Painful mistakes
Avoid trouble with IRS by steering clear of a few common pitfalls
How full of gotchas is the tax code? Just ask the list of political figures and entertainers who have run into trouble because of glitches on their form 1040.
Here are some ways ordinary taxpayers and even supposedly tax-savvy high fliers can avoid getting ensnared.
Nanny tax: People who hire nannies, maids, and other household help face a tax chore that is commonly ignored. But that can be costly in back taxes and penalties if you're caught in an audit.
When you hire someone, you become an employer with tax responsibilities. Generally, the tax responsibilities are triggered if you pay a household employee $1,600 or more during 2008 ($1,700 for 2009).
As an employer, your duties can include remitting Social Security tax, paying federal and state unemployment tax, reporting to the Internal Revenue Service the income paid, and even possibly withholding and remitting income tax.
Hiring an outside firm, such as a housekeeping service, or taking your kids to a day-care center, can help you avoid responsibilities as an employer.
Another escape is to argue that a worker is self-employed. It can be somewhat of a judgment call that relates in part to how many hours the worker puts in, the advertising or search for other work that he or she does, and the amount of direction you provide.
"Someone who works for you part time and also does work for others, generally controls when and how they perform the work and otherwise doesn't act like an employee may be considered self-employed and responsible for his or her own taxes," says certified public accountant Ronald Perry, at Boston's Russell, Brier & Co.
Self-employment tax: Being your own boss means wearing two hats: employer and employee. "Not only do you have to pick up the employee portion of Social Security and Medicare tax but also the employer portion," Perry says. "People making a switch from employee to self-employed are often shocked by that."
This can mean a combined employer-employee Social Security tax rate of 12.4 percent instead of a 6.2 percent employee-only rate, and a 2.9 percent Medicare tax instead of a 1.45 percent rate. You calculate and report this on schedule SE of your form 1040. Relief: A business deduction for part of the tax eases that higher rate a bit.
Fringe benefits: What you may see as a nice on-the-job perk can be viewed by the IRS as compensation trying to escape income tax.
In most cases, the angst is over the amount of taxation rather than whether it is reported since the value of a taxable fringe benefit is generally included on the W-2 form that you get from your employer.
That might include employer-paid benefits that are for personal rather than business use or fringes that exceed certain limits. But it's possible that an IRS examiner might challenge an employer's determination and seek back taxes from you. Executives, who more often may run into difficulty, are usually briefed by their tax and legal advisers.
Among perks given special tax-free treatment, though within various limits, are medical insurance, assistance with education or adoption, day care, and parking benefits or commuter passes.
Charitable donations: Strict rules must be followed to avoid an audit, infrequent as they may be, from disallowing a tax deduction for gifts to charity.
"If you don't have adequate records and substantial proof of your donations, there's a place in heaven for your contribution, but not on your tax return," says Nancy Goedecke, a federally authorized enrolled agent tax preparer in Hudson.
Among the requirements is a receipt or canceled check for all cash contributions, no matter how small. Additionally, used items that you donate must be fairly valued and in generally good or better condition.
A no-no: Raffle tickets are not deductible. Nor is helping out a needy friend or neighbor; only donations to recognized charities are deductible.
Estimated tax: Withholding on wages keeps most people from owing a lot when they file their return. It's more common to get a refund because of over-withholding.
But people with sizable income not subject to withholding - such as the self-employed, investors, and retirees - can get caught by a requirement that withholding, supplemented if need be by quarterly payments of estimated tax, keep you fairly current through the year as your tax liability accrues.
That can necessitate records of when income is received and calculations on how much tax must be paid and when.
As a rough rule, you can't owe more than 10 percent of your total tax when filing, unless you owe less than $1,000. But traps abound.
"It's possible to get a tax refund at filing time and still owe a penalty for not having paid enough estimated tax earlier in the year when it was due," cautions Laura Kenney, a senior tax manager in Boston at Grant Thornton.
One trick to make up for underpayments of estimated tax is to boost withholding from paychecks late in the year, she suggests.
Also, basing a current year's estimated payments and withholding on the amount of tax paid in the previous year may block a penalty even if you do end up owing a lot.
