What are some of the ways people tend to get into trouble with the IRS?
One of the ways that might surprise you is little, or not so little, sharing arrangements. I’ve seen two service providers agree to split fees, some expenses, didn’t file partnership returns, and just keep some books on the bank account where the “splits” were to take place. One of the individuals just picked up as income the distributions out of that account, not his 50% of the fees going in to the account. Income unreported was major figure, which came up during an IRS exam. The result was the right income got taxed, there was a huge penalty, but no handcuffs which might well have been an issue.
A little bit of foreign inheritance can be a problem. Former Chairman of the Ways & Means Committee, Charlie Rangel, didn’t get around to reporting foreign rental income and would complain about the tax rules being too complicated. Maybe he would argue he didn’t get the memo, but the rule is citizens and even resident aliens are taxed on worldwide income. I’ve seen innocent enough circumstances, such as a parent who didn’t move to the US dies and passes foreign assets to the now-U.S. kid, who doesn’t bother to report the dividends and interest for some years. A bequest or outright gift is not subject to income tax but the income from the asset is almost always taxable.
A U.S. inheritance is more often a problem. The surviving parent passes stocks and bonds to you, and they end up in one brokerage a/c and that broker passes the assets to your broker who may or may not know your basis. Your “basis” which is compared to proceeds to determine gain or loss is usually fair market value at the time of the surviving parent’s death, not original cost. Fairly early in the process, the IRS starts getting little pieces of paper from the broker reporting proceeds, but the IRS never keeps track of your basis. The IRS will at some point (this may even take years) begin sending you notices figuring your tax assuming the proceeds are 100% taxable and there is no basis to subtract against proceeds. It is the way the IRS uses to say “deal with it,” and you’re much better off dealing with major changes in your facts, such as a significant inheritance, early in the process.
Barter deals rarely come up but they can be very problematic. The income tax general rule is you’re taxable on the fair market value of goods and services received. There is an exception for gifts, if there is clearly donative intent. The gifts under the Christmas tree don’t get reported for income tax purposes because they are gifts. Non-cash items are usually taxable just like cash but you have to determine fair market value. If your employer went to the grocery store and gave you a sack of groceries as your compensation, the FMV of the groceries (the FMV of the sack can be disregarded as immaterial) is taxable at the time received. If you’re a tax lawyer and trade haircuts with your barber for doing his/her tax return, the FMV of the haircuts is taxable when your hair hits the barber’s floor. There is nothing wrong with barter deals but keep in mind that they are usually taxable deals.