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Beat an IRS Audit provides readers with everything they need to know to handle an audit. From discussing information on avoiding the audit in the first place, to explaining what steps to take to prepare for one if selected, the entire process is simplified and made understandable.
Excerpted from Beat an IRS Audit by James O. Parker ©2007
In addition to the personal exemption available to taxpayers and their spouses, exemptions may also be taken for dependents. However, they must meet the five dependency tests to qualify the taxpayer to take an exemption for them.
The Relationship Test In order for a taxpayer to be entitled to take an exemption for someone as his or her dependent, that party must have either lived with him or her as a member of the party's household for the entire tax year or must be related to the taxpayer to the degree specified in I.R.C. §152. Those who are considered to be relatives of a taxpayer under the provisions of Section 152 are children, stepchildren, grandchildren, and great-grandchildren; brothers and sisters, including half brothers and sisters and stepbrothers and stepsisters; parents, stepparents, grandparents, and great-grandparents; aunts and uncles; nieces and nephews; parents and siblings of a spouse; and, sons-in-law and daughters-in-law. Any of the relationships created by marriage are not terminated by divorce or by the death of the taxpayer's blood relative.
The Citizenship or Residency Test A person for whom a taxpayer wishes to take an exemption as a dependent must be a citizen or resident of the U.S., or a resident of Canada or Mexico. As long as the party meets this requirement for some part of the calendar year in which the taxpayer's tax year begins, the requirement of the test is considered met for the year.
The Joint Return Test Generally, if a taxpayer is otherwise entitled to take an exemption for a dependent, but the dependent is married and files a joint return, the taxpayer will not be allowed to take the exemption. The lone exception to this provision is the situation in which a party's married dependent files a joint return with his or her spouse in order to claim a refund of taxes withheld from earnings, but would otherwise have such low earnings that no taxes would have been due for either of them if they had filed separate returns.
The Gross Income Test In order to be entitled to take an exemption for a dependent, the dependent person cannot have gross income in excess of the amount of the exemption deduction. However, a parent is allowed to claim an exemption for his or her dependent child, regardless of how much the child earns, as long as that child is either under the age of 19 at the end of the year, or under the age of 24 at year's end and a full-time student for at least five calendar months during the calendar year. Even though parents may be allowed to take an exemption for dependent children with incomes of their own, the result will be that the children will not be allowed to take an exemption for themselves on their own returns.
The Support Test To qualify to take an exemption deduction for a dependent, a taxpayer who is otherwise qualified to take the exemption must usually provide more than half of the support for that person. However, there are two exceptions to this rule.
Multiple Support Agreements If two or more otherwise qualified people together provide over 50% of a party's support, but no individual person provides the party with over half of his or her total support, any otherwise qualified person who provides over 10% of the party's support may claim the exemption for the dependent, as long as every other qualified party who provided over 10% of the dependent's support signs a Form 2120, which is a Multiple Support Declaration, stating that they will not claim the exemption for the dependent. An executed Form 2120 from each otherwise qualified party who is not taking an exemption for someone that they provided over 10% of their support to must be included with the tax return of the taxpayer who does claim an exemption for the dependent. Taxpayers should keep a copy of each Form 2120 for their own records, as well.
Children of Divorced or Separated Parents Normally, if a child's parents are divorced, legally separated under a written separation agreement, or they lived apart for the last six months of the calendar year, the parent who had custody of the child for the larger part of the year will be considered to have provided over half of the child's support and will be entitled to claim the child as a dependent for tax purposes. This rule will not apply if the noncustodial parent can show that he or she actually provided over half of the child's support for the year. If there is a divorce decree or a decree of separate maintenance that states which party will be entitled to claim an exemption for a couple's dependent child, the decree will govern.
Audit Aspects of Tax Exemptions There are a couple of situations in which exemptions can trigger an audit. The first is when more than one person claims the same person as a dependant for an exemption. In order to be allowed to take an exemption for a dependent, a taxpayer must supply the IRS with the claimed dependent's Social Security number and describe the relationship between the parties. The IRS automatically cross-references Social Security numbers to detect situations in which more than one taxpayer has claimed a person as their dependent. When this occurs, the IRS will contact the parties involved to make a determination as to whom, if anyone, is entitled to claim the exemption.
The second occurs when the taxpayer is in a relatively high tax bracket. Taxpayers with relatively large incomes must reduce their allowance for exemptions. Taxpayers whose incomes exceed a statutorily set threshold amount must reduce their exemptions deductions by 2% for every segment of $2,500 that their income exceeds the threshold amount, up to a maximum of 100%. The threshold amounts are adjusted for inflation each year and reflected in a worksheet, provided in the Form 1040 instructions, for calculating the exemption deduction phaseout. If a taxpayer fails to make the required adjustment, the IRS will recalculate the taxpayer's tax liability and notify him or her of the recalculation and resulting tax deficiency.
SECTION I: The Basics of U.S. Income Taxation of Individuals
Chapter One: Income Who is an Individual?
Income of Individuals Earnings from Employment Interest Rents Royalties Dividends Distributive Share of Partnership Income Income from Discharge of Indebtedness Other Section 61 Sources of Gross Income Gross Income Income Excluded From Taxation Gifts and Inheritances Insurance Proceeds Recovery of Adjusted Basis from the Sale of an Asset Gain from a Primary Residence Assigning Income
Chapter Two: Deductions Qualifying to Take Business Deductions The Ordinary and Necessary Requirement Non-Business Adjustments for Adjusted Gross Income Deductions Available Only to the Self-Employed Deductions for Adjusted Gross Income that are Available in General Deductions from Adjusted Gross Income Itemized Deductions Medical and Dental Expenses Taxes Paid Itemized Interest Expenses The Home Mortgage Interest Deduction Investment Interest Charitable Contributions Casualty and Theft Losses Calculating the Personal Deduction for Casualty and Theft Losses Miscellaneous Deductions The General Limitations on Itemized Deductions The Standard Deduction Determining Filing Status Additional Standard Deduction Allowance for the Aged or Blind The Standard Deduction for Those Claimed as a Dependent by Others Those Ineligible for the Standard Deduction
Chapter Three: Exemptions Personal Exemptions Exemptions for Dependents The Relationship Test The Citizenship or Residency Test The Joint Return Test The Gross Income Test The Support Test Multiple Support Agreements Children of Divorced or Separated Parents Audit Aspects of Tax Exemptions
Chapter Four: Federal Income Taxes and Common Tax Credits Regular Federal Income Taxes Alternative Minimum Tax Self-Employment Taxes Tax Credits
SECTION II: Audit Essentials
Chapter Five: The Audit Process The Letter Audit The Office Audit The Field Audit
Chapter Six: IRS Approaches to Audits The Bank Deposits Method Indirect Methods of Establishing Income-Using Earnings to Reconstruct Income Indirect Methods of Establishing Income-Using Expenditures Plus Increase in Net Worth to Determine Income The IRS Response to the Cash Hoard Defense
Chapter Seven: Circumstances that are Most Likely to Cause an Audit Income From Self-employment Using the Services of Independent Contractors Owning an Interest in a Partnership or Small Business A Dealer Showing Investment Income in the Items in Which He or She Deals Securities Dealers Real Estate Dealers Royalty Income Deducting Business Losses Combining Activities in Order to Qualify for the Presumption Proving a Profit Motive When the Presumption Does Not Apply Taking a Deduction for an In-Home Office Uses That Must Be Both Exclusive and Regular Uses That Must Be Regular But Not Exclusive What Draws Attention From the IRS Toward Home Offices Engaging in Bartering Taking Abnormally Large Itemized Deductions Other Activities that May Trigger an Audit
SECTION III: Responding to Audit Notices and Dealing with Deficiencies
Chapter Eight: Preparing for an Audit and Responding to the Findings Keeping Proper Records Auto Expense Records Records of Business Meals and Entertainment Supporting Schedule A Deductions Making Notes During Preparation of Tax Returns Responding to an Audit Notice
Chapter Nine: Responding to Audit Results and Tax Deficiencies Dealing with a Tax Deficiency Consequences of Failure to Pay Taxes Installment Agreements Offers In Compromise Discharging Tax Liability by Filing Bankruptcy
Glossary Appendix A: IRS Form 656, Offer in Compromise Appendix B: Payment Plans Appendix C: IRS Form 2848, Power of Attorney and Declaration of Representative Index About the Author
James O. Parker received his law degree from Memphis State University Humphreys School of Law. He received his LLM in taxation from Emory University School of Law. Mr. Parker currently practices in the areas of taxation, business law, probate and real estate. His private practice is located in Memphis, Tennessee.