reason to avoid taking a deduction for which you have clear and accurate documentation.
The simple fact that the IRS sent you a letter asking for more documentation about one of your tax deductions does not necessarily mean that the IRS will penalize you or that you’ll owe additional taxes.
No matter what, responding within the usual 30 days the IRS requests is essential, or at least contacting the agency to let them know if you need more time.
It’s important to know that the documentation required by each IRS letter is different. When a deduction is questioned, you could be asked for business travel logs, records of charitable contributions, legal paperwork, receipts and more.
Read the letter you received carefully to make sure you know what you are required to submit. You might have to obtain documents from third parties as well.
Here are some of the common reasons the IRS might seek to verify or request more information related to deductions:
Business Deductions Taken By Self-Employed And Small Business Owners On Schedule C
Self-employed independent contractors who run a sole proprietorship or small business are often targets of questions around deductions.
IRS agents are aware that these taxpayers sometimes try to take higher deductions than they are rightfully owed or fail to claim all their income. Targets include sole proprietors at any income level and small businesses that record a significant loss on their Schedule C.
In recent years, the IRS has upped the ante on examining small business tax returns, including S corporations, partnerships, and limited liability companies (LLCs).
Businesses that operate largely in cash, including restaurants and bars, salons, taxis and car washes, are also targets.
Issues with deductions for self-employed individuals and small businesses come into play when a taxpayer attempts to claim personal expenses as deductions on their Schedule C.
For example, business-related legal expenses are deductible, such as business incorporation expenses and fees for drafting contracts. But personal legal fees, such as for divorce or estate planning, may not be deducted by your business.
Another red flag sometimes happens when a taxpayer attempts to deduct their car entirely on the business, when the IRS expects the vehicle is also used for personal reasons.
If you want to deduct a business expense, keep detailed receipts and records of your expenses for seven years. Estimated, round numbers on a tax return can be a red flag.
The types of records you should keep include, but are not limited to:
- Credit card sales slips
- Cash register tapes
- Canceled checks
- Rental contracts
- Mileage logs
- Bank and credit card statements
You can expect than an IRS request for additional information to substantiate a Schedule C deduction will require copies of business expense records and a completed Form 11652: Questionnaire and Supporting Documentation Form 1040 Schedule C.
Home Office Deductions
The home office deduction is one that the IRS has been flagging for years. That’s because the rules for taking this deduction are specific and subjective.
Generally, a taxpayer qualifies for a home office deduction if they use the area solely as their principal place of business. You can’t simply use your kid’s room or guest room as your office and claim it as a home office. The home office area must be used exclusively for business to claim a deduction.
Also, you are more likely to be questioned by the IRS for a home office deduction if you took a loss on your Schedule C or received income from wages.
Business Meals, Entertainment And Travel Deductions
Deductions for business meals, travel and entertainment continue to be prime contenders for IRS audits. That is true whether you are a Schedule C taxpayer or an employee who files a Schedule A.
It is important to take reasonable, factual write-offs for meals, entertainment, and travel, along with keeping specific, detailed records, including the amount of the expense, the reason, who attended, and the purpose of the meeting.
The IRS is likely to question large deductions for these categories that exceed what would be expected for the type of business or the amount of the taxpayer’s income.
Charitable Contribution Deductions
The IRS often sends audit letters to taxpayers who try to deduct significantly higher charitable contributions as compared their prior year donations or their current year income.
Taxpayers must keep a record of all itemized charitable contributions, and for donations over $250, you must have written documentation from the charity.
You open yourself up to an audit if you fail to get an appraisal for donations of property, or if you don’t file Form 8283 for noncash donations greater than $500.
The IRS also checks to make sure any listed charities actually exist, in the wake of a recent surge in fake charities.
Deductions Split With A Third Party
If you share any deduction with another taxpayer, you are open to question by the IRS if any reporting information between the two returns doesn’t match.
You may only split a deduction with a spouse, partner or other third party if both of your names are on the relevant property, such as a mortgage or property taxes.
The person who received the mortgage interest statement is the only one who can deduct it, even if you and a partner pay for the mortgage out of a joint checking account or with two separate checks.
Similarly, a property tax statement must have both parties’ names on it to split the deduction.
If you need help understanding an IRS audit letter questioning a deduction, talk to a tax expert who understands the IRS rules and can help you solve your tax problem now.
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