Tax audits haven’t been high on most Americans’ list of concerns lately. IRS funding cuts and staffing shortages reduced the audit rate from 0.9% in 2010 to 0.2% in 2020. But that decline is poised to rebound—recent legislation has allocated billions of dollars to the IRS. More money for the IRS inevitably means more audits for taxpayers. It shouldn’t shock anyone that Washington wants to boost its audit revenue—the government has spent a massive amount in recent years, and that money has to come from taxpayers.
Some tax returns have far higher audit risk than others. Examples: Taxpayers who claim the earned income tax credit face increased audit odds, as do those who claim home-office deductions. But in addition to those audit triggers, certain matters seem to be of particular interest to the IRS recently…
Cryptocurrency. The IRS considers crypto to be property (not currency). That means purchases and sales of cryptocurrency must be tracked and reported to the IRS much like stock trades—and taxes are due on the capital gains. Someone who regularly uses cryptocurrency to make purchases and/or who trades it might have dozens of reportable transactions in a year—even converting one form of cryptocurrency to another may be a taxable event.
The IRS is watching this closely because some crypto owners don’t understand or follow these tax-reporting rules…and others believe that the IRS will never find out if they fail to report their crypto transactions. Reality: The IRS has forced online crypto-trading platforms to surrender user information and transaction records.
What to do: With IRS attention so clearly focused on this topic, taxpayers would be wise to track and report crypto transactions carefully and honestly using IRS Form 8949, Sales and Other Dispositions of Capital Assets.
Foreign accounts. The IRS is paying attention to foreign accounts and not just those belonging to billionaires stashing assets in offshore tax havens. Ordinary Americans who have foreign accounts of any size, perhaps because they once lived abroad or have foreign vacation homes, increasingly are under scrutiny as well.
It’s easy to make mistakes with the IRS’s foreign-account rules. Some taxpayers believe they don’t have to report foreign accounts that contain less than $10,000, for example—but that $10,000 threshold determines only whether the taxpayer must file a Report of Foreign Bank and Financial Accounts (FBAR) form by April 15 (there is an automatic extension to October 15). Also note that the threshold is aggregate, meaning that the accounts can all be under $10,000 but if together they add up to more than $10,000, there is a filing requirement.
What to do: Taxpayers who have any foreign account—even one with a single peso or euro—must check a box on Schedule B acknowledging this account.
Other taxpayers interpret the $10,000 minimum to mean that they don’t need to file FBAR if they don’t have a foreign account worth $10,000 at year-end. In fact, this form must be filed if the total value of all of a taxpayer’s foreign accounts exceeds $10,000 at any point during the year, even if no one account value reaches $10,000. This applies not just to foreign bank accounts but also to brokerage accounts, pensions and life insurance policies that have cash value. The penalties for failing to file a FBAR can be up to $10,000 per year per account if the failure is deemed “nonwillful”…and potentially more if it’s considered “willful.”
Warning: A taxpayer who worked for a foreign employer at any point during his/her career might have a tax-deferred or tax-exempt foreign pension plan comparable to a 401(k). To what degree these foreign accounts receive favorable tax treatment from the IRS depends on the terms of the tax treaty the US has with that country, if such a treaty exists. These rules can be confusing—taxpayers who have foreign pensions should seek out tax preparers who have significant experience with foreign pension plans.
Side-hustle earnings. The IRS is cracking down on people who fail to report even modest income from “side hustles,” such as selling things online. Until this year, digital-payment-processing companies such as PayPal and Venmo were required to report earnings of this sort via a form 1099-K only when someone had more than $20,000 in gross receipts and more than 200 transactions in a year. But: Starting in 2022, these companies must generate a 1099-K for anyone who has more than $600 in gross receipts regardless of the number of transactions. Taxpayers who fail to report this income on a 1099-K likely will receive IRS attention.
Important: Anyone who failed to report income handled by payment-processing companies in past years should consider filing amended returns for those years. Reason: Taxpayers were supposed to report income from side hustle businesses in prior years even if that income fell short of the earlier $20,000/200 transaction 1099-K thresholds. People who get on the IRS’s radar for failing to properly report 1099-K income in 2022 might discover that auditors investigate whether they failed to report similar income in past years as well.
Keep in mind: Many transactions handled by payment-processing companies are not considered taxable income—they’re settling up debts. Example: One friend buys theater tickets for a group outing, then the others use Venmo to pay him back. These transactions should not trigger 1099-K forms from payment-processing companies. If you receive a 1099-K form related to a personal transaction that was not taxable income, contact the processing company to have this corrected and advise the IRS that it is incorrect. Reaching the customer service department might be a hassle, but it’s a far better option than sorting out the situation with the IRS.
S corps, partnerships and sole proprietorships. The IRS historically has paid close attention to small businesses in sectors where cash payments are common, such as bars and restaurants. Audits of these small businesses declined during the pandemic but appear to be roaring back. The IRS also is cracking down on owners of S corps.
Dilemma facing these small-business owners: The IRS doesn’t define what constitutes a “reasonable salary.” To play it safe: Small-business owners should pay themselves salaries that are in the ballpark of what they would earn if they took a job serving a similar role for someone else’s company.
Rental properties. There are plenty of tax advantages to owning rental properties—maintenance costs and depreciation can be used to offset rental income, for example. But there also are plenty of ways to make mistakes with rental-property tax-reporting and/or to intentionally exaggerate expenses. Result: Returns of taxpayers who own rental properties often receive extra attention.
Beware: Rental-property losses can be used to offset rental income…but because rental income usually is considered passive income, these losses generally cannot be used to offset many other types of earnings, such as income reported on a W-2.
In addition: Taxpayers who have a rental unit on the same property where they reside sometimes face especially aggressive IRS attention. An IRS auditor might demand proof that deductions related to maintenance or upgrades for this rental unit actually were for the rental unit and not for the owner-occupied portion of the property. In addition to invoices and receipts, keep detailed records and/or photos to establish that these expenses were indeed for the rental unit.
Pandemic-era retirement account early withdrawals. Special 2020 pandemic rules made it possible for people younger than 59½ to remove money from their tax-deferred retirement accounts without paying the 10% early-withdrawal penalty that ordinarily would have applied. But while the 10% penalty could be avoided, income taxes still were due on money removed from tax-deferred retirement accounts. One of the options available for paying those taxes was to divide them up over three years—2020, 2021 and this year. The IRS is monitoring this closely to confirm that these taxes get paid.