Don\’t Be Caught by Surprise

Don\’t Be Caught by Surprise, for much of 2012, uncertainty about the fate of various favorable tax law provisions set to \”sunset\” at the end of the year has complicated tax planning. Although the situation may change, as this article goes to press, taxpayers are still waiting for answers from lawmakers and weighing what planning steps, if any, they should take before year-end. Key questions include:

• Will individual income-tax rates be higher in 2013?
• Will capital gains rates increase?
• Will qualified dividends lose the benefit of lower rates?
• Will a decreased exemption make more estates vulnerable to estate tax after 2012?

Until issues like these are resolved, taxpayers making important financial decisions may find it helpful to have projections of the potential tax effects of those decisions run under different tax law scenarios. Projections can provide a clearer up-front understanding of the possible tax impact.

 Ask Questions 

We also encourage taxpayers to consult with us before they engage in significant financial transactions if they have questions about how any tax law provision will apply to those transactions. Not knowing the whole picture can sometimes lead to unexpectedly harsh tax results.

A recent case illustrates this point. A taxpayer, age 56, rolled over a retirement plan distribution to an individual retirement account (IRA) when he terminated his job. A year later, he withdrew a large sum of money from the rollover IRA before he reached age 591/2. Normally, a 10% tax penalty applies to such withdrawals, but the taxpayer thought he qualified for one of the tax code\’s penalty exceptions. Unfortunately, the particular penalty exception the taxpayer thought he was eligible for applies only to distributions from an employer\’s retirement plan \”made to an employee after separation from service after attainment of age 55.\”

If the taxpayer had taken the distribution directly from the retirement plan, he would have satisfied those requirements. But instead he rolled the plan distribution into the IRA, and then made the withdrawal. Since he wasn\’t taking the distribution from his former employer\’s plan, he didn\’t qualify for the penalty exception – not necessarily a logical result, but one dictated by the wording of the tax code.

Have Good Records

When it comes to tax deductions, taxpayers should be sure they keep the records the IRS requires them to have. For example, business travel and entertainment expenses require very specific documentation. The IRS can (and does) disallow deductions on audit if taxpayers can\’t produce the required records.

S Corporation Audits

In fiscal years 2007 through 2011, the IRS completed 53,544 audits of S corporation returns – a 54% increase over the number of returns audited in the previous five-year period. For each return audited, examiners recommended about $105,534 ill adjustments to reported net profits and losses. Audit adjustments made at the corporate level also generally affect the individual tax returns of S corporation shareholders.

One way the IRS selects returns for audit is by using its Discriminant Index Function (DIF) system, which score returns based on their audit potential using mathematical formulas. But a high score doesn\’t always mean an auditor will find problems with a return. Some 62% of DIF-selected S corporation returns audited in 2011 were closed with no changes.

The IRS anticipates that by 2015 it \\will receive nearly 5.7 million S corporation returns for processing, a 26% increase compared to 2011.

Source: Treasury Inspector General for Tax Administration, Report Number 2012-30-062, 612112012

November 2012 Page 1