| The 5 Red Flags of an Audit (202)328-3503 DC Office (202)667-3710 Fax
5 Red Flags that Could Signal An Audit in Your Future
1. Independent Contractor Classification Error
(1099 Employee Misclassification and lost of IRS funds) In recent years, the IRS has begun to realize that large sums of potential tax revenues are being lost due to employee misclassification associated with an employer filing IRS form 1099-MISC instead of IRS form W-2. In previous years an employer had only to list an employee as an independent contractor and then file IRS form 1099-MISC at the appropriate time. However, when a company pays a contracted employee on a 1099-MISC form, they avoid paying or reporting the following: federal and state withholding tax, deposits and reports, the employee's share of Social Security and Medicare taxes, state and federal unemployment insurance premiums, state disability insurance premiums, Worker's Compensation costs, fringe benefits, and EEOC regulations. The IRS estimates that it loses $4 to $25 billion per year in unpaid taxes as a result of this misclassification issue. Consequently, the IRS has made it a priority to investigate any and all 1099-MISC filings that are turned in at the end of the tax season. As a result, IRS audit flags are promptly triggered when 1099-MISC forms are submitted by employers when they file their taxes.
Due to the consequences of these audits, many companies have found out the hard way that they owe back taxes and penalties ranging in the thousands of dollars due to the misunderstanding of this classification. And quite often the employees owe as well! The proper course of action to avoid this misery is really quite simple. The company in question should have their accountant file a special petition to the IRS requesting independent contractor status for the prospective employees. Once this petition is approved by the IRS, the company can then file the necessary 1099-MISC forms without fear of IRS audits and penalties. Even if an audit is accidently triggered, the special petition status is your insurance protection against the alledged penalties.
2. Employer's Quarterly & Annual Federal Tax Returns
Employers must file four different reports regarding payroll taxes (Form 941, 940, W-2 and W-3).
- The first report, IRS form 941, is the Employer's Quarterly Federal Tax Return which is filed four times during the year. This report details the number of employees the business had, the amount of wages they were paid, and the amount of taxes that were withheld for the quarter. The other three reports are filed annually.
- IRS form W-2 - the annual Wage and Tax Statement - must be sent to all employees before January 31 of the following year. It details how much each employee received in wages and how much was withheld for taxes over the course of the year. Copies of the W-2 forms for all employees also must be sent to the Social Security Adminsitration.
- The third report, IRS form W-3, Transmittal of Wage and Tax Statement, must be sent to the IRS by February 28 of the following year. It provides a formal reconciliation of the quarterly tax payments made on IRS form 941 and the annual totals reported on IRS form W-2 for all employees.
- The final annual report is the Federal Unemployment Tax Return, IRS form 940, which outlines the total FUTA taxes owed and paid for the year.
3. Significant Capital Gains Earnings
Capital gains are directly related to a capital investment. The IRS defines capital gains as the money earned when an asset of value is sold for more than its original purchasing price. (Conversely, a capital loss is defined as money lost when an asset of value is sold for less than it was originally purchased.) An asset of value, referred to as a capital asset, can be defined as stocks, mutual funds, bonds, real estate, precious metals, coins, fine art and other collectibles. The profit you realize from selling these items constitutes a capital gain. However, wages, interest, dividends and tax deferred investments are considered, by the IRS, to be ordinary income. Examples of tax deferred investments would be: IRA's, Roth IRA's, 401(k) plans and savings bonds. These tax deferred investments are not reported as capital gains, because at the time of withdrawal, these accounts are taxed as ordinary income, thereby avoiding CGT (capital gains tax).
Significant to the capital gains tax (CGT) is the amount of increase or decrease of the investment. An audit is often triggered by any substantial income increase - if for no other reason than the fact that red flags are hard-wired into the software. However, just as this can work to your disadvantage, it can also work to your advantage. With a shift in income status comes a needed review of your deductions, charitable gifts, and indeed, your filing status. For instance, it may be more advantageous to file as Head of Household instead of Married Filing Jointly, particularly if marital status has recently changed.
4. Non-verifiable Number of Deductions
Tax deductions and income tax returns are directly tied to the number of deductions each filer declares. The IRS has a rigid set of rules governing the number of taxable deductions one can claim in a given year. The quickest way to prompt an audit is to submit deductions that are significantly inconsistent with previous filing years. Many people claim the children of their siblings, cousins, neighbors, etc - and there is generally nothing wrong with this - unless the said children are being claimed by somebody else or the claim is unjustified. This is a tricky area and one that must be navigated through with verifiable facts, figures and dates of significance. Before adding persons to your tax deduction status, take the time to get professional advice as to what is allowable and legal and what is not. Taking this step can save you a world of misery and regret.
5. Payroll Tax & Employees FUTA
Every quarter an employer submits copies of the W-2 forms for all employees to the Social Security Administration. This is in compliance with the Federal Unemployment Tax Act, enacted in 1963.
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