Are you an unwitting tax cheat?
The focus on accuracy has grown more intense as the estimated tax gap (the difference between what taxpayers owe and what they actually pay) has grown to $300 billion each year. And, in a bad economy, many Americans are feeling the burden of paying what they perceive to be more than their fair share of taxes -- causing some to be more prone to cutting corners. In fact, the IRS Oversight Board reported that 13% of the people it polled last year said it was acceptable to cheat, up from 9% in 2008.
While some taxpayers may think it's okay to cheat, others do so without even realizing it. Here are seven common ways that taxpayers cheat (deliberately or otherwise) on their tax returns:
1. Using the wrong filing status. Whether you are single or married is determined by state law (exceptions apply for same-sex marriages) and is based on your status as of the last day of the year. With that in mind, just because you run your household doesn't make you Head of Household (HOH). For tax purposes, you generally file as HOH if you are single, divorced, or otherwise unmarried and provide a home for a dependent. You are considered unmarried for purposes of HOH if you lived apart from your spouse for the last six months of the tax year (excepting temporary absences); you filed a separate tax return from your spouse; you paid over half the cost of keeping up your home for the tax year; and your home was the main home of a child, stepchild, or foster child for more than half of the tax year who you could claim as your dependent. A number of caveats, special rules, and exceptions apply, so check Publication 504, Divorced or Separated Individuals for more details.
2. Failing to report income. If you don't get a form 1099 or W-2 for your income, you don't have to report it, right? Wrong. If you are required to file a tax return, you are responsible for reporting all income, regardless of the amount. If you earned less than $600 for services and, as a result, did not receive a form 1099, you are still responsible for reporting the income. Similarly, you are required to report income from all sources, even illegal sources; remember, taxes are how they finally got Al Capone.
3. Taking a bogus home office deduction. Many taxpayers work from home from time to time. You may even drag out your computer to check email or take the occasional conference call in the comfort of your pajamas. So would that make the spot on your kitchen table a proper home office deduction? Nope. To qualify for the home office deduction, you must use the part of your home attributable to business "exclusively and regularly for your trade or business." That means your home office must be your actual office and not just a spot where you occasionally work. Additionally, if you use part of your home as a workspace, it must be exclusively workspace and not, like the kitchen table, also used for other purposes.
4. Overstating your charitable deductions. With a self-reporting system, it may feel easy to improperly classify or overstate your charitable deductions. While donations of non-cash items over $5,000 require a formal appraisal, donations of non-cash items under that amount can be valued using one of several methods. A common method of valuing items such as used clothing and furniture is to use the "thrift shop value" -- an estimate of the value of what the item would sell for at a thrift shop. As tempting as it may be to bump up the value of that sweater you wouldn't dare wear in public before you finally donated it to charity, don't do it.
5. Claiming dependents who aren't really dependent. There are a number of provisions, such as the Earned Income Tax Credit (EITC), that allow additional deductions and credits for taxpayers who claim dependents for tax purposes. The rules about exemptions and dependents are pretty clear. And this is one area where the IRS is fairly vigilant: They match Social Security numbers with taxpayers. You can't simply classify your daughter's boyfriend who occasionally stops by your house -- or that cousin you pay to stay away -- as your dependent. Your own children may not even qualify as your dependents in some circumstances, especially when it comes to matters of support.
6. Paying household employees "under the table." If you pay someone to come to your home and care for your children or clean your house on a regular basis, you may be considered a household employer. If so, you will be responsible for payroll taxes and federal income tax may be withheld on behalf of your employee. You may also be responsible for state unemployment tax and other state and local taxes, depending on your state. While it may be tempting to try and pay your household employees under the table, it's against the rules (remember "Nannygate"?). Even worse, if something were to happen to your employee on the job -- and you've failed to properly report and pay for your employee -- you may be criminally or civilly liable.
7. Failing to report reimbursed job-related expenses. Employees can deduct job-related expenses as an itemized deduction. To be deductible, the expense must be paid or incurred during the tax year; used for carrying on your trade or business; and "ordinary and necessary." That would include professional dues, work uniforms, licenses, tools, etc., which you use in your work. But if your employer reimburses you for those expenses, they are no longer deductible. To properly take the deduction, the expenses must remain un-reimbursed. Don't be tempted to claim those expenses anyway; your employer probably keeps pretty good records (and the IRS knows it).
While some taxpayers feel it's okay to cheat now and again on their taxes, consider the consequences. If you get caught -- and with audits on the rise, you certainly may -- you will have to pay the tax due, plus interest and a penalty. Penalties apply if you substantially understate your tax, understate a reportable transaction, file an erroneous claim for refund or credit, or file a frivolous tax return. And don't be lulled into a false sense of security after three years -- the statute of limitations for under reporting income has been extended to six years (Section 6501(e) of the Tax Code). There's no statute of limitations for filing a fraudulent return, meaning you can be assessed at any time (Section 6501(c) of the Tax Code). And, in some cases, IRS examiners who find strong evidence of fraud will refer the case to the Internal Revenue Service Criminal Investigation Division for possible criminal prosecution.
It's clear that penalties, prosecution, and the fear of an audit are compelling enough to keep some taxpayers compliant. But despite the gloom and doom, there are some encouraging numbers to report, too. Of those polled, 81% cite "personal integrity", not fear, as the primary factor in filing their taxes correctly. Doing the right thing for the sake of doing the right thing. That's finally some good news this tax season.