Are you about to get audited by the IRS? Have you ever wondered why some tax returns are audited while others aren’t? The IRS doesn’t have enough personnel and resources to examine every tax return, so they rely on a variety of tools and systems to target returns to audit that will generate the most revenue per hour for an auditor’s time.
As a performer, you don’t have the time to figure out how to play the IRS’s game. And even if you did, why would you want to? The key is to be careful up front!
Here are common miscues that may get you audited:
1. Your tax return doesn’t match reports sent to the IRS.
The IRS receives copies of 1099s, W-2s, and other financial documents about you using your Social Security number or other tax identification number. The No. 1 reason you may be called into an audit is that the amounts reported on your tax return do not match the information the IRS receives. Not only must the amount match, it must match to the proper form and line number of the form.
Actors and other performers receive W-2s for some of their work. But what if you get a 1099?
If you receive a Form 1099 for income you believe is incorrect, you should request that the issuer file a corrected form with the IRS. If the issuer refuses to file a corrected 1099, a competent tax professional can still make your tax come out correctly by reporting the incorrect amount on your tax return (to keep you under the IRS’s radar) and then make any necessary adjustments to arrive at the correct amount of tax.
2. Ignoring IRS inquiry letters.
With your busy schedule, running from audition to audition or from one gig to another, you may get behind on opening your mail. This could present a big problem! If you receive a notice from the IRS, it is important that you answer it within the time frame indicated. The IRS is giving you a chance to respond to what they think is an error on your tax return. If you are unable to explain why your tax return is correct to the satisfaction of the IRS, you may find yourself embroiled in a full-fledged audit.
If your address changes, the IRS notice may not be able to reach you. You may not know that you failed to show for your audit appointment and that you owe additional taxes. In that case, your clue would come when your bank or employer notified you of an IRS levy. To avoid this, be sure to file a change of address form or notify the IRS of your new address by phone as soon as possible after a move.
3. Deducting “reimbursable” employee business expenses.
Clearly, as a performer, you are juggling multiple responsibilities and you likely incur expenses that you never get reimbursed for, right? Are they deductible? It depends.
The IRS keeps a list of the larger employers who have an official reimbursement policy. They can match you to your employer through your W-2. If you deduct business expenses and work for one of these companies, the IRS may want to talk to you in person. This happens quite frequently when you work for a big entertainment company that has a reimbursement policy you may not even be aware of. But the IRS is aware, and their systems are just waiting to catch you.
For the IRS, it’s a very low-cost way to collect money from taxpayers. It only takes some programming of their computers to find taxpayers who have W-2s from these companies and kick out a letter disallowing these business deductions you thought you could deduct.
The IRS disallows business deductions if you could have been reimbursed. If you are in an audit in this situation, the IRS will disallow all of your employee business expenses. The IRS assumes that if your employer did not reimburse you, the expense must not be related to your job. Since most people in this situation would not know how to defend their deduction, they give up and pay the additional taxes.
There are strategies to minimize the damage. Most reimbursement policies do not reimburse all expenses; often, the mileage reimbursement is less than the allowable IRS rate. In addition, I would argue that all of your expenses in excess of what would have been reimbursed by the employer should be allowed, since the employer would not have reimbursed them anyway.
Those in the entertainment profession may run up against one or more of these situations that can be a trap for the unwary. The IRS has rules that are strange and bizarre, and if you don’t know how to play their game, you could very well lose thousands of dollars where you don’t have to.
4. Using round numbers on your tax return.
Using more than a couple of round dollar amounts on your tax return is daring the IRS to audit you. Their computers are set up to find this method of “estimating”; they don’t believe that your office supplies added up to exactly $1,000 and your cell phone cost exactly $1,200.
You can’t estimate your income and expenses. You must be able to support what is on your return with substantial documentation. However, if you find yourself in a pickle because you did estimate, there are ways that a good tax professional could defend you.
And remember, “SALY” (same as last year) doesn’t work, either. The IRS is on to those who input the same amounts in the same boxes year after year.
5. Reporting cancellation of debt income incorrectly.
If you owe a debt and it is forgiven, the canceled debt may be reportable as income. This is a very complex area of the tax code, especially when it applies to real estate, but there are a few exceptions to it being taxable. You should also be aware that many of the 1099s reporting this information are frequently incorrect. Most people don’t know how to sort through the mess and fix the problem, thereby increasing their chance of an audit.
6. Failing to match gambling winnings and losses.
Gambling winnings are reportable earnings. You may deduct gambling losses against the winnings, but only if you itemize your deductions. Your gambling losses are limited to the amount of your winnings. Many people fail to report this correctly and are audited. For your deductions to hold up in an audit, you must be able to provide receipts, tickets, statements, or other records that show both your winnings and losses.
7. Incorrectly claiming charitable donations.
Everyone likes to be charitable, right? But even that can put you in the IRS crosshairs if you’re not careful.
The IRS will often audit tax returns with large charitable contributions. If your deductions appear to be disproportionately large compared to your income, or if you fail to file the correct supporting forms—or, worse yet, fail to properly complete the correct sections of the IRS forms—you are begging for an audit.
Don’t think you’re immune. The IRS frequently denies even small charitable donations if its procedures are not followed. If you are audited, the IRS will automatically deny every monetary gift of $250 or more if you don’t have an acknowledgment letter from the charity for the amount of the donation, a description of any property donated, and whether the organization provided any “goods or services.” For non-cash charitable donations, you must be able to prove the condition of the items given and have support for the value of the item you are deducting.
If your donation is worth more than $5,000, you need a qualified appraisal of the property and the appraiser’s signature on Form 8283, Section B.
8. Not understanding how DIF scores work.
What’s that? A DIF score? When your tax return is filed, the IRS computers compare it against a database called the Discriminant Function System (DIF).
This score is calculated based on averages in many categories such as income, family size, where you live, your occupation, and how you earn your money. If your tax return falls outside the averages, your DIF score rises, along with your chance of an unwelcome letter from the IRS letting you know you are being audited.
9. Not showing enough income on your return.
Yes, you read that right: not making enough income can draw IRS scrutiny. You can actually be audited for being too poor. I said that three times because it seems so far-fetched, but it’s true.
Many times, performers don’t get a W-2; they get a 1099 and are considered “self-employed.” People who are classified as self-employed may be audited if the IRS believes they reported too little income and too many expenses. For example, let’s say you reported $50,000 in income for your “business.” The IRS will call you in because, based on your occupation as a performer, your deductions, ZIP code, and family size, they have data that says you’d need at least $79,000 to pay your bills. Therefore, you must have unreported income.
Unfortunately, the IRS audit triggers do not account for a frugal lifestyle or non-taxable resources, such as child support, living off credit cards, savings, or help from family members. You may be forced to do battle with the IRS because they believe you are not being entirely truthful.
10. Conflating a hobby with a business.
Many actors and performers just starting out end up with more money going out than coming in. If this happens for multiple years in a row, the IRS might decide that your burgeoning industry career is, in fact, a hobby. The IRS uses multiple factors to determine whether something is a business or a hobby, but they all boil down to profit. According to the IRS, ”A business operates to make a profit. People engage in a hobby for sport or recreation, not to make a profit.” Keep “complete and detailed records” of ongoing activities in case you need to prove that you’re running a business, advises Peter Jason Riley, the author of “New Tax Guide for Writers, Artists, Performers, and Other Creative People” and a CPA who specializes in helping artists, actors, and performers with their taxes. “‘Hobby loss’ is an audit trap that you do not want to land in, as it can be very expensive,” he explains.
11. Making big cash deposits.
Large cash deposits can be a warning sign to the IRS that something isn’t right. Under the Bank Secrecy Act, financial institutions must report deposits of over $10,000 to the IRS—even if that money is structured across multiple deposits.
How to represent yourself against the IRS
1. Keep detailed records.
Detailed records are a necessity “in case the IRS comes knocking,” Riley advises. This is particularly important for business expense deductions. Always record the who, why, and where of your business expenses.
2. Be prepared for battle.
Unfortunately, even with the most detailed records and receipts, you still may not be treated fairly at an IRS audit. The government wants to collect the maximum possible from you and is willing to beat you up with technicalities in the law. They have tricks up their sleeve to collect more taxes from you and to assess additional penalties. An example of one of these techniques is the lifestyle audit: taxing you on the amount of income they believe you must have earned, but failed to report, based on your household lifestyle.
Correspondence audits (audits done through the mail) are another technique. The IRS uses this method to frustrate you until you give up and pay the extra taxes and penalties. Further, they might create phantom income for you based on various databases. For example, when they see your occupation as “actor” or “singer” or “entertainer” or “comedian,” they will make up numbers based on others who put that on their tax return as their occupation. They won’t care that you may have gone several months of the year with no work or had gaps in your income. They will interpret this data as “proof” that you must be hiding income. And they may assess additional taxes and penalties based on a claim that you neglected to report certain income that was, in fact, accurately reported.
Based on my experience, about 50% of the IRS notices I have seen are actually incorrect. But many people simply pay the bill, believing the IRS must be right.
Remember how I told you the IRS was tricky? Well, here’s one of the most common tricks they use: The auditor doesn’t tell you everything. Once you agree to the additional taxes for the year being audited, they will make the very same adjustments for the other two “open” years. This usually comes as a big surprise. The IRS auditor most likely did not disclose this before you signed the agreement to pay more taxes.
Let’s say that things weren’t going well for you in an audit and you decided to bite the bullet and agree to an additional assessment of $4,000 for the year under audit. After signing the agreement, you learn that the IRS has made similar adjustments to the other two open years, and suddenly your total tax liability is $12,000. Then, to make matters worse, the auditor adds an “accuracy” penalty, failure-to-pay penalty, and interest from the due dates of the original returns to the date of the audit. The total assessment could reach $16,000 or more. That’s not a bad return on investment for the auditor who may have put in only two or three hours of time ripping you to shreds.
3. Hire a professional.
A professional representative, such as an Enrolled Agent or a CPA, will take the IRS to task and require them to present you with their reasons for each assessment of additional tax. If you are audited, you need a representative who will be your advocate and stand up to the IRS.
Although there is no sure way to avoid an audit, choosing a skilled representative can save you money in taxes and penalties. It can be well worth it to hire a qualified professional to save you the time and grief and substantial taxes, penalties, and interest.
Disclosure: This communication is on behalf of Backstage LLC and its affiliates (“Backstage”). This communication is for informational purposes only and contains general information only. Backstage is not, by means of this communication, rendering legal, financial, accounting, business, tax, or other professional advice or services. This communication is not a substitute for such professional advice or services nor should it be used as a basis for any decision or action that may affect your interests. You should consult a qualified professional advisor. Backstage does not assume any liability for reliance on the information provided herein.