Avoid these common mistakes and help shrink the tax gap
California's tax gap is estimated at $6.5 billion a year, based on federal tax gap estimates, and may actually be larger than this figure. One certainty is that the largest percentage comes from the combination of underreported income, and over-deducted expenses.
Many factors contribute to underreporting and over-deducting, including taxpayers who unintentionally make mistakes. Our focus on tax gap enforcement has uncovered some common taxpayer mistakes made. We hope that our education and outreach efforts to highlight these common income and expense mistakes will increase voluntary compliance.
Common income mistakes
- California residency status
- All income, regardless of source, is taxable for residents of California. Residents should not be subtracting income on Schedule CA for sources of income earned outside of California.
- California nonresidents are only taxed on income from California sources, e.g., gain from sale of property in California, wages earned while in California, etc.
- Part-year residents are taxed on all income received while a resident, and income from California sources while a non-resident. Several factors are involved in determining a change in residency status. Please refer to Guidelines for Determining Resident Status, FTB Publication 1031, to learn more about this issue.
- Fringe benefits
Employees often receive fringe benefits associated with their employment, like housing or automobile allowances. If these benefits are taxable, the employer will usually include the amounts on a form W-2. The taxpayer is still responsible, however, for knowing if they receive a taxable benefit, and for reporting the income, even if the income is not shown on the W-2.
If your clients barter goods or services for other goods or services, they must include the fair market value of the goods or services received.
- Internet earnings
Earning money by selling items on the Internet affects a growing number of individuals. People who receive income from occasionally selling items through online auctions or virtual economies may be underreporting income. Any time an individual earns income, even if it's as unusual as cashing out their virtual wealth for real dollars, they should evaluate whether the transaction is taxable. Individuals whose online transactions reach the level of a business activity should evaluate whether it is appropriate to deduct ordinary and necessary business expenses.
- Qualified small business stock
Keeping adequate records will help taxpayers correctly claim the following tax benefits associated with selling certain qualified stock.
- Deferring gains: When taxpayers elect to defer the gain from the sale of qualified small business stock, they must reduce the basis of their replacement stock by the deferred gain. This defers their gain until the time when the replacement stock is sold. Failing to properly reduce their stock basis results in underreporting income when the replacement stock is sold.
- Excluding gains: When taxpayers elect to exclude 50 percent of their realized gains from the sale of qualified small business stock, there is a lifetime limitation of $10,000,000 (or 10 times the basis in the stock sold, whichever is greater).
Common expense mistakes
- Mortgage interest
As property values in California have increased, there has been a corresponding increase in the number of mortgages exceeding $1 million. Most taxpayers are aware they can deduct their mortgage interest. Many, however, deduct amounts exceeding the limit. Mortgage interest can only be deducted in association with loan amounts up to $1,100,000. Interest allocated to amounts above $1,100,000 is not deductible.
- Charitable contributions
Donations to charities are governed by very specific rules, including what is donated, and to whom. Taxpayers should take great care when claiming donations as a charitable contribution. The type of charitable organization, and the type of property donated will determine the limitations that apply to the deduction. Only certain types of donations are subject to the 50 percent of adjusted gross income (AGI) limitation. Other donations are limited by either 20 percent or 30 percent of AGI.
- Home basis
Verifying the basis in your client's home is essential for determining the proper amount of gain. Taxpayers should maintain adequate records of their home improvements to correctly compute their gain on the sale of their rentals, or personal residences.
- Schedule C
- Meals and entertainment. Generally, only 50 percent of your clients' business meals and entertainment expenses are deductible. They should not deduct 100 percent of these expenses on the Schedule C "Other Expenses" line, or elsewhere on the return.
- Client gifts. Taxpayers can deduct a maximum of $25 in business gifts per client, per year.
- Personal expenses: Taxpayers may not commingle personal expenses with their legitimate business expenses.
Law changes for 2006 filings
Changes in the law can contribute to taxpayers underreporting their income or over-deducting their expenses. Some recent law changes that might have this effect are described below.
- For 2006, taxpayers can contribute $4,000 to an IRA, or $5,000 if over 50 years old. For 401(k) plans, taxpayers can contribute $15,000, or $20,000 if over 50 years old.
- California conforms to the new federal law for charitable contributions from IRAs. Taxpayers may now exclude up to $100,000 in "qualified charitable distributions" from their adjusted gross income for both federal and state purposes. In order to qualify, the distribution must be:
- Made directly by the IRA trustee to a charitable organization.
- Made on or after the taxpayer reaches age 70 and one-half.
- A new 2006 federal law adds new restrictions on charitable contributions of clothing and household items made after August 17, 2006. Federal law asserts that no deduction will be allowed for clothing and household items unless they are at least in "good" used condition. California has not yet conformed to this legislation.
- The filing deadline for the 2006 California personal income tax returns is Monday, April 17, 2007. A six-month extension is automatically granted until October 15, 2007. An extension of time to file tax returns is not an extension of time to pay. All taxes due must be paid by April 17, 2007.
- Individuals will not have to file returns for tax year 2006 if they:
- Claim either single or head of household filing status, and total income was less than $13,713.
- Claim married filing status, and total income was less than $27,426.