Individual tax rates
All of the following individual marginal tax rates are retained (10%, 15%, 25%, 28%, 33%, and 35%). A new top rate of 39.6% is imposed on taxable income over $400,000 for single filers, $425,000 for head-of-household filers, and $450,000 for married taxpayers filing jointly ($225,000 for each married spouse filing separately).
Phase-out of itemized deductions and personal exemptions
The personal exemptions and itemized deductions phase-out is reinstated at a higher threshold of $250,000 for single taxpayers, $275,000 for heads of household, and $300,000 for married taxpayers filing jointly.
Capital gains and dividends
A 20% rate applies to capital gains and dividends for individuals above the top income tax bracket threshold; the 15% rate is retained for taxpayers in the middle brackets. The zero rate is retained for taxpayers in the 10% and 15% brackets.
Alternative minimum tax
The exemption amount for the AMT on individuals is permanently indexed for inflation. For 2012, the exemption amounts are $80,800 for married taxpayers filing jointly and $51,900 for single filers. Relief from AMT for nonrefundable credits is retained.
Estate and gift tax
The estate and gift tax exclusion amount is retained at $5 million indexed for inflation ($5.12 million in 2012), but the top tax rate increases from 35% to 40% effective Jan. 1, 2013. The estate tax “portability” election, under which, if an election is made, the surviving spouse’s exemption amount is increased by the deceased spouse’s unused exemption amount, was made permanent by the act.
Various temporary tax provisions were made permanent. These include:
- Marriage penalty relief;
- The liberalized child and dependent care credit rules
- Expanded adoption credit and adoption-assistance program amounts;
- The exclusion for employer-provided educational assistance ;
- The enhanced rules for student loan deductions;
- The higher contribution amount Coverdell education savings accounts;
- The employer-provided child care credit .
Additional hospital insurance tax on high-income taxpayers.
The employee portion of the hospital insurance tax part of FICA, normally 1.45% of covered wages, is increased by 0.9% on wages that exceed a threshold amount. The additional tax is imposed on the combined wages of both the taxpayer and the taxpayer’s spouse, in the case of a joint return. The threshold amount is $250,000 in the case of a joint return or surviving spouse, $125,000 in the case of a married individual filing a separate return, and $200,000 in any other case.
For self-employed taxpayers, the same additional hospital insurance tax applies to the hospital insurance portion of SECA tax on self-employment income in excess of the threshold amount.
Medicare tax on investment income.
Starting Jan. 1, 2013 Sec. 1411 imposes a tax on individuals equal to 3.8% of the lesser of the individual’s net investment income for the year or the amount the individual’s modified adjusted gross income (AGI) exceeds a threshold amount. For estates and trusts, the tax equals 3.8% of the lesser of undistributed net investment income or AGI over the dollar amount at which the highest trust and estate tax bracket begins.
For married individuals filing a joint return and surviving spouses, the threshold amount is $250,000; for married taxpayers filing separately, it is $125,000; and for other individuals it is $200,000.
Net investment income means investment income reduced by deductions properly allocable to that income. Investment income includes income from interest, dividends, annuities, royalties, and rents, and net gain from disposition of property, other than such income derived in the ordinary course of a trade or business. However, income from a trade or business that is a passive activity and from a trade or business of trading in financial instruments or commodities is included in investment income.
Medical care itemized deduction threshold.
The threshold for the itemized deduction for unreimbursed medical expenses has increased from 7.5% of AGI to 10% of AGI for regular income tax purposes. This is effective for all individuals, except, in the years 2013–2016, if either the taxpayer or the taxpayer’s spouse has turned 65 before the end of the tax year, the increased threshold does not apply and the threshold remains at 7.5% of AGI.
Health flexible spending arrangement.
The maximum amount of salary reduction contributions that an employee may elect to have made to a flexible spending arrangement for any plan year is $2,500.
How to Avoid An Audit
Most people cringe when they hear the word audit. Going through the ropes and ultimately resolving an audit is no fun and could be costly, so it’s important to determine a plan of action to avoid being audited in the first place.
What Is A Tax Audit?
A tax audit takes place when the Internal Revenue Service or a state agency conducts a closer review of the financial records of a business, an organization, or an individual. The IRS primarily focuses on examining tax returns. This examination is done to ensure that all information is being properly reported on an actual tax form, such as IRS Form 1040.
In addition to traditional audits, there are also joint tax audits. A joint audit is the examination of a business or individual tax return by 2 or more auditors in 2 or more states who examine cross-border tax issues. These auditors work together on a single audit to gain a full understanding of the situation at-hand.
How Does An Audit Work?
While the process of flagging tax returns
for potential audits may seem random, the IRS uses the Discriminate Income Function (DIF) – a computer program that compares your deductions with those of others in your income
bracket – to search for inconsistencies.
If you get audited, it’s likely you’ll receive a notice in the mail that indicates you’re being audited, along with the specific reason. From there, you can either agree or disagree with the audit. To agree, you must sign off on the paperwork and send it back with any requested documents and payments to account for the inconsistencies on your audited return.
For an in-person audit, the auditor will visit your office or place of business to conduct a thorough review of your records. This process may involve examining your printed documents or computer systems. It varies on how long such an audit can take. In some cases, it could take an auditor several days – or even a few weeks –to sufficiently review the records in your office.
If you do receive a notice from the IRS detailing the issue with your tax return, make the recommended changes and send the requested documentation to fulfill the request. If you disagree with an audit, you can file an appeal with the IRS, which could ultimately lead to landing in a tax court if the issue cannot be resolved between you and the auditor.
What Causes An Audit?
Certain discrepancies raise red flags for auditors, such as miscalculations on tax returns, overestimations on deductions, and other information that appears to be inaccurate, inconsistent, or out of the ordinary.
Let’s take a look at a hypothetical example of a tax audit:
Jack miscalculated his home office deduction by claiming more expenses than he actually incurred while running his small business from home. Instead of writing down $500 for his home office deduction, he wrote down $5,000 on his tax return. The IRS agent reviewing the tax form noticed the unusually large deduction and flagged the return for an audit. The IRS then mailed Jack an audit notice, requesting that he clarify the write-off. He submitted his records, and it became evident to the agent that he miscalculated the deduction. It took 3 months to resolve the issue, and Jack had to file for an extension to avoid late-filing fees. He ultimately was able to claim the correct $500 amount for the home office deduction.
Who Normally Gets Audited?
In 2014, the IRS audited more than 1.2 million taxpayers. IRS statistics show that out of every 37 returns for people with incomes of $200,000 or higher, someone will get audited. For those who earn $1 million or higher, the probability is more like 1 out of 13.
But don’t think that the only people getting audited are the ones with yearly incomes that reach 6 or 7 figures. If you are a waitress, bartender, hairdresser, or are involved in any cash-based industry, you’re already more likely to be audited. The same goes for doctors, lawyers, or accountants who normally keep their own books. Sole proprietors and Schedule C filers also have a higher chance of getting audited than formally established business owners who operate LLCs or corporations.
Why To Avoid An Audit
There are several reasons why you should do your best to avoid being audited. For one, an audit can be a time-consuming process that will take away valuable time from focusing on your priorities and could result in you having to pay more in taxes to the IRS. Additional accuracy-related penalties exist for filers whose returns are incorrectly reported. Nobody wants to owe more money than they think they do. Also, the chances of a future audit increase if you’ve been audited before. Getting in major hot water can occur when taxpayers try to evade the IRS or file fraudulent returns. These actions could result in criminal charges.
IRS auditors are instructed to close audits within 28 months of the date you filed your tax return or the date it was due – whichever is later. This means an audit can be hanging over your head for over 2 years.
An audit could involve sending and receiving several pieces of mail in order to fully resolve the issue and pay any requested fees you owe to the IRS. Imagine having to open your mailbox every day wondering what your latest letter from Uncle Sam will say. Audits can be very tedious because of how much detail is involved in getting on the same page with the IRS. It can be what seems like a never-ending, back-and-forth nightmare.
Who wants to deal with the IRS for any reason at all – let alone for a long period of time in order to resolve one audited return? Of course, nobody does.
Tips To Avoid A Tax Audit
There are a few basic strategies you can use to significantly reduce your chances of getting that dreaded audit notice in your mailbox:
1) Ensure your tax return is 100% complete.
After your tax return has been completely filled out from top to bottom, review it with a fine-tooth comb. Make sure that every line that is applicable to your tax situation has been filled out completely and correctly. If you submit an incomplete tax return, a tax authority may question why you did not disclose certain information on your return.
If a line on your return doesn’t apply to you, still fill it in with a “0” or dash (—) so that nothing is left blank. A blank space can raise a big red flag.
2) Report all taxable income on your return.
Taxpayers who are categorized into higher income tax brackets – particularly earners of over $200,000 per year – typically have a higher chance of getting audited. While the good majority of individuals bring in most of this income legitimately from a small business, a W-2 job, or through interest or investments, all taxable income must be reported on your return. The IRS wants to know about every taxable penny you earn, so be sure you disclose it appropriately.
3) Avoid claiming large itemized tax deductions.
If you choose to itemize your tax deductions rather than claiming the standard deduction, the IRS may compare your write-offs to what fellow taxpayers in your income tax bracket claim on their returns. If the agent reviewing your return determines that your deductions are a little high, they might give it a second look.
4) Properly claim all eligible tax deductions on expenses.
Home office deduction: To claim the home office deduction when filing your return, you must use a specific area of your residence for business activities. You can write off either an appropriate percentage of your bills, or you can claim the flat-rate deduction of $5 per square foot with a maximum deduction of $1,500 for up to 300 square feet of home office space. It’s critical to fully document all of your home office expenses.
Meals and entertainment deduction: Self-employed professionals are also allowed to write off 50% of business-related meals and entertainment activities as a tax deduction. But you must follow a few rules to ensure the agent reviewing your return doesn’t question the deduction. Stick to the 50% write-off amount, document who was present at the gathering, and don’t forget to write down the type of business that was conducted or discussed. Saving receipts is a must, and failing to do any of these things could trigger an audit.
Travel expenses: Don’t forget travel expenses you can also write off. As long as you travel by plane, train, or automobile for business purposes, you can deduct these costs. Let’s say you fly from New York City to Los Angeles to meet with a client. You can deduct your flight, rental car, hotel, and any other travel expenses you incur for the trip. If you’re an employee, you may write off unreimbursed employee expenses, which could include travel costs.
Deducting charitable contributions: As a business owner, it’s also nice to be philanthropic. And you can save on taxes while helping others, too. Consider making donations to your favorite charity – clothing, toys, household goods, or even a vehicle. As long as you donate to a qualifying charity and save your receipts, you can deduct 100% of your non-cash charitable contributions on your tax return. Documentation is key here to help you avoid an audit.
5) Always claim accurate deductions on business losses you incur.
Business losses are commonly incurred, especially during the startup phase of a brand new company. To properly deduct any business losses you incur, they must qualify as deductible losses. The best way to meet this requirement is to launch or maintain a formally established business entity, such as an LLC, S corporation, or C corporation. Doing so helps you prove to the IRS that these losses are actually tied to your business and are not simply personal losses.
6) Explain yourself to the IRS.
If you think your tax return has a good chance of raising an audit flag, you should include extra forms, worksheets, or receipts with your filing. Use them to explain inconsistencies on any audited returns from the last few years in areas such as your name, your dependents, deduction amounts, and income. This can help you avoid unnecessary correspondence with the IRS when it comes to clarifying your information.
7) Double-check your numbers.
It’s easy to skip over numbers or calculations – Especially when you consider how many figures can appear on your tax form. So, you could easily make errors between the number 100 and the number 1,000 if you’re in a hurry to fill out your return. Calculations should always be done on a calculator – or even with an app on your smartphone – to ensure accuracy. Make the same calculations more than once to guarantee certainty in the numbers you record on your return for income and deductions. Pay close attention to zeroes, decimal points, and commas.
8) Incorporate if you work for yourself.
Filing a Schedule C as a self-employed taxpayer automatically increases your audit risk. If you are your own boss, consider incorporating or setting up an LLC for yourself. In general, corporations and LLCs are audited less frequently than sole proprietorships and partnerships. This is because what would ordinarily look abnormal on a personal return would make more sense for a business.
In essence, having a formal entity proves to the IRS that you are indeed operating a business, rather than claiming you are.
9) Avoid filing amendments to your IRS tax returns.
If you file an amended return, your original return could also come under scrutiny, so make an effort to file correctly the first time around. An amended tax return is filed in order to make corrections to an original return. This may involve correcting income amounts or deductions you are claiming. If you file an amended return, your original return could also get a second look. That’s why it’s critical to file correctly from the get-go. You don’t want the IRS to get suspicious when you’re submitting numerous returns for a single tax year.
The Bottom Line on Audits
There is no surefire way to guarantee that you will never receive an IRS audit notice in the mail in your lifetime. The same can be said for audits from non-federal agencies like state and local tax authorities. However, the aforementioned steps can significantly reduce your chances. It is also wise to work with an accounting professional who has dealt with audits in the past and knows how to avoid them in the future.