As income for real estate investors increases, so have IRS audits in these areas. While it is important to minimize our tax liabilities, it is just as important that we do so in the most strategic way to protect ourselves from unwanted correspondence from the IRS.
Today, I want to write about some of the top issues that the IRS is focusing their audit efforts on. These are some of the areas where IRS agents are being trained to specifically focus on in the coming years. It’s always good to know what these areas of interests are so that we can plan for and document accordingly in case of a potential audit.
A current IRS target area is meals and entertainment deductions. The IRS has realized that a lot of taxpayers overstate company meals and entertainment expenses on their tax returns. So here is the technical rule: A meal or entertainment expense can only be claimed if business occurs immediately before, during, or after the meal. Some of you may think, “How is the IRS going to prove that I didn’t discuss business during lunch?” Well, remember that the law states that the burden of proof is on the taxpayer. In other words, the IRS doesn’t have to prove anything. It’s up to you to prove that business occurred in order for you to take the expense.
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The Top 3 IRS Audit Areas Real Estate Investors Should Know About
Meals and Entertainment
A good way to provide the support is to obtain the business card of the individual you met with. You can further substantiate that by jotting down a couple words regarding what business was discussed. If your business is in an industry that involves a lot of entertaining and eating, make sure you have sufficient documentation to support that deduction.
Another good fact pattern to have is to create a company policy regarding meals and entertainment. State in the policy that the company will only reimburse these expenses if business occurred before, during, or after the meal. I have seen situations where the IRS looks very favorably upon companies who have these policies in place.
Large, Vague Expenses
Another area that IRS agents love to dig into is individuals or businesses with big, unexplained expenses. Examples of these expenses are commonly called “credit card expenses” or “general and administrative expenses” or simply “other expenses.” IRS auditors love digging into these expenses because these descriptions are very vague. One of the reasons the IRS has decided to focus on these vague deductions is because this is where taxpayers typically will throw in some questionable items.
This is not to say that we should not have any general and administrative or other expenses on our tax return. Instead, what we recommend is that you try to break it out and be as descriptive as possible. An example would be instead of showing $5,000 of other expenses, you might show $1,000 for telephone, $500 for magazine subscriptions, $3,500 in continuing education, and so on. Knowing that this is an area of focus for the IRS, we recommend that you revisit your accounting and bookkeeping system. If you currently have a large balance in vague accounts such as “Other Expenses,” take the time now to separate out those expenses so that you can be more descriptive when it comes time to file your tax returns.
Related Party Transactions
Another area the IRS is ramping up efforts to audit is related party transactions. This is a fairly complicated area of the tax law, so we won’t go into details on this. But examples of related party transactions would be: 1) making a business loan to your children, 2) selling a business to your brother, or maybe 3) having one of your entities pay the other entity for services or goods. Again, this is not to say that you should avoid this type of tax mitigation strategy because frankly, these are good strategies to shift income and transfer assets. So let’s not abandon these ideas; rather, if you have these types of related party transactions, be proactive in working with your tax advisor on how to correctly document these transactions.
Now that we know some of the important areas that the IRS has been targeting, we can be proactive in minimizing our risk. One of the best ways to audit-proof our tax return is to have sufficient documentation to support the positions taken. For example, if you are a real estate professional, make sure you have the documentation that indicates the amount of time spent on qualified activities. Similarly, if you are a business owner taking auto deductions, having a mileage book will help to overcome scrutiny from the IRS.
If you are like most people, you probably hate the idea of all this documentation and tracking. As mundane as these things may be, the documentation and support are your insurance to get out of paying the IRS in the event of an audit. My recommendation is to put some steps in place to help you systemize this process.
Create a tracking process that is simple yet thorough to capture all relevant data. Once the process is in place, make sure to use it consistently. Don’t wait until the auditor comes knocking to create your documentation!
It is important to understand that audit flags do not necessarily lead to actual audits. Don’t hesitate to take deductions you are legally entitled to. Do spend the time to make sure that you have all your ducks lined up in case of an unwanted IRS visitor.
What do you do as an investor to decrease your audit risk? Have you run into issues in any of the above mentioned areas in your business?
Leave me a comment, and let’s discuss!