IRS Targeting Returns with Schedules A, C, or E

By Marcia Richards Suelzer, Toolkit Staff Writer

It's no secret the federal government is short on money. So the nation's tax collector is trying to fix this situation.

The IRS is attempting to increase revenue collection by closely scrutinizing individual tax returns most likely to contain errors. To this end, the Service mailed letters to 21,000 paid tax preparers who complete large volumes of tax returns with Schedules A (Itemized Expenses), C (Business Expenses) or E (Supplemental Income). In addition, 2,100 of these individuals can expect a visit from the IRS to verify that they are using due diligence and complying with all requirements when they prepare individual tax returns.

Warning. The IRS focused on returns with a high percentage of attributes that indicate errors in filing Schedules A, C or E. This does not mean returns that were actually found to contain errors. Rather, it means the IRS is targeting certain types of deductions that are likely to be on every small business owners' tax returns. Even if your tax return preparer did not receive a letter, you can rest assured that he or she is well aware of the initiative and is going to expect you to provide documentation for every expense.

While the IRS doesn't require that your preparer audit your books or verify every detail, he or she cannot ignore the implications of information that you furnish to him or her. In addition, your preparer is required to make reasonable inquiries whenever information that you provide appears to be incorrect, inconsistent with an important fact or assumption, or incomplete. Additionally, your preparer is obligated to make appropriate inquiries to determine the existence of facts and circumstances required as a condition for claiming a deduction or credit.

Be Aware of the Hot Buttons on Returns

When the IRS evaluates a return, the staff members zero-in on certain deductions. The letters sent to preparers provide both them (and you) with advanced warning of where the IRS will direct its attention for the 2011 tax year. Based on last year's returns, these are the items that are going to be examined more closely. Make sure you have the documentation to support each one that you claim.

Targeted items on Schedule A (Itemized Deductions):

• Unreimbursed Employee Business Expenses claimed on Form 2106. Taxpayers may only claim allowable unreimbursed expenses.
• Mileage claimed on Form 2106. Taxpayers should have documentation to support business miles claimed.
• Travel, meals and entertainment expense. Taxpayers must have documentation of business purpose, as well as receipts to support expenses claimed.
• Charitable contributions. Taxpayers must have receipts for all cash contributions and adequate documentation for all non-cash contributions.

The most common issues on Schedule C (Business Expenses):

• Gross receipts not being fully reported. Books and records should be available for review to substantiate amounts reported.
• Ordinary and necessary test met. Expenses claimed must be ordinary and necessary for the type of business reported. Make sure your preparer understands the exact nature of your business and uses the correct industry code on your tax return. In addition, make sure you can show the business purpose for each expense.
• Expenses deducted in correct year. All expenses claimed must have been paid or incurred during the tax year, and the allowable amount of the expense must be correctly computed. Be certain you have documentation for all expenses.

Schedule E (Supplemental Income) items mostly likely to pique the IRS's curiosity:

• Rental income and expenses not being properly reported. Make sure your documentation is adequate.
• Rental depreciation not being correctly calculated. This rests primarily on the preparer, but make sure that you advise him or her of any improvements you made or losses that you sustained.
• Deduction limitations correctly applied. Limitations surrounding passive activities, basis and at-risk rules not properly considered or calculated. Be prepared to prove how much time you put into your residential real estate activities and how much money you have on-the-line in connection with these properties.

As the year draws to an end--and the countdown to tax season begins--be prepared to help your tax professional prepare an accurate tax return on your behalf by assembling necessary documentation and following the rules regarding expense deductions. Advance preparation can reduce the likelihood of costly penalties and interest that can result from an inaccurate return.

And if you happen to prepare your own tax returns, consider yourself forewarned.