In our line of work as tax practitioners, clients and advisors often ask us to share the income tax audits we are encountering most commonly at any given time. Audits are conducted by Federal or state taxing authorities to ensure the accuracy of positions taken by taxpayers on their income tax returns. Audits can be conducted based on random selection or because of a specific item reported on a tax return. Below is a list of some positions that taxing agencies have chosen to scrutinize more frequently in recent audits.
QSBS (Qualified Small Business Stock)
The IRS has recently begun auditing Qualified Small Business Stock (“QSBS”) sales. Auditors tend to be most interested in these areas:
- Aggressive positions held by married taxpayers wherein each spouse reports their own QSBS exclusion.
- QSBS company verification. Certain business ventures, such as those in accounting or law, do not qualify for QSBS.
- Taxpayers sometimes “stack” their QSBS exclusion by gifting to various trusts or family members. QSBS “stacking” is also triggering audits at this time.
If claiming a QSBS exclusion on a tax filing, please consult carefully with your advisors and ensure that you have retained all the proper documentation, including legal opinions, documents to confirm QSBS eligibility, and purchase/sale documents so that you can be prepared in case of audit.
Bad Debt and Worthless Securities
Both the Federal and state taxing authorities have long scrutinized the bad debt and worthless security write-offs.
Taxpayers are allowed to write off bad debt in certain circumstances. Business bad debt that was created or acquired during the course of a taxpayer’s trade or business is generally deductible when the debt becomes worthless. Nonbusiness bad debt such as loans to friends can be much trickier to deduct. To qualify as a legitimate deduction, the loan must be completely worthless without the slightest hope or possibility that any amount, no matter how small, will be repaid. In addition, you must be able to demonstrate reasonable collection efforts were undertaken, and further efforts would have been useless. Tax examinations test to confirm that a bona fide debt exists, collection efforts were made, and that the debt is truly worthless.
Similarly, in order to write off worthless securities, the security must be completely worthless without even the slightest expectation for future return, no matter how small. In addition, the loss for the worthless security must be taken in the proper year or the year in which the security becomes worthless. Uncertainty where value and timing are concerned may cause problems for the taxpayer’s case. For many of our clients, if there is uncertainty, we advise taking certain actions such as affirmatively abandoning the stock by relinquishing it back to the company or selling to an unrelated third party to provide a more definitive position for write-off.
If claiming a write-off of bad debt or worthless stock, it is best to consult your tax advisor to ensure that you have all documentation to support your deduction. Ask your tax advisor if you should take further action, such as an abandonment or sale to strengthen your position should you be audited.
Losses from Failed Business Ventures
Taxpayers who report consistent or large losses via their business ventures may be subject to increased audit scrutiny. This includes taxpayers who report income and deductions from their sole proprietorships directly on their returns. Taxing agencies have also audited those who elect to be treated for tax purposes as “real estate professionals” who can deduct losses from their real estate ventures without certain limitations for Federal purposes. Audit scrutiny may focus on substantiating the business expenses claimed, ensuring that the business venture is not a hobby, or confirming that certain requirements are met in order to claim certain tax beneficial deductions, credits, or positions.
Work closely with your tax advisor to report business venture losses correctly. To claim losses, understand what is deductible and what substantiation should be retained for said deductions.
Charitable Contributions
Charitable donations have long been an audit focus for both Federal and state taxing authorities. In order to deduct contributions, taxpayers must maintain a bank record (e.g. a cancelled check) to prove that the donation was made. Taxpayers should also keep a contemporaneous written acknowledgment of their contribution from the recipient. The contemporaneous written acknowledgment must include the name of the charity, date of the contribution, amount contributed, and a statement related to whether goods or services were provided in exchange for the gift. In addition, further disclosures and information may be required when reporting noncash charitable gifts.
More information may be required for more complex charitable gifts like stocks donated shortly before a sales or merger transaction. Taxing agencies may require documentation of timing as well as facts and circumstances to ensure that a definitive agreement regarding a sale/merger transaction was not in place at the time of the gift. Both the Federal and State taxing authorities will generally audit these types of transactions to review timing as well as facts and circumstances. If it is determined that a definitive agreement was in place, an audit adjustment may be made to the income associated with the gift, often negating any benefit to the gift being made.
It is important to gather all necessary documentation when making a donation, as this could affect your deductibility. On more complex transactions, ensure that you have documentation not only related to the required disclosures on the return, but also notes regarding the timing as well as the facts and circumstances in place at the time of the gift supporting that there was no definitive agreement in place at the time of the gift.
Residency
When taxpayers move out of state, they can trigger certain residency tax issues, as most states assess income tax differently.
California’s Franchise Tax Board has increased audits of taxpayers who have moved out of the state. The audits examine whether a taxpayer has truly broken California residency and examine certain sources of income, as some income can still be sourced to California even after a move. For example, income from restricted stock vesting could still be sourced to California after a change in California residency if the restricted stock was initially granted while the taxpayer was a California resident.
Residency audits tend to be very detailed and time-consuming. If you are considering breaking residency, it is important to work with your tax advisor to build a strong file for the change in residency.
“Audit Ready” with Realize:
Please note that the above list is meant to be illustrative of the types of common audits we have seen in the last year. This list is not meant to be definitive for all types of audits that may be opened by Federal and state taxing authorities. Your Realize advisors are aware of all audit issues and will work hard to ensure that you are “audit ready” if you decide to take one of these positions.
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