Thursday, March 17, 2011

FAQ: What are the rules for claiming dependents on my tax return?

A familiar issue to CPAs involves taxpayers who are confused by whether or not they can still claim that college graduate as a dependent on their taxes, or can Grandma be claimed since she lives with them all year. Parents of an adult child with disabilities, or an in-law situation where they live in their own home but require substantial financial assistance are additional examples of dependency questions taxpayers face when preparing their returns.

The tax rules surrounding the dependency exemption deduction on a federal income tax return can be complicated, with many requirements involving who qualifies for the deduction and who qualifies to take the deduction. The deduction can be a very beneficial tax break for taxpayers who qualify to claim dependent children or other qualifying dependent family members on their return. Therefore, it is important to understand the nuances of claiming dependents on your tax return, as the April 18 tax filing deadline is just around the corner.

Dependency deduction

You are allowed one dependency exemption deduction for each person you claim as a qualifying dependent on your federal income tax return. The deduction amount for the 2010 tax year is $3,650. If someone else may claim you as a dependent on their return, however, then you cannot claim a personal exemption (also $3,650) for yourself on your return. Additionally, your standard deduction will be limited.

Only one taxpayer may claim the dependency exemption per qualifying dependent in a tax year. Therefore, you and your spouse (or former spouse in a divorce situation) cannot both claim an exemption for the same dependent, such as your son or daughter, when you are filing separate returns.

Who qualifies as a dependent?

The term "dependent" includes a qualifying child or a qualifying relative. There are a number of tests to determine who qualifies as a dependent child or relative, and who may claim the deduction. These include age, relationship, residency, return filing status, and financial support tests.

The rules regarding who is a qualifying child (not a qualifying relative, which is discussed below), and for whom you may claim a dependency deduction on your 2010 return, generally are as follows:

-- The child is a U.S. citizen, or national, or a resident of the U.S., Canada, or Mexico;

-- The child is your child (including adopted or step-children), grandchildren, great-grandchildren, brothers, sisters (including step-brothers, and -sisters), half-siblings, nieces, and nephews;

-- The child has lived with you a majority of nights during the year, whether or not he or she is related to you;

-- The child receives less than $3,650 of gross income (unless the dependent is your child and either (1) is under age 19, (2) is a full-time student under age 24 before the end of the year), or (3) any age if permanently and totally disabled;

-- The child receives more than one-half of his or her support from you; and

-- The child does not file a joint tax return (unless solely to obtain a tax refund).

Qualifying relatives

The rules for claiming a qualifying relative as a dependent on your income tax return are slightly different from the rules for claiming a dependent child. Certain tests must also be met, including a gross income and support test, and a relationship test, among others. Generally, to claim a "qualifying relative" as your dependent:

-- The individual cannot be your qualifying child or the qualifying child of any other taxpayer; -- The individual's gross income for the year is less than $3,650; -- You provide more than one-half of the individual's total support for the year; -- The individual either (1) lives with you all year as a member of your household or (2) does not live with you but is your brother or sister (include step and half-siblings), mother or father, grandparent or other direct ancestor, stepparent, niece, nephew, aunt, or uncle, or inlaws. Foster parents are excluded.

Although age is a factor when claiming a qualifying child, a qualifying relative can be any age.

Special rules for divorced and separated parents

Certain rules apply when parents are divorced or separated and want to claim the dependency exemption. Under these rules, generally the "custodial" parent may claim the dependency deduction. The custodial parent is generally the parent with whom the child resides for the greater number of nights during the year.

However, if certain conditions are met, the noncustodial parent may claim the dependency exemption. The noncustodial parent can generally claim the deduction if:

-- The custodial parent gives up the tax deduction by signing a written release (on Form 8332 or a similar statement) that he or she will not claim the child as a dependent on his or her tax return. The noncustodial parent must attach the statement to his or her tax return; or

-- There is a multiple support agreement (Form 2120, Multiple Support Declaration) in effect signed by the other parent agreeing not to claim the dependency deduction for the year.

Circular 230 notification - Any U.S. federal tax advice that is contained in this document was not intended or written to be used by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer by the Internal Revenue Service, and it cannot be used by any taxpayer for such purpose.

Sunday, March 13, 2011

Taxpayers the IRS Is Targeting This Year

Every year clients inquire as to the probability of their returns being selected for audit and what can trigger an examination. The following article explains in general what areas are of special interest to the Internal Revenue Service.

Taxpayers the IRS Is Targeting This Year
Mark P. Cussen

Excerpted from

Out of the millions of tax returns that are filed with the IRS each year, a certain percentage are inevitably flagged and chosen to be audited. In some cases, this is because the taxpayer filing the return is already being investigated for tax fraud or other crimes, while other returns are merely selected at random. The formula that the IRS uses to flag returns for random audit, known as the Discriminant Function, is a highly classified secret known only to a few. However, there are several types of returns that the IRS tends to focus on in general. Filers with returns that fall into one of these categories must accept that there is a higher probability that they will be audited than other taxpayers. Some of the types of returns that the IRS tends to scrutinize more closely include:

Returns that Itemize Deductions
Taxpayers who include a Schedule A with their 1040 likely have a higher chance of being audited than those who don't. This is because the additional calculations invite a greater possibility of fraud or error by the taxpayer.

Self-Employed Taxpayers
Taxpayers who report income on Schedule C or E are prime targets of the IRS, because of the number of expenses that can be claimed as deductions. Those who report net losses for the year that reduce other taxable income, such as salaries or investment income are especially vulnerable to examination by the IRS.

"Cash Cow" Businesses
Many businesses have traditionally operated largely on a cash basis, such as laundry services, restaurants, casinos and gaming establishments and other similar enterprises. A substantial percentage of these businesses have traditionally underreported their income on their tax returns, due to the difficulty of proving revenue that is received in cash from thousands of separate transactions. For this reason, the mafia and other organized crime syndicates have been heavily involved with these industries for the past several decades. Of course, this has not escaped the notice of the IRS, which has collaborated with various law enforcement agencies who pursue these criminals.

Small Businesses
Even businesses such as florists, hobby store owners, construction contractors and other local enterprises are often scrutinized by the IRS. This is because even honest business owners and partners often don't understand the rules for correctly reporting their income and expenses and therefore submit erroneous returns. This is particularly true of those who are filing a business return for the first time, such as the proprietor of a new company.

Private Transactions
Taxpayers who engage in the sale of substantial pieces of real estate or hold interests in oil and gas leases or other such investment property can often realize enormous income and profits from individual buyers or small companies. The IRS knows how easy it can be to underreport the profits from these transactions, in some cases.

The Bottom Line
Remember that if the IRS does flag your return for audit, it does not mean that they suspect you of cheating. As mentioned previously, many returns are selected at random, according to a formula. As long as you have not cheated on your return, then you don't have to worry about what they find. If there is an error, the IRS will notify you in writing of the discrepancy and tell you how much more you owe. Of course, this process can work both ways; it is possible that the IRS could state that you owe less than you reported as well. Just make sure that you have all of the documentation that you need to prove your deductions, such as copies of receipts and bills. As long as you can supply what the IRS requests, your audit should be a relatively quick and painless process.
March 4, 2011

Circular 230 notification - Any U.S. federal tax advice that is contained in this document was not intended or written to be used by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer by the Internal Revenue Service, and it cannot be used by any taxpayer for such purpose.