Small Business Taxes & Management

News On The Tax Front--The latest tax news.

IRS Updates the "Dirty Dozen" for 2004: Agency Warns of New Scams

IRS Provides List of 12 Most Common Mistakes on Individual Returns

In Brief:--Tax, business, and personal finance tips.

News On The Tax Front

Previously Reported In Daily Update

The IRS is issuing temporary and proposed regulations (T.D. 9116; REG-115471-03) revising the new markets tax credit.

The IRS can issue a summons to a taxpayer (or other party) seeking documents and records. You may be able to quash the summons, but it's not easy. In order to obtain enforcement of a summons the IRS must make a showing that it has satisfied the requirements of enforcement by demonstrating:

(1) that the investigation is being conducted for a legitimate purpose;
(2) that the information is relevant to that purpose;
(3) that the information sought is not already in the Government's possession; and
(4) that the administrative steps required by the Code have been followed.

To meet its burden of establishing a prima facie case for the enforcement of the summons, the IRS need make only a minimal showing the above requirements have been met. In Philip A. Kaiser, et al. (2004-1 USTC 50,163; U.S. District Court, East. Dist. Mo., East. Div.) the Court held that the IRS had established a prima facie case for enforcement of the summons. That switched the burden of proof on to the defendants. The Court rejected the defendants' claim that there was no legitimate purpose for the investigation and that the summonses did not adequately describe the records sought.

Determining whether an amount received is taxable as a capital gain or ordinary income isn't always easy. In Mark J. Steel, Connie J. Steel, Odd-Bjorn Huse, Lisa J. Huse (2004-1 USTC 50,159; U.S. Court of Appeals, 9th Circuit) the investors sold all the stock of a corporation. The corporation had filed a lawsuit for breach of contract against an insurance company. The investors signed an agreement that authorized the assignment of the lawsuit to the partners. The agreement did not treat any potential proceeds as additional consideration for the sale of the company. Instead, the proceeds of the suit were to be assigned to the individual investors. The Court of Appeals sided with and affirmed the Tax Court's holding that the proceeds were ordinary income.

In Joseph Dutton (122 TC--, No. 7) the taxpayer argued that an offer in compromise should be set aside and he should be allowed to seek relief from joint and several liability under Sec. 6013(a) and 6015(b), (c)and (f). The Court found the offer in compromise, once accepted, is, like certain other agreements between the IRS and taxpayers, is governed by general principles of contract law. While the taxpayer argued there was a mutual mistake which would allow the taxpayer to void the contract, the Court found no such mistake existed and that the taxpayer was not entitled to relief.

You may be able to enter into an agreement with the IRS to settle a dispute by means of a qualified offer. Under the regulations, there are three requirements: (1) The offered amount must specify the dollar amount for the liability, (2) the offered amount must be with respect to all adjustments at issue and only those adjustments, and (3) the offered amount must be an amount that will fully resolve the taxpayer's liability for the type(s) of tax and tax year(s) at issue. In Thomas E. Johnston and Thomas E. Johnston, Successor in Interest to Shirley L. Johnston, Deceased (122 TC--, No. 6) the taxpayer at first accepted the offer to settle his liability, but then sought to reduce the amount by the amount of net operating losses (NOLs). The Court found the taxpayers could not apply the NOLs to reduce the offered amount. The Court also noted that the fact that the NOLs were not in dispute at the time the qualified offer was made is a matter of petitioners' own doing. The taxpayers could have included the NOLs among the "adjustments at issue in the administrative or court proceeding" by the simple expedient of moving to amend their petitions to claim the NOL deductions before, rather than after, making their qualified offer.

Sec. 6404(e)(1) provides that the IRS may abate the assessment of interest on payment of tax to the extent a delay in such payment is attributable to any error or delay by an officer or employee of the Internal Revenue Service in performing a ministerial act. Section 301.6404-2(b)(2) provides in part that a ministerial act means a procedural or mechanical act that does not involve the exercise of judgment or discretion, and that occurs during the processing of a taxpayer's case after all prerequisites to the act, such as conferences and review by supervisors, have taken place. A decision concerning the proper application of federal tax law is not a ministerial act. In Dolores Nelson (T.C. Memo. 2004-34) the Court found that the section above did not apply to the taxpayer's situation. In addition, the fact that the taxpayer received incorrect advice from the IRS, but that is not a ministerial act. The Court denied the taxpayer's claim for an abatement of interest.

Be careful how you plan you finances. The IRS and courts can view a transaction differently than you. In Tony J. Cavender (T.C. Memo. 2004-33) the taxpayer's corporation drew a check on the company's checking account to the taxpayer in the amount of $95,233 on December 30, 1998. The check was received by and endorsed by the taxpayer as payee. The taxpayer did not actually receive the $95,233 in cash. Rather, on March 29, 1999, the endorsed but unnegotiated check was given by petitioner to the bank for deposit of the $95,233 face amount of the check into company's checking account. The bank treated the transaction as if the taxpayer had cashed the check on March 29, 1999, and then immediately deposited the $95,233 back into the company's checking account. The IRS issued a notice of deficiency for 1998 claiming the $95,233 check was additional compensation to the taxpayer. The taxpayer argued that the reason the $95,233 check from the company was made out to and was given to him was to support an inflated wage expense deduction on the company's 1998 corporate tax return. The taxpayer alleged that the $95,233 check was not signed by him on behalf of the company until March 29, 1999, and that it was backdated by the company's part-time bookkeeper to December 30, 1998. The Court noted the taxpayer offered no evidence that there was any requirement or understanding that the $95,233 check would be returned to the company. At trial, none of the company's books and records were produced. The taxpayer failed to call the company's bookkeeper as a witness. The Court held that the $95,233 check had to be treated as wages taxable in 1998.

In Rev. Rul. 2004-8 (IRB 2004-10) the IRS held that the Forest Land Enhancement Program (FLEP) is substantially similar to the type of programs described in Sec. 126(a)(1) through (8) within the meaning of Sec. 126(a)(9). All or a portion of cost-share payments received under the FLEP is eligible for exclusion from gross income to the extent permitted by Sec. 126. See Sec. 126(b)(1) and Sec. 16A.126-1 to determine what portion, if any, of the cost-share payments is excludable from gross income under Sec. 126.

Rev. Proc. 2004-19 (IRB 2004-10) provides an elective safe harbor that the owner of an oil and gas property may use in determining the property's recoverable reserves for purposes of computing cost depletion under Sec. 611 of the Code.

Amounts paid to an employee for services rendered are compensation. That's true even if you the amounts aren't included on a paycheck, but the employee simply charges personal expenses to the company. In Adrian D. Troutman, Jr. (T.C. Memo. 2004-32) the Court did not allow an expense deduction for personal purchases an employee charged on the company's credit card. The taxpayer claimed the amounts were intended as additional compensation, but the amounts were not included on the employee's W-2. In addition, the employee did not testify that the amounts were additional compensation. Reduced rented paid by the employee on the taxpayer's house which she rented was also not compensation. The Court noted the employee was a friend of the taxpayer and was injured at the time she rented the home.

In Eric N. Umbach, Joseph D. Specking (2004-1 USTC 50,148; U.S. Court of Appeals, 10th Circuit) the Court sided with the Tax Court in holding that Johnston Island, a U.S. insular possession was not a foreign country and the taxpayer could not exclude from their income compensation under Sec. 911 (foreign earned income exclusion) they earned while working on the island.

In J. Michael Maginnis, Janet Y. Maginnis (2004-1 USTC 50,149; U.S. Court of Appeals, 9th Circuit) the Court upheld a District Court decision (Oregon) that lump-sum proceeds a taxpayer received by assigning his remaining state lottery installments to a financial corporation for a payment of $3,950,000 was ordinary income and not a capital gain. The Court said the taxpayer's lottery right did not reflect an underlying capital investment or an increase in value over cost.

In Sunoco, Inc. (122 TC--, No. 4) the Tax Court held that it had jurisdiction under Sec. 6512(b) to determine an overpayment composed of overpayment interest computed under Sec. 6611(a).

If it sounds too good to be true, it probably is. That adage is good advice when you're investing. In Paul R. Peete (T.C. Memo. 2004-31) the Tax Court cited it in its decision. The taxpayer took large deductions on a Schedule C for a pyramid scheme. The taxpayer testified that he was recruited by participants in the scheme and attended a seminar describing the activity. The only way for the taxpayer to accumulate money was if he recruited other people to join the activity. had difficulty explaining how the various items constituting the Schedule C loss related to a business activity. He testified that he did not know of any advertising expenses, that he had "absolutely no idea" what the $24,944 reported as depreciation related to, that he did not know what the $8,707 in repair service expenses related to, and that he did not make any gifts to charities other than those listed on other parts of his tax return. He testified that he claimed expenses related to playing golf and meals on the basis of the advice of his return preparer. He acknowledged that it occurred to him that this may have been too good to be true and that he did not take steps to investigate what he was told other than trusting the judgment of the return preparer. The taxpayer also acknowledged a large part of food expenses were for meals that he had by himself and that the hospital visits were in connection with his position as a reverend. The taxpayer was open and candid at trial regarding his involvement in the pyramid scheme. Unfortunately, his own testimony clearly establishes that he did not have reasonable cause and did not act in good faith in claiming the Schedule C loss. He was unaware of certain items claimed as expenses on the return, he knew that some of the claimed deductions were too good to be true, and he failed to investigate the appropriateness of the claimed deductions after learning that his tax return preparer was being investigated in connection with the same activity. The taxpayer failed to call the return preparer or any other witnesses at trial to corroborate his claim of good faith reliance, and his testimony indicates that he did not rely on the advice of an independent, competent tax professional. The Court held the taxpayer was liable for the accuracy-related penalty.

The IRS has issued proposed regulations (REG-165579-02) that provide guidance relating to the effect of certain asset and stock transfers on the qualification of certain transactions as reorganizations under section 368(a). This document also contains proposed regulations that provide guidance relating to the continuity of business enterprise requirement and the definition of a party to a reorganization. These regulations affect corporations and their shareholders.

Form 3115, Application for Change in Accounting Method, and its instructions have been revised. This revision is the current Form 3115 and replaces the May 1999 version of the Form 3115. In general, a taxpayer requesting a change in accounting method must complete and file a current Form 3115. See Announcement 2004-16 (IRB 2004-13) for additional details including specific changes to the form and references to revenue procedures.

In Rev. Rul. 2004-34 (IRB 2004-12), Rev. Rul. 2004-33 (IRB 2004-12), Rev. Rul. 2004-32 (IRB 2004-12), Rev. Rul. 2004-31 (IRB 2004-12), Rev. Rul. 2004-29 (IRB 2004-12), Rev. Rul. 2004-28 (IRB 2004-12), Rev. Rul. 2004-27 (IRB 2004-12), the IRS provided detailed guidance on some of the 12 top tax scams. The rulings address zero returns, reparations tax credit, home-business scams, chargeback of debts to the government, frivolous claim of right, frivolous foreign residence claim, and frivolous corporation sole, respectively.

In George Maciel (T.C. Memo. 2004-28) the Tax Court agreed with the Service's reconstruction of the taxpayer's income using the specific items and bank deposits methods. The specific items method showed that the taxpayer had income from the sale of two businesses. An undocumented loan the taxpayer claimed increased his basis in the business sold was not allowed. The Court rejected the taxpayer's claim that deductions for telephone and utility bills were not taken into account in the income reconstruction. The invoices did not adequately identify the business and the taxpayer's testimony was considered vague.

The IRS announced (IR-2004-27) that interest rates on under- and overpayments will rise by one percentage point for the calendar quarter beginning April 1, 2004. The interest rates are as follows:

• 5% for overpayments (4% in the case of a corporation);
  
• 5% percent for underpayments;
  
• 7% for large corporate underpayments; and
  
• 2.5% for the portion of a corporate overpayment exceeding $10,000.

The rate of interest is determined on a quarterly basis. For taxpayers other than corporations, the overpayment and underpayment rate is the federal short-term rate plus 3 percentage points. Generally, in the case of a corporation, the underpayment rate is the federal short-term rate plus 3 percentage points and the overpayment rate is the federal short-term rate plus 2 percentage points. The rate for large corporate underpayments is the federal short-term rate plus 5 percentage points. The rate on the portion of a corporate overpayment of tax exceeding $10,000 for a taxable period is the federal short-term rate plus one-half (0.5) of a percentage point.

In Notice 2004-15 (IRB 2004-9) the IRS provided guidance regarding when a distribution from a non-qualified annuity will satisfy Sec. 72(q)(2)(D) and, therefore, be exempt from the penalty tax imposed by Sec. 72(q)(1). Specifically, the Internal Revenue Service (IRS) and Treasury will treat a distribution as satisfying Sec. 72(q)(2)(D) if the taxpayer uses one of the methods described in Notice 89-25, as modified by Rev. Rul. 2002-62, to determine whether the payment is part of a series of substantially equal periodic payments.

The IRS has issued final, temporary and proposed regulations (T.D. 9115; REG-106590-00; REG-138499-02) relating to the depreciation of property subject to Section 168 of the Internal Revenue Code (MACRS property). Specifically, these temporary regulations provide guidance on how to depreciate MACRS property acquired in a like-kind exchange under Section 1031 or as a result of an involuntary conversion under Section 1033 when both the acquired and relinquished property are subject to MACRS in the hands of the acquiring taxpayer. These temporary regulations will affect taxpayers involved in a like-kind exchange under Section 1031 or an involuntary conversion under Section 1033. The text of these temporary regulations also serves as the text of the proposed regulations set forth in the notice of proposed rulemaking.

The IRS has issued proposed regulations (REG-156421-03) that provide guidance regarding the meaning of "school, college, or university" and "student" for purposes of the student FICA exception under Sections 3121(b)(10) and 3306(c)(10)(B) of the Internal Revenue Code (Code). In addition, this document contains proposed regulations that provide guidance on the meaning of "school, college, or university" for purposes of the FICA exception under Section 3121(b)(2) for domestic service performed in a local college club, or local chapter of a college fraternity or sorority by a student.

You're required to keep a contemporaneous log of business auto usage, tips if you receive them in your work, etc. and you may want to keep a log of work you do for your S corporation, partnership, etc. to prove you materially participated during the year. Keeping the log current is called keeping a contemporaneous record. Some taxpayers may avoid doing that, preparing it only when the IRS comes it to audit. How's the IRS to know? In Jon A. and Linda A. Jewett (T.C. Memo. 2004-26) the taxpayer, a merchant seaman, took deductions for per diem meal and incidental expenses. The Court noted that taxpayers who take the per diem deduction don't have to substantiate the amount of the expenditure, they still have to substantiate the other elements such as time, place, etc. To substantiate a deduction by means of adequate records, a taxpayer must maintain an account book, diary, log, statement of expense, trip sheets, and/or other documentary evidence, which, in combination, are sufficient to establish each element of expenditure or use. The log must be made at or near the time of the expenditure. The Court said "the taxpayer claimed that he prepared a log listing his travel expenses at or near the times of the expenditures. We are not required to accept petitioner's self-serving statements. Our review of this log leads us to conclude it was prepared at one time, and the entries could not have been made at or near the times of the expenditures. The IRS also observed that the taxpayers took the position on their return that they were entitled to a deduction based on a per diem rate without the need for substantiation, and maintenance of a calendar log of actual expenses is inconsistent with that position. The IRS further commented that the return had nearly 30 documents attached to it to support petitioners' claim, but the log was not attached. For the aforesaid reasons, we do not give the purported log any credence."

IRS Updates the "Dirty Dozen" for 2004: Agency Warns of New Scams

Introduction

In an update of an annual consumer alert, the IRS urged taxpayers to avoid falling victim to one of the "Dirty Dozen" tax scams and a variety of other schemes. In the new 2004 ranking, several new scams have reached the top of the consumer watch list, including abusive trusts and the "claim of right" doctrine.

In addition, the IRS has taken a new step this year and issued 10 new pieces of legal guidance involving scams in the "Dirty Dozen" and other tax schemes. The new guidance debunks the schemes and provides new legal details to help tax practitioners and taxpayers. The IRS is actively targeting promoters, taxpayers themselves should be wary of anyone who promises to eliminate their taxes.

The IRS and other federal agencies are aggressively pursuing and successfully prosecuting promoters of these schemes and many of their clients for fraud and tax evasion. Participation in these schemes can result in imprisonment, fines and repayment of taxes owed with interest and penalties. Even innocent taxpayers involved in these schemes can face a staggering amount of back interest and penalties.

Taxpayers who suspect tax fraud can report it to the IRS at 1-800-829-0433. More information on tax scams and schemes is available by visiting "The Newsroom" section of IRS.gov.

The Scams

Misuse of Trusts. Promoters of abusive tax transactions are increasingly urging taxpayers to transfer assets into trusts. The promoters promise a variety of benefits, such as the reduction of income subject to tax, deductions for personal expenses paid by the trust and reduction of gift or estate taxes. Taxpayers should be aware that abusive trust arrangements will not produce the tax benefits advertised by their promoters and that the IRS is actively examining these types of trust arrangements. More than a dozen injunctions have been obtained against promoters, and numerous promoters and their clients have been criminally prosecuted. Before entering any trust arrangements, taxpayers should seek the advice of a trusted tax professional.

Claim of Right Doctrine. In this emerging scheme, people file returns and attempt to take a deduction equal to the entire amount of their wages. The promoters advise them to label the deduction as "a necessary expense for the production of income" or "compensation for personal services actually rendered". The deduction is based on a complete misinterpretation of the Internal Revenue Code and has no basis in law.

Corporation Sole. Participants in this scam apply for incorporation under the pretext of being a "bishop" or "overseer" of a one-person, phony religious organization or society. The idea is that the arrangement entitles the individual to exemption from federal income taxes as a nonprofit, religious organization as described in tax laws. When used as intended, Corporation Sole statutes enable religious leaders--typically bishops or parsons--to become incorporated as individuals as a way of separating themselves legally from the control and ownership of church assets. But the rules have been twisted at seminars where promoters charge fees of up to $1,000 or more per person. Would-be participants are mistakenly told that Corporation Sole laws provide a "legal" way to escape paying federal income taxes, child support and other personal debts.

Offshore Transactions. Some people use offshore transactions to avoid paying U.S. taxes. Use of an offshore bank account, brokerage account, credit card, wire transfer, trust, offshore employee leasing or other arrangement to hide or underreport income or to claim false deductions on a federal tax return is illegal. A taxpayer involved in these schemes could be subject to payment of taxes, interest, penalties and potential criminal prosecution. This was the top scam in the 2003 "Dirty Dozen." A special program last year has yielded more than $170 million in taxes, interest and penalties, and the IRS and the states continue to aggressively pursue taxpayers and promoters in this area.

Employment Tax Evasion. The IRS has seen a number of illegal schemes that instruct employers not to withhold federal income tax or other employment taxes from wages paid to their employees. These schemes are based on an incorrect interpretation of "Section 861" and other parts of the tax law and have been refuted in court. Recent court cases have resulted in criminal convictions of promoters. Employer participants could also be held responsible for back payments of employment taxes, plus penalties and interest. Employees who have no withholdings are still responsible for payment of their personal taxes.

Return Preparer Fraud. Unscrupulous return preparers can cause a lot of problems for taxpayers who use their services. Abusive return preparers derive financial gain by diverting a portion of the taxpayer's refund for their own benefit, charging inflated fees for the return preparation services, and increasing their clientele by advertising guaranteed larger refunds. Taxpayers should choose carefully when hiring a tax preparer--no matter who prepares the return, the taxpayer is ultimately responsible for all of the information on that return.

Americans with Disabilities Act. Another scheme seen for several years involves the purchase of equipment and services that the promoter alleges meets the strict criteria of the Disabled Access Credit, which was created with the passage of the "Americans with Disabilities Act". A minimal payment is made and a non-recourse note signed. The investor then provides insignificant services to complete the purchase agreement. This scheme is based on an incorrect interpretation of law and an over-inflated value of the services rendered.

African-Americans get a Special Tax Refund. Thousands of African Americans have been misled by people offering to file for tax credits or refunds related to reparations for slavery. There is no such provision in the tax law. Some unscrupulous promoters have encouraged clients to pay them to prepare a claim for this refund. But the claims are a waste of money. Promoters of reparations tax schemes have been convicted and imprisoned. And taxpayers could face a $500 penalty for filing such claims if they do not withdraw the claim. Related scams include claiming an illegal tax credit by misusing Form 2439, "Notice to Shareholder of Undistributed Long-Term Capital Gains." The slavery reparations scam was at the top of the 2002 "Dirty Dozen," and, although claims have fallen considerably, the IRS continues to see activity in this area.

Improper Home-Based Business This scheme purports to offer tax "relief" but in reality is illegal tax avoidance. The promoters of this scheme claim that individual taxpayers can deduct most, or all, of their personal expenses as business expenses by setting up a bogus home-based business. But the tax code firmly establishes that a clear business purpose and profit motive must exist in order to generate and claim allowable business expenses. This scam has been around for years, but the IRS continues to see activity in this area.

Frivolous Arguments. Frivolous arguments are false arguments that are unsupported by law. When a scheme promoter says "I don't pay taxes--why should you" or urges you to "untax yourself for $49.95," beware. The ads may claim that the promoter knows the "secret" for never paying taxes again, but that's just plain wrong. The U.S. courts have continuously rejected this and other frivolous arguments. Unfortunately, people across the country have paid for the "secret" of not paying taxes or have bought "untax packages." Then they find out that following the advice contained in them can result in civil and/or criminal penalties. Numerous sellers of the bogus schemes have been convicted on criminal tax charges. More than a dozen injunctions have been issued.

Identify Theft. Identity thieves use someone's personal data to steal his or her financial accounts, run up charges on the victim's existing credit cards, apply for new loans, credit cards, services or benefits in the victim's name and even file fraudulent tax returns. The IRS is aware of several identity theft scams involving taxes or the IRS.

In one example, fraudsters sent bank customers fictitious bank correspondence and IRS forms in an attempt to trick them into disclosing their personal and banking data. In another, abusive tax preparers have used clients' Social Security numbers and other information to file false tax returns without the clients' knowledge. For taxpayers, it pays to be choosy about disclosing personal and financial information. And the IRS encourages taxpayers to carefully select a reputable tax professional.

Share/Borrow EITC Dependents.Unscrupulous tax preparers "share" one client's qualifying children with another client in order to allow both clients to claim the Earned Income Tax Credit. For example, one client may have four children but only needs to list two to get the maximum EITC. The preparer will list two children on the first client's return and the other two on another client's tax return. The preparer and the client "selling" the dependents split a fee. The IRS prosecutes the preparers of such fraudulent claims, and participating taxpayers could be subject to civil penalties.

For more information see IR-2004-26.

Other Points

Beyond the "Dirty Dozen," the IRS sees many more tax schemes. In one, a telephone caller says you've won a prize, and all you have to do to get it is to pay the income tax due--to the caller. Other scams can play off recent news events, such as one last year targeting members of the military.

Some of these schemes have been around for years in various forms and have been attacked by the IRS. When taxpayers have gone to court under these circumstances, they have consistently lost and frequently been assessed penalties on top of it. The old saying "if it sounds too good to be true, it probably is" still makes sense.

IRS Provides List of 12 Most Common Mistakes on Individual Returns

Introduction. In Notice 2004-13 (IRB 2004-12) the IRS provided a list of the most common mistakes made by individuals while preparing their tax returns. The results could result in an underpayment and could result in delays in processing returns and receiving any refunds. Taxpayers should carefully read all the instructions to the tax forms and schedules and review their entire return before filing. In addition, e-filing, either through the Service's Free File Program at www.irs.gov or through a tax professional, will help reduce errors and speed refunds. Taxpayers who e-file and use direct deposit will receive their refunds in as little as two weeks.

Choosing the wrong filing status. Taxpayers should confirm that the filing status (e.g., single, married filing jointly, etc.) selected is correct. For examples, taxpayers often incorrectly claim "head of household" filing status without meeting the requirements. In addition to delaying the processing of the return and any refund, designating the wrong filing status may affect a taxpayer's eligibility for the Earned Income Credit.

Failing to include or using incorrect social security numbers. The names and social security numbers for the taxpayer, taxpayer's spouse, dependents, and qualifying children for the Earned Income Credit or Child Tax Credit must be included on the return exactly as they appear on the social security cards.

Failing to use the correct forms and schedules. Taxpayers should review the instructions to all applicable forms and schedules to be sure they have correctly used, and accurately completed, each form or schedule.

Failing to sign and date the return. Taxpayers must sign and date their return under penalties of perjury. If the return is not signed, it will not be accepted as filed by the IRS. Both spouses must sign a joint return.

Claiming ineligible dependents. Taxpayers may claim a person as a dependent only if they person meets the legal definition of a dependent. Taxpayers should consult the instructions to Form 1040 to confirm whether a person qualifies as a dependent. Each dependent must have a valid social security number, which must be included on the tax return. The failure to include a dependent's name and social security number, or claiming an ineligible dependent, may result in an underpayment of tax and/or a denial of the Earned Income Credit.

Failing to File for the Earned Income Credit. Taxpayers should review carefully the eligibility requirements for the Earned Income Credit, including income limits, before filing returns. For example, many military families may qualify for the Credit because supplemental payments and combat pay are exempt from the income calculations. Detailed instructions for claiming and computing the Credit are contained in the instructions to the Form 1040, Fact Sheet 2004-8, in Publication 596 and through links at 1040 Central at www.irs.gov.

Improperly Claiming the Earned Income Credit. Taxpayers must have a qualifying amount of earned income to claim the Earned Income Credit. For example, a taxpayer whose sole income is from the receipt of disability payments does not have qualifying earned income and is ineligible for the Credit. Detailed instructions for claiming and computing the Credit are contained in the instructions to the Form 1040, Fact Sheet 2004-8, in Publication 596 and through links at 1040 Central at www.irs.gov.

Failing to Pay and Report Domestic Payroll Taxes. Taxpayers employing household workers, such as a house cleaner, an in-home caregiver, or a nanny, must pay and report payroll taxes for those individuals where the payments exceed certain threshold amounts. Failure to pay and report payroll taxes may result in the assessment of additional tax due, interest on the unpaid amounts, and penalties. The Instructions to Form 1040, Publication 926 (Household Employer's Tax Guide), and Publication 15-A (Employer's Supplemental Tax Guide) contain detailed information to assist taxpayers in determining whether an individual providing household help is a household employee for whom the taxpayer must pay and report payroll taxes.

Failing to Report Income Because it was not Included on a Form W-2, Form 1099 or Other Information Return. Taxpayers must report all income, even if the income was not reported on a third-party reporting statement such as a Form W-2, Form 1099, or similar statement. Failure to report all income may result in the assessment of additional tax due, interest on the unpaid amounts, and penalties.

Treating Employees as Independent Contractors. Employers may not treat an employee as an "independent contractor" to avoid paying and reporting payroll taxes. Employers who improperly treat an employee as an independent contractor may be liable for additional tax due, interest on the unpaid amounts, and penalties. Publication 15-A (Employer's Supplemental Tax Guide) contains detailed information to assist taxpayers in determining whether an individual is an employee or an independent contractor.

Failing to File a Return When Due a Refund. Taxpayers must file a return to claim a refund of withheld taxes when a refund is due. Taxpayers will forfeit refunds of withheld tax if a return requesting a refund is not filed within three years of the due date.

Failing to Check Liability for Alternative Minimum Tax. Taxpayers should determine whether the alternative minimum tax, or AMT, applies. If the taxpayer is liable for AMT, the Service may reduce or deny a requested refund or may assess any additional tax due, interest on the unpaid amounts and penalties.

In Brief:

Previously Reported In Daily Update

Credit for the elderly or disabled . . . You may not qualify for the credit, but there's a chance someone you know, a relative, friend, etc. does. A taxpayer may be able to take the Credit for the Elderly or the Disabled if you are age 65 or older, or if you are retired on permanent and total disability, according to the IRS. The maximum amount of the credit is $1,125. The taxpayer must be a U.S. citizen or resident, age 65 or older or permanently disabled, his or her adjusted gross income must be less than $12,500 or $25,000 (depending on filing status) and the taxpayer's nontaxable income from social security or other nontaxable pension is less than $3,750 to $7,500 (also depending on filing status). If you are under 65, you must have your physician complete a statement certifying that you were permanently and totally disabled on the date you retired. Use Schedule R, Form 1040, or Schedule 3, Form 1040A, to compute the credit. IRS Publication 524, Credit for the Elderly or the Disabled, has more information.

Where's my refund? . . . If that's your question, the IRS has an answer. You can go to the IRS web site and, by inputting your social security number, your filing status and the exact amount of the refund claimed, you can find the status of your refund. Here's the link to get there--Where's My Refund?

Estate administrative fees . . . You can take attorney's, accountant's and certain other administrative expenses as a deduction on an estate tax return or you can elect not to take them on the estate return and use them as an itemized deduction on the decedent's final return. If you're actually subject to the estate tax, you'll almost assuredly be better off deducting them on the estate return. But because of the marital deduction, exemptions, etc. there may be no estate tax liability. In that case deducting them on the decedent's final return will result in real tax savings.

Electronic deposit requirements . . . For federal tax purposes, you've got to make electronic deposits of taxes using the Electronic Federal Tax Payment System (EFTPS) in 2004 if your total deposits of such taxes in 2002 were more than $200,000 or you were required to use EFTPS in 2003. Many states now require electronic deposits and electronic filing of many returns, and the threshold requirements can be much less. For example, in Massachusetts you have to file electronically if your deposit for:

• wage withholding
  
• state and local room occupancy tax
  
• or sales and use tax

exceeds just $10,000. Check the rules in your state. There are usually penalties for failing to pay or file electronically.

Health insurance scams on rise . . . We've reported on this before, but it's worth mentioning again, particularly in light of recent testimony and discussions before the Senate Finance Committee on bogus health insurance plans. Rising premiums make this type of scam ever more attractive. The "insurer" takes the money and, before having to pay out any significant amount of claims, ceases business. The health plans frequently have two factors in common--they offer plans that claim to provide employee benefits that are subject to ERISA and they claim to be exempt from state insurance regulation under ERISA. The plans are often sold through licensed agents. Small businesses are prime targets because they're unlikely to do a complete check of the insurer. You should be suspicious if a quote you get is significantly (more than 15%-20%) below quotes from other companies. Don't rely just on a name. The use of names similar to established companies makes the scam more believable. The National Association of Insurance Commissioners (NAIC) has state contact information on its web site. Go to www.naic.org, for more information and links to state insurance sites. While Congress may act to make the scams more difficult, that's not going to happen tomorrow and it won't close every loophole.

Do business through multiple entities? . . . It's not unusual for business owners to have more than one corporation or a corporation and a sole proprietorship, etc. If so, be sure invoices, bills, etc. that substantiate expenditures clearly give the name of the entity who purchased the item or service. It's even more important if the names of the entities are similar. For example, Madison Parts Co. and Madison Auto Parts Co.

Canceled check not full substantiation . . . While your canceled check will show you paid for a service or product, the IRS wants proof that the expenditure was for a business. That means you must also have an invoice showing the nature of the expenditure and business purpose.

Advance payments on lease . . . If you've entered into a lease for business purposes and there's an up-front payment (auto leases typically require such a payment), you can't deduct the full amount in the year paid. Since the payment applies to the full lease, you've got to spread the payment out over the lease term. For example, if you enter into a 5-year lease and make an $1,800 up-front payment, deduct $30 per month ($1,800/60 months) the lease is in effect. If you had the car for 5 months in 2003, you could deduct $150 ($30 x 5) of the payment in 2003.

Deducting auto lease expenses . . . If you lease a car that you use in your business, you can use the standard mileage rate or actual expenses to compute your deductible expenses. If you use actual expenses, only the portion of the lease payments that relate to business use are deductible. For example, if you use the car 60% for business, only 60% of the lease expenses are deductible. Add insurance, maintenance, gas, etc. (pro rated for business use). In the car of a leased auto, you may have to reduce your lease payment deduction by an "inclusion amount". The inclusion amount depends on the value of the auto. See IRS Publication 463 or our tables at Auto and Vehicle Tables.

Do you have to file? . . . There are some instances when you may not be required to file a federal income tax return. But, if you're entitled to a refund, you can't get it without filing. The law does require you to file a tax return if your income is above a certain level. Check the instructions for Form 1040, 1040A or 1040EZ (under filing requirements) for specific details that may affect your need to file a tax return with IRS this year. Here are some general guidelines for anyone under age 65. Remember, these guidelines may change based on your particular situation. In general, once you have the following gross income amounts, the law requires you to file a federal tax return with the IRS:

Single 			        $  7,800
Head of Household 		  10,050
Married Filing Jointly 	          15,600
Married Filing Separately	   3,050