BLOG

IRS Tax Amnesty & Voluntary Disclosure Practice

Houston Tax Attorney

0

IRS Tax Amnesty & Voluntary Disclosure Practice

What do you do if you have committed a serious tax crime but the IRS has not yet discovered it? Tax amnesty has been a longstanding practice of the IRS Criminal Investigation division whereby taxpayers are allowed to make timely, accurate, and complete voluntary disclosures to avoid criminal prosecution.

Taxpayers are given tax amnesty for “coming clean” regarding their tax crimes. There are two such programs depending on whether the tax evasion involves domestic or foreign income:

  1. Domestic Voluntary Disclosure Program (not to be confused with streamlined domestic offshore procedures which is a completely unrelated program)
  2. Offshore Voluntary Disclosure Program (OVDP)

Read more

What Happens After an IRS Audit?

Houston Tax Attorney

0

What Happens After an IRS Audit?

Clients often come to us after going through an IRS audit and receiving a large tax bill. They either represented themselves or hired someone who did not represent them effectively. This article is not about audit representation, but rather the steps that occur after an audit has concluded, and what taxpayers can do to challenge an audit determination. Read more

Dealing with an IRS Audit

Houston Tax Attorney

0

Getting Audited by the IRS

If you’re visiting this page, perhaps it’s because you’re being audited by IRS; or maybe you’re wondering what the IRS audit triggers are; or perhaps you’re just interested in learning about the IRS audit process. Regardless of why you’re here, it’s important to understand how to protect your rights during an audit.

Types of IRS Audits

Most individuals will likely deal with an IRS audit at some point in their lives. It may be a simple correspondence audit, or it may be a field visit to your business.

Correspondence Audit Program

A correspondence audit is conducted through (you guessed it), correspondence. Such audits are for issues that involve records that can easily be submitted by mail. Examples of issues that are covered by a correspondence audit include:

• Dependent Exemptions
• Earned income tax credits (EITC)
• Child Care Credits
• Adoption Credits
• Educational Credits
• Certain itemized deductions and Schedule C expenses

While correspondence audits are less intimidating since they do not involve a face-to-face audit, they can be extremely frustrating. First, there is no one assigned to your case. These cases are worked by Tax Examiners, which is an entry-level position requiring no college education. The case will be handled by a different person each time you call the IRS or submit documents. Because it’s an entry-level position, Tax Examiners are given very little ability to make judgments in gray areas of the law. You may have to go back and forth over the course of several months to get an issue resolved at the correspondence audit level. If you’ve been unable to resolve your issues in a correspondence audit, hiring a tax professional may help.

Automated Underreporter Program (AUR)

The IRS uses computer-matching and error-checking programs to verify the accuracy of tax returns. The most common notice generated by the AUR is a Notice CP2000. A CP2000 informs the taxpayer that there is a discrepancy between income shown on the tax return and income that was reported by others. For example, if you had cancellation of debt (which is considered income), the creditor will issue a 1099-C to you and file it with the IRS. If your tax return does not include that income, the AUR will generate a Notice CP2000 informing you of the mismatch.

Office Audits

An office audit is a face-to-face examination with a Tax Compliance Officer (TCO). The majority of cases worked by a TCO involve Schedule C issues. The TCO will audit up to 4 vital issues and possibly additional issues on the return with managerial approval. If you are chosen for an office audit, you will receive an examination letter, requesting you to call and set up a day and time to have your return and supporting documents examined. The TCO will also send you an Information Document Request (IDR) which contains a list of documents that the TCO wants to review.

TCOs are trained to not only verify questionable expenses and credits on the tax return, but to also look for unreported income. Such examinations can be highly invasive and difficult for clients. However, you should know that TCOs are not allowed to automatically request bank statements without meeting specific criteria in the Internal Revenue Manual.

If you’ve received a letter requesting an office examination, you need to hire a tax professional. There’s too much at stake to attempt this yourself. One thing that taxpayers and even tax professionals don’t know is that the TCO will have completed a background search on you prior to the appointment. They also have the authority to make 3rd party contacts to verify documents that you provide. A false statement or document from you could result in the audit turning into a fraud case. I’ve seen it happen, and in fact, I’ve personally had to turn an audit case to fraud on a few occasions while working at the IRS.

Field Audits

Field audits are conducted through on-site visits by a Revenue Agent (RA). Unlike TCOs who examine individual, self-employed, and disregarded entity returns, RAs examine only business returns. In addition, there are RAs in the Small Business/Self-Employed (SB/SE) department and RAs that are assigned to Large Business and International (LB&I). SB/SE revenue agents will audit business returns with assets under $10 million.

The first contact with an RA is through a letter providing a time, date, and place of examination of the taxpayer’s books and records, along with an Information Document Request (IDR). If you have a representative, the examination can be conducted at the practitioner’s office.

A field audits will always include a reconciliation of income from books, records, and bank statements to the tax return. The revenue agent will already have picked some issues to review prior to the examination but will examine additional issues as warranted.

IRS Audit Triggers (“Red Flags”)

If your tax return doesn’t match information returns (e.g., 1099s, 1098s, W-2s etc) filed by 3rd parties, that’s obviously an automatic trigger for an adjustment letter from the IRS.

All tax returns are scored through a computer program called Discriminant Inventory Function (DIF). Certain tax filers, such as those with Schedule C or EITC, seem to have higher DIF scores and therefore a higher chance of getting audited. Additionally, any tax returns that appear to have “large, unusual, or questionable” (LUQ) deductions or expenses may cause the return to be flagged for an audit. For example, if you’re claiming $30,000 charitable contributions but earning only $70,000 of income, this is LUQ based on your income level. However, for an individual earning $500,000, a $30,000 contribution might not be considered LUQ.

For Schedule C and business filers there are various factors that can cause the DIF score to increase. For instance, your business expenses will be compared with similar businesses nationally and locally as identified through the business’ NAICS code. If your business expenses appear out of line compared to other similar businesses, that may increase your DIF score.

How to Prepare for an Audit

If there’s ever a reason to hire an attorney, an IRS audit should be at the very top. Unless your records are in perfect order and you have records to substantiate every deduction taken on the return, do not attempt to handle this on your own. The benefits of having a tax attorney on your side, especially one with prior IRS experience, will more than offset the costs of representation.

After you’ve hired a tax attorney, you and the attorney should have an honest discussion about your tax returns and identify any weak links, such as expenses that you may have accidentally overstated or are unable to provide documents. Your attorney can help limit the damage.

FAQ

IRS Audits

How Far Back can the IRS Audit you?

The Internal Revenue Code (IRC) contains time periods within which the IRS must assess and collect tax. These limitations are known as “statute of limitations.” Section 6501(a) of the IRC states that an assessment of any income tax must be made “within 3 years after the return is filed.” This applies even if a return is filed late.

However, there are exceptions to the 3 year statute of limitations:

  1. False, fraudulent, and unfiled tax returns. There is no statute of limitations where a taxpayer files a false return, engages in a willful attempt to evade tax, or does not file a tax return.
  2. A return is filed with a substantial omission of income. The IRS may assess taxes within 6 years of a tax return filing where the taxpayer omitted more than 25% of the reported income for the year under examination.

Example 1: Bob files his 2014 tax return on 4/15/2015. The IRS has until 4/15/2018 to audit and assess any additional taxes on the return, absent fraud or more than a 25% omission of income.

Example 2: Bob files his 2011 tax return on 4/15/2012. Bob’s 2014 tax return is audited by the IRS and after reviewing his bank statements, the IRS discovers that he underreported his income by more than 25% in 2014. The IRS now has until 4/15/2018 to audit his 2011 tax return.

Sources:

26 U.S. Code § 6501 – Limitations on assessment and collection

 

A Simple Solution for Reducing your Chances of an Audit

Houston Tax Attorney

0

The IRS Tells You how to Reduce your Chances of an Audit

If you’re an independent contractor (aka self-employed or sole proprietor), or in a general partnership, here’s another reason why you should form a separate legal entity.

In its annual Data Book, the IRS has released the percentages of tax returns that were audited in 2015. One of the most heavily audited returns were Schedule C business returns, which are filed by unincorporated businesses (i.e., those that have not formed a business entity). The stats reveal that your chances of audit are at least 4 times higher if your business is not incorporated.

And if you’re not already aware, incorporating your business also offers limited liability protection and lowers taxes by eliminating your self-employment tax.

Read more about the different options for incorporating your small business or sole proprietorship

Unreported Income

Houston Tax Attorney

1

IRS Income Examination Process

How does Uncle Sam know that you haven’t reported income if you don’t receive W-2s or 1099s? And you’re also clever enough not to deposit your unreported income in your bank account, so there is no “paper trail.” What then? The IRS uses what are called “indirect methods” of uncovering this income during IRS income examinations. Don’t worry, the IRS won’t come after you for the $100 winnings you didn’t report from your office fantasy football league challenge. The materiality threshhold is generally $10,000 for most taxpayers.

Direct vs. Indirect Methods

A direct method for the IRS to look for potentially unreported income would involve looking for direct evidence of omitted income such as cancelled customer checks, public records, deeds, etc. An indirect method would involve the IRS reconstructing your financial records. Indirect methods are used when there is no “paper trail.”

Why Would the IRS Use an Indirect Method?

When you are audited by the IRS, it almost always includes a “minimum income probe”, which is required under Internal Revenue Manual (IRM) 4.10.4.3.2. This applies to both business and non-business returns. Non-business includes individuals, self-employed/sole proprietors, and disregarded LLCs. A large majority of taxpayers fall into this section. When the IRS suspects a large amount of unreported income during the minimum income probe, then the scope of the income probe is expanded.

A minimum income probe of an individual return consists of:

  • Matching income reporting documents (W-2s, 1099s, etc) with the tax return
  • Asking a standard list of income questions during your initial interview. The examiner will note your responses on the “initial interview questionnaire.” You will be asked about sources of income and your record-keeping practices. A taxpayer who intentionally lies on the questionnaire would be a prime candidate for a civil fraud penalty.
  • Financial status analysis: This is a spreadsheet in which the examiner enters sources of funds on the left side of the T-Account and expenditures of funds on the right side. Total sources are compared with total expenditures. It’s common practice before an audit for the IRS to complete a public records check to determine what assets you own and when they were purchased. If you purchased 3 brand new BMWs in 2014 and you’re being audited for that year, the purchase price of those vehicles (or a close approximation) would be entered into the expenditure side.

If the T-Account does not show a material imbalance, then the examiner should stop here. And if he doesn’t, get a tax attorney! The examiner is not allowed to continue examining your income under the minimum income probe section of the IRM.

If the T-Account shows a material imbalance, additional questions will be asked of you to reconcile the difference. For example, you received a $100,000 nontaxable inheritance from your “nana”, which would explain the 3 BMWs you purchased. The examiner will likely ask you for proof such as probate records. A lie here also makes you a candidate for the civil fraud penalty.

If the T-Account is not reconciled during the audit of a non-business return, the examiner will request bank statements for all your accounts and conduct a bank deposit analysis. Here, the examiner is looking for unexplained cash deposits. If additional income is found here that resolves the T-Account, then your financial status audit should end. However, if the income still is not reconciled, then the IRS will use an indirect method. See further below, “Results of Minimum Income Probes.”

A minimum income probe of an individual “business” return includes the following:

  • Financial Status Analysis – Prepare a financial status analysis to estimate whether reported income is sufficient to support the taxpayer’s financial activities. See IRM 4.10.4.3.3.1.
  • Interview – Conduct an interview with the taxpayer (or representative) to gain an understanding of the taxpayer’s financial history, identify sources of nontaxable funds, and establish the amount of currency the taxpayer has on hand. Consider possible bartering income as part of the minimum income probes. See IRM 4.10.4.3.3.2.
  • Tour of Business – Tour the business site and review of the Internet website to gain familiarity with the taxpayer’s operations and internal controls, and identify potential sources of unreported income. However, a tour of the physical business site is not required for office audit cases but may be conducted if appropriate and with manager approval. See IRM 4.10.4.3.3.3.
  • Internal Control – Evaluate internal controls to determine the reliability of the books and records (including electronic books and records), identify high risk issues, and determine the depth of the examination of income. See IRM 4.10.4.3.3.4.
  • Reconciliation of Income – Reconcile the income reported on the tax return to the taxpayer’s books and records. An analysis of the IRP information in the file should also be completed to ensure all business and/or investment activities reflected on the IRP document are properly accounted for on the tax return. See IRM 4.10.4.3.3.5.
  • Testing Gross Receipts – Test the gross receipts by tying the original source documents to the books. See IRM 4.10.4.3.3.6.
  • Bank Analysis – Prepare an analysis of the taxpayer’s personal and business bank and financial accounts (including investment accounts) to evaluate the accuracy of gross receipts reported on the tax return. See IRM 4.10.4.3.3.7.
  • Business Ratios – Prepare an analysis of business ratios to evaluate the reasonableness of the taxpayer’s business operations and identify issues needing a more thorough examination. See IRM 4.10.4.3.3.8.
  • E-Commerce and/or Internet Use – Determine if there is Internet use and e-commerce income activity. See IRM 4.10.4.3.7.1.

Results of the minimum income probes

After completion of the minimum income probes for both business and non-business returns, the examiner must evaluate the information collected to this point and determine the scope of the examination of income, using the following criteria:

IF THEN
The results show that the taxpayer reported all taxable income from known sources, the books and records can be reconciled to the tax return, all financial activities are in balance, and the bank deposits do not exceed reported income. The examination of income may be limited to the Minimum Income Probes. The results and conclusions reached should be documented in the examination workpapers.
The results indicate the potential of unreported income due to inaccurate reporting of taxable income from known sources, the books and records cannot be reconciled to the tax return, a material imbalance in the financial status analysis that cannot be reconciled, excess unexplained bank deposits, or inadequate internal control. A more in-depth examination of income is warranted. See IRM 4.10.4.5 for suggested guidelines for an in-depth examination of income.

A “more in-depth examination of income” would depend on the taxpayer and the type of business being conducted. A preliminary step might be to contact 3rd parties (for example, business associates) to obtain information or evidence to reconcile income issues. It may also involve reviewing your books and records.

A formal indirect method to make the actual determination of tax liability may be pursued when the taxpayer’s books and records are missing, incomplete, or irregularities are identified; or the financial status analysis indicates a material imbalance after consideration of specific adjustments identified during the examination.

Results of the in-depth examination of income

After completion of the in-depth examination of income, the examiner will decide the next step using the following decision criteria:

IF THEN
The taxpayer or third parties have successfully explained the reason for the understatement. Document the results in the workpapers and conclude the examination of income without adjustment.
The adjustments to income and understatement meet the criteria for referral to Criminal Investigation. A referral should be made to Criminal Investigation.
The taxpayer agrees to the proposed adjustments to income. There is no indication of additional unreported income. Document the results in the workpapers and make the adjustment, resolve other issues, and close the case agreed.
The taxpayer does not agree to the proposed adjustments to income and the adjustments are not based on estimated personal living expenses derived from BLS data or comparable statistics. Document the results in the workpapers and close the case unagreed.
The taxpayer does not agree to the proposed adjustments to income and the adjustments are based on estimatedpersonal living expenses derived from BLS data or comparable statistics. Consider using one of the formal indirect methods to determine the actual amount of unreported income. NOTE: A case should not be closed unagreed if adjustments to income are based on estimated Personal Living Expenses.

Formal Indirect Methods of Determining Income

Authority to use formal indirect methods come from two sources
  • Internal Revenue Code. IRC 446(b) provides that if no method of accounting has been regularly used by the taxpayer, or if the method used does not clearly reflect income, the computation of taxable income shall be made under such method as, in the opinion of the Secretary, does clearly reflect income.
  • Case law. If the examiner has a reasonable indication that unreported income exists, the Service has been granted the authority, through the development of case law, to use a formal indirect method of reconstructing income to determine whether or not the taxpayer has accurately reported total taxable income received. The “formal” indirect method need not be exact, but must be reasonable in light of the surrounding facts and circumstances. Holland v. United States, 348 U.S. 121, 134 (1954).

When the IRS will use an indirect method?

The use of a formal indirect method to make the actual determination of tax liability should be considered when the factual development of the case leads the examiner to the conclusion that the taxpayer’s tax return and supporting books and records do not accurately reflect the total taxable income received and the examiner has established a reasonable likelihood of unreported income.

The following list, which is not intended to be all inclusive, identifies circumstances that, individually or in combination, would support the use of a formal indirect method.

  • MOST COMMON for non-business taxpayers. A financial status analysis that cannot be balanced; i.e., the taxpayer’s known business and personal expenses exceed the reported income per the return and nontaxable sources of funds have not been identified to explain the difference. This was discussed above under “minimum income probes.”
  • Irregularities in the taxpayer’s books and weak internal controls.
  • Gross profit percentages change significantly from one year to another, or are unusually high or low for that market segment or industry.
  • The taxpayer’s bank accounts have unexplained items of deposit.
  • The taxpayer does not make regular deposits of income, but uses cash instead.
  • A review of the taxpayer’s prior and subsequent year returns show a significant increase in net worth not supported by reported income.
  • There are no books and records. Examiners should determine whether books and/or records ever existed, and whether books and records exist for the prior or subsequent years. If books and records have been destroyed, determine who destroyed them, why, and when.
  • No method of accounting has been regularly used by the taxpayer or the method used does not clearly reflect income. See IRC 446(b).

There are 5 types of indirect methods

  • Source and Application of Funds Method: The Source and Application of Funds Method is an analysis of a taxpayer’s cash flows and comparison of all known expenditures with all known receipts for the period. Net increases and decreases in assets and liabilities are taken into account along with nondeductible expenditures and nontaxable receipts. The excess of expenditures over the sum of reported and nontaxable income is the adjustment to income.
  • MOST COMMON for non-business taxpayers. Bank Deposits and Cash Expenditures Method: Sources of funds are the various ways the taxpayer acquires money during the year. Decreases in assets and increases in liabilities generate funds. Funds also come from taxable and nontaxable sources of income. Unreported sources of income even though known, are not listed in this computation since the purpose is to determine the amount of any unreported income. Specific items of income are denoted separately.
  • Markup Method: The Markup Method produces a reconstruction of income based on the use of percentages or ratios considered typical for the business under examination in order to make the actual determination of tax liability. It consists of an analysis of sales and/or cost of sales and the application of an appropriate percentage of markup to arrive at the taxpayer’s gross receipts. By reference to similar businesses, percentage computations determine sales, cost of sales, gross profit, or even net profit. By using some known base and the typical applicable percentage, individual items of income or expenses may be determined. These percentages can be obtained from analysis of Bureau of Labor Statistics data or industry publications. If known, use of the taxpayer’s actual markup is required.
  • Unit and Volume Method: In many instances gross receipts may be determined or verified by applying the sales price to the volume of business done by the taxpayer. The number of units or volume of business done by the taxpayer might be determined from the taxpayer’s books as the records under examination may be adequate as to cost of goods sold or expenses. In other cases, the determination of units or volume handled may come from third party sources.
  • Net Worth Method: The Net Worth Method for determining the actual tax liability is based upon the theory that increases in a taxpayer’s net worth during a taxable year, adjusted for nondeductible expenditures and nontaxable income, must result from taxable income. This method requires a complete reconstruction of the taxpayer’s financial history, since the government must account for all assets, liabilities, nondeductible expenditures, and nontaxable sources of funds during the relevant period.

Summary

The IRS is thorough when it comes to examinations of income, and examiners are expected to document their findings in detail. The reason is that the IRS has the burden of proof when it comes to income (as apposed to deductions, for which taxpayers carry the burden of proof). This is why it is important to be represented by a tax professional for an IRS audit. For complex income issues, it’s even more important to hire a tax attorney who understands the IRS process. Even after the audit has ended and adjustments have been made, it’s not too late to hire an attorney. There’s a good chance the examiner did not properly document the income examination, made procedural errors, or made substantive errors. The first thing a knowledgeable attorney should do after a contested audit is request a copy of the examiner’s workpapers under the Freedom of Information Act (aka FOIA request).

Rental Property Losses

Houston Tax Attorney

1

Rental Property Losses

It is not uncommon for real estate investors to have rental property losses. The goal for many investors is not cash flow, but rather to hold on to the property for future appreciation.

The deductibility of net rental losses on your personal tax return depends on many factors.

General Rule: Rentals are Passive Activities

Under IRC § 469(c)(2), rental income and losses are considered to be passive income/loss, and are therefore subject to passive activity rules. Passive losses can only be deducted against passive income. For example, if your rental home produces a $15,000 loss on Schedule E, you are generally not able to offset your other (non-passive) income against this loss. The loss is carried forward to the next year.

Exception 1: The taxpayer actively participates in a rental real estate activity and qualifies for the $25,000 special allowance.

Exception 2: There is a qualifying disposition under IRC § 469(g). A qualifying disposition would be a sale of the property.

Exception 3: The taxpayer meets the requirements of IRC § 469(c)(7) for real estate professionals.

$25,000 Special Allowance Loss

A taxpayer may deduct up to $25,000 in rental real estate losses as long as the taxpayer actively participates and his modified adjusted gross income is less than $100,000.

Active participation test: As long as a taxpayer participates in management decisions in a bona fide sense, he actively participates in the real estate rental activity.  There is no specific hour requirement.  However, the taxpayer must be exercising independent judgment and not simply ratifying decisions made by a manager. Most taxpayers are able to meet this test if they can show they made important management decisions in regards to their rental property. You can have a management company if you are making the key decisions, such as accepting tenants, signing the contract, making the final determination on the rental price, etc.

Modified adjusted gross income (MAGI) is calculated by taking your Adjusted Gross Income and subtracting:

  • Any passive loss or passive income, or
  • Any rental losses (whether or not allowed by IRC § 469(c)(7)),  or
  • IRA, taxable social security or
  • One-half of self-employment tax (IRC § 469(i)(3)(E)) or
  • Exclusion under 137 for adoption expenses or
  • Student loan interest.
  • Exclusion for income from US savings bonds (to pay higher education tuition and fees)
  • Qualified tuition expenses (tax years 2002 and later)
  • Tuition and fees deduction
  • Any overall loss from a PTP (publicly traded partnership)

The full $25,000 allowance is available for taxpayers whose MAGI is less than $100,000.  For every $2 a taxpayer’s MAGI exceeds $100,000, the allowance is reduced by $1.

Qualified Disposition

In the year that you sell your rental property, you can deduct all of the carryover passive losses that you accumulated during the rental period. For example, Bob has $100,000 of W-2 wages in year 10. From years 1-9 he had $30,000 of passive loss carryovers from his rental property because they were not deductible on his tax returns. In year 10 he sells the rental property for a gain of $10,000. He therefore has total income of $110,000 (the W-2 wages and gain from the sale). However, his net income (before deductions) will be $80,000 since the $30,000 passive loss carryover will be applied.

Real Estate Professional

If you are considered a real estate professional, then your rental income/losses are not subject to passive activity loss limitations and all losses can be fully deducted on your tax return. In order to be considered a real estate professional, you must meet the material participation test, which involves meeting at least one of the following:

  1. The taxpayer works 500 hours or more during the year in the activity.
  2. The taxpayer does substantially all the work in the activity.
  3. The taxpayer works more than 100 hours in the activity during the year and no one else works more than the taxpayer.
  4. The activity is a significant participation activity (SPA), and the sum of SPAs in which the taxpayer works 100-500 hours exceeds 500 hours for the year.
  5. The taxpayer materially participated in the activity in any 5 of the prior 10 years.
  6. The activity is a personal service activity and the taxpayer materially participated in that activity in any 3 prior years.
  7. Based on all of the facts and circumstances, the taxpayer participates in the activity on a regular, continuous, and substantial basis during such year. However, this test only applies if the taxpayer works at least 100 hours in the activity, no one else works more hours than the taxpayer in the activity, and no one else receives compensation for managing the activity.

If you are a W-2 wage employee or have another significant source of income, and you do not spend significant time managing the rental property, you most likely will not meet the test. Real estate agents or those with real estate businesses are generally able meet at least one of the requirements.

Whether you are able to deduct your rental loss in the current year or not, the losses are not “lost.” You can carry them forward to future years and deduct them fully when you sell the property. It is important to keep track of your loss carryovers and to log the time you spend participating in rental activity if you are a real estate professional.

Hire an Independent Contractor or an Employee?

Houston Tax Attorney

1

Hire an Independent Contractor or an Employee?

Your business is growing and you need help. Do you hire an employee or an independent contractor?

Difference between an employee and independent contractor

It can be at times difficult to make a clear-cut distinction between an employee and independent contractor. The term independent contractor has been defined by common law, the Fair Labor Standards Act, and court cases. The IRS looks at the degree of control and independence of the worker. The tests for making this determination fall into three categories:

  1. Behavioral: Does the company control or have the right to control how the person does her job?
  2. Financial: How is the worker paid, how are expenses reimbursed, and who provides the the tools, etc?
  3. Type of relationship: Are there written contracts or employee-like benefits? Will the relationship continue, and is the work performed a key aspect of the business?

The IRS has an extensive 20 factor test for determine whether the person is an employee or independent contractor. Basically, if you are directing the person how to do the work, providing significant training, and paying a guaranteed set wage amount, you likely are in an employer-employee relationship.

The pros and cons of employee vs. independent contractor

There are major benefits to having a worker classified as an independent contractor (IC).

  1. Financial. When you hire an employee you will pay a number of expenses that you wouldn’t if you hired an IC, such as employer-provided benefits, office space, and equipment. You must also make contributions on behalf of the employee, including your share of the employee’s Social Security and Medicare taxes (7.65%), state unemployment compensation insurance, and workers’ compensation insurance. These costs could increase your payroll costs by 20 to 30%.
  2. Staffing flexibility. An independent contractor is generally hired for a specific task or project and the relationship ceases at that point. There is no headache of hiring and terminating an employee. In addition, independent contractors are already trained and can be productive on the job almost immediately.
  3. Reduce your exposure to lawsuits. Minimum wage laws, employment discrimination laws, right to form a union, and right to take time off to care for a sick family member or new child are not applicable to ICs as they are to employees

If after applying the above three factors, it is not clear whether the person qualifies as an employee of IC, you may file a Form SS-8 “Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding” with the IRS. The form can be filed by either the employee or the worker and can take up to 6 months for the IRS to make a determination. This can be useful for business owners who repeatedly require the same services.

The downside to hiring an independent contractor is that you do not have as much control over the work that is performed, your right to terminate the IC is not at will, and you may b at greater risk for government audits by the IRS or Department of Labor.

Forms and taxes

If you’ve made the decision to hire an independent contractor, the first step would be to have to worker fill out a Form W-9. This is used to request the correct name and SSN/EIN of the worker. This form should then be kept in your files for future reference if required by the IRS. If you’ve paid the person more than $600 during the year, you must fill out a Form 1099-MISC. The 1099-MISC must be provided to the IC by January 31st of the year following the payment and you must mail a copy to the IRS by February 28th.

If you have hired an employee, there are several forms and taxes for which you are responsible as the employer, including:

  1. Federal income tax withholdings. You should have your employee fill out Form W-4 prior to employment in order to determine the correct amount of taxes that should be withheld from his or her paycheck.
  2. Social Security and Medicare taxes. Employers must withhold part of social security and Medicare taxes from employees’ wages and pay a matching amount. There is also an additional Medicare Tax amount that must be withheld if the employees’ salary exceeds a certain threshold.
  3. Federal Unemployment tax. Employers pay a 100% of this tax. The employee does not pay any portion of this.
  4. State Unemployment tax.

These taxes must be deposited by the employer with the IRS according to two schedules, monthly and semi-weekly. At the beginning of the calendar year you will need to determine the correct schedule to use. The state unemployment tax is deposited with the Texas Workforce Commission.

Conclusion

There some strong advantages to hiring an independent contractor. But employers would be well-advised to understand the importance of classifying their workers correctly. Misclassification can result in having to pay back state and federal taxes for unemployment, disability, social security, and Medicare, as well as expenses, overtime, and retirement benefits.

It is important that you make the correct determination the first time to avoid costly mistakes. The Law Office of Kunal Patel, LLC can guide you through every stage of this process and save you time and money down the road.

Attorneys’ Fees – Are they Deductible?

Houston Tax Attorney

0

Attorneys’ Fees – Are they Deductible?

The good news for taxpayers is that attorneys’ fees in relation to tax services for individuals and small business issues are deductible!

Basic Rule

The basic rule is that attorneys’ fees are taxable if incurred to:

  1. Produce or collect taxable income; or
  2. Help determine, collect, or obtain a tax refund.

Simply put, you can deduct an attorney’s help to make money that you’ll have to pay taxes on; or if an attorney helps you with a tax matter such as an audit, back taxes, etc. For small businesses, you can deduct incorporation fees, tax planning, bookkeeping services, etc.

Examples of Deductible Attorneys’ Fees

Examples of fees that would be deductible are:

Examples of Non-deductible Attorneys’ Fees

Attorney fees such as the following are not deductible:

  • Filing a personal injury lawsuit
  • Drafting a will or settling a probate matter
  • Obtaining custody of a child
  • Non-tax issues in a divorce
  • Name changes
  • Civil suits that are not work or business related