February 5, 2010

How Taxpayers Can Avoid Preparer Fraud

Paid tax return preparers are acutely aware of increased IRS scrutiny of their industry. The IRS has recently issued an announcement aimed at clients of return preparers enlisting their help in reducing tax return preparer fraud and warning them that they are responsible for what is submitted on their behalf to IRS.

The vast majority of preparers are good, honest professionals, but as usual, a few “bad apples” have forced the IRS to address the fraudulent and other illegal activities of unscrupulous members of the tax return preparer community. These activities involve the preparation of fraudulent returns generally by claiming false business and personal tax deductions and credits, such as the Earned Income Credit. Many times the taxpayer or client is not even aware of the fraud. Nevertheless, taxpayers and not the preparer are liable for the additional tax, interest and penalties. The taxpayer may also have to pay for professional assistance in representing him or her before the tax examiners. Tax fraud can also be a crime, punishable by imprisonment and hefty fines.

In its announcement, the IRS delineated numerous ways in which taxpayers can avoid tax preparer fraud. First of all, clients should review their tax returns and question entries they are not familiar with. They should never sign a blank return and never use a preparer who charges a fee based upon a percentage of the refund. Be especially wary of preparers who promise a larger refund than other tax return preparers. Make sure the preparer signs the tax return (as required by law) and provides a copy.

Clients should also do some research on their potential preparer. Only CPAs, Attorneys and Enrolled Agents can represent clients in all matters related to federal income taxes such as audits, appeals and collection issues. Other tax return preparers, which may be as competent as CPAs, Attorneys and Enrolled Agents, can only represent taxpayers for audits of returns prepared by them. Taxpayers should also take into consideration whether the preparer will be around to answer questions about the return several years after the return has been filed. The IRS can audit tax returns generally until three years after it has been filed
(Six years for potential fraudulent returns). Finally, clients should inquire as to what professional organizations their preparer is affiliated with. Most professional organizations require its members to obtain continuing education credits and to adhere to it’s code of ethics.

Individual Retirement Accounts (IRAs)

The beginning of tax season is always a good time to review the rules applicable to IRAs. Early 2010 is an especially good time because for the first time anyone can change their Traditional IRA to a Roth IRA. IRAs are tax advantaged personal retirement vehicles legislated into existence several decades ago. Over the years, several different types have evolved. The original IRA is now termed “Traditional IRA” to which an individual may make either a deductible or non deductible contribution. Contributions to a “Roth IRA” are never deductible. The third type is a “Simplified Employee Pension or SEP” which is nothing more than an individual’s Traditional IRA to which the individual’s employer makes contributions on behalf of such individual.

There are several rules applicable to both Traditional and Roth IRAs. The maximum contribution that can be made to all IRAs is $5,000 for 2009 and 2010 ($6,000 if the individual is at least 50 years old). A contribution for 2009 can be made up to 4/15/2010. An individual (or spouse in certain cases) must have earned income or alimony at least equal to the contribution. Finally, deductible contributions to a Traditional IRA and contributions to a Roth can be limited or eliminated if certain income limitations are exceeded.

Most people make contributions to Traditional IRAs only if tax deductible. Earnings and appreciation are tax deferred until distributed at which point the full amount of any distribution is taxed at ordinary income tax rates. If non deductible contributions have been made, a prorated portion of any distribution is a tax free return of after tax dollars. One cannot contribute to a Traditional IRA once they reach 701/2 years of age. Distributions must begin the year after attaining age 70 1/2 (“Required Minimum Distributions or RMDs”). Distributions before age 59 1/2 are subject to a 10% premature distribution penalty, with certain exceptions.

Contributions to a Roth IRA are never tax deductible. Distributions of contributions, earnings and appreciation are tax free if made after the 5th anniversary of opening a Roth account when the individual either attains age 591/2 or certain other conditions are met. Contributions to a Roth can be made after reaching age 70 1/2. There is no Required Minimum Distribution for the owner of a Roth and generally no 10% premature distribution penalty.

As previously mentioned, deductible contributions to a Traditional IRA and contributions to a Roth IRA may be limited by income (“Modified Adjusted Gross Income” or “MAGI”). The amount of deductible contributions for unmarried individuals participating in their employer’s retirement plan begins to phase out for 2009 when MAGI equals $55,000 and is completely phased out at $65,000 ($56,000 and $66,000 respectively for 2010). For married individuals filing a joint return, if both spouses are covered by an employer plan, the deductible contribution for both 2009 and 2010 begins to phase out when MAGI equals $89,000 and is completely phased out at $99,000. If your spouse is covered but you are not, your deduction begins to phase out at $166,000 and is eliminated at $176,000 for 2009 ($167,000 and $177,000 respectively for 2010). For 2009 and 2010 the deductible contribution for married taxpayers filing separately begins to phase out at $0 and is totally phased out at $10,000 of MAGI if either the taxpayer or in some cases their spouse is a participant in an employer plan for both 2009 and 2010. Non-deductible contributions to a Traditional IRA are not limited by income.

The ability to make a contribution to a Roth IRA is phased out when MAGI exceeds certain levels irrespective of active participation in an employer retirement plan. For unmarried taxpayers, this ability begins to phase out when MAGI equals $105,000 and is completely phased out at $120,000 for both 2009 and 2010. For married taxpayers filing a joint return, the phase out amounts are $166,000 and $176,000 for 2009 ($167,000 and $177,000 respectively for 2010). The phases out amounts are $0 and $10,000 for married taxpayers filing separately for 2009 and 2010.

Many taxpayers think a Roth IRA would be favorable to a Traditional IRA considering the inevitable increase in income tax rates. Conversion to a Roth was previously available only to those with income less than $100,000. The tax law offers a window of opportunity to anyone, regardless of income, to convert to a Roth beginning in 2010. The next post will examine this opportunity.

Avoid These Mistakes When You File Your Tax Return

According to the IRS, taxpayers continue to make the same mistakes every year when they file their tax returns. These mistakes lead to at best a delay in receiving your refund and at worse, closer scrutiny of your return by the IRS examiners. All of the following common mistakes are easily avoidable by exercising due diligence.

Using and verifying one’s proper social security or taxpayer identification number seems to be more difficult than one would expect. While entering a taxpayer’s proper number on the return is easy enough, problems can and do arise when a third party reports income and deductions to IRS using the wrong number. Pay careful attention to 1099’s. For example, reporters sometimes use your number on your child’s account or vice versa. Divorced taxpayers sometimes have their home mortgage interest deduction reported on form 1098 under their ex-spouse’s social security number Also, be careful to enter the correct social security number of your dependent child or your return will bounce.

Some taxpayers, at least according to IRS, have difficulty in determining their proper filing status. This mistake is especially common among taxpayers whose marital status is in flux. With respect to the tax code, you are either married or not on the last day of the year. If you are married, you can choose between filing a joint return with your legal spouse or choose to file as married filing separately. You cannot file as a single taxpayer. For most taxpayers, filing a joint return will result in lower taxes, but can subject an “innocent” taxpayer to the tax liabilities of their spouse. When in doubt, use the married filing separately status because you can later amend your return and file jointly with your spouse. You cannot initially file a joint return and later amend to file married filing separately. Single and certain married but legally separated taxpayers who maintain the household of certain dependents may qualify for the head of household filing status, which is better than single or married filing separately. According to IRS, this option is either frequently overlooked or wrongfully used.

Failing to claim or wrongfully claiming the Earned Income Credit is another common error. The rules are extremely complex but if not addressed you can cost yourself a lot of money by failing to claim or subject yourself to substantial penalties by wrongfully claiming the credit.

The IRS seems to have developed a form for every issue and strongly prefers that you use their forms. For example, if you claim unreimbursed employee business expenses as a deduction, be sure to use form 2106 or you return may bounce. Similarly, non cash charitable contributions over $500 will be disallowed unless IRS Form 8283 is attached to the tax return.

An error that is increasingly becoming more common is the failure to compute and pay the Alternative Minimum TAX (AMT). The AMT is a tax that parallels the income tax and is payable to the extent it exceeds the regular income tax. Taxpayers with income greater than the AMT exemption of $46,700 ($70,950 for joint returns) must consider this tax or IRS may do it for them. As usual. IRS has a form (6251) to help compute this tax.

Finally, be sure to sign and date your tax return.