A majority of our taxpaying public get a tax refund in the spring of each year. But there is another group of folks who are not as eager to check their mailbox. Instead of a refund, they find a tax bill.
Some individuals made a simple mistake; others perhaps struggle to manage their finances. Whether inadvertent, slipshod or intentional, here are the ten reasons why taxpayers find themselves in the red come tax.
Claiming too many exemptions to tax
At the outset of their employment, wage-earning taxpayers are asked to complete a Form W-4, Employee's Withholding Allowance Certificate. This form tells your employer at what rate you wish to be withheld at for income tax withholdings.
The more exemptions to tax you opt to claim on the form (represented by numerical elections), the less you will have deducted from your pay each pay period. Remember, just because you legally can claim a higher number of exemptions, does not mean you should.
If you realize that you have been under-withheld when you get your W-2 at the beginning of the new year, it's already too late. Check your withholding now by using the online IRS Withholding Calculator. If you find that you are projected to owe the IRS, give your employer a new W-4.
Not making estimated tax payments
This is the self-employed version of reason number 1. Unlike wage-earning taxpayers, if you work for yourself, the responsibility rests with you to set aside a portion of your earnings to account for tax. In some cases, the IRS requires that these funds be paid in as estimated tax payments.
In general, the IRS requires any self-employed individual to make estimated tax payments if their gross earnings are expected to yield a net tax due of at least $1,000 or more for the year.
There are exceptions to that, such as if you did not owe any tax on your previous year return, or if your current tax withholdings from other income sources and or tax credits will cover at least 90 percent of tax stemming from your self-employment.
For more information on making estimated tax payments, see IRS Publication 505, Tax Withholding and Estimated Tax.
Incorrectly choosing to file as Head of Household
The Head of Household (HOH) filing status provides a total exemption amount of $8,400 for 2010 taxes. Compare this to Single or Married Filing Separate filers who can deduct only $5,700 from their gross income.
Although the HOH status provides an attractive exemption amount, there are specific qualifications that must be met before you can elect to file this way. You are allowed to file HOH if both of the following apply:
- You are unmarried or considered unmarried. Considered unmarried means your spouse did not live with you at any time during the last 6 months of the filing year.
- You paid more than half the cost of keeping up a home for yourself and a qualifying person, who is generally, but not always, considered your dependent for tax purposes.
Claiming HOH incorrectly means that your tax due will be skewed and ultimately you may owe money back. Make sure you are eligible for this status before you send in your return; don't guess at the qualifications.
Claiming the Earned Income Tax Credit (EITC) wrongly
EITC is a popular credit available to certain lower income taxpayers. It is a refundable credit in that it can wipe out any tax due but can also equate into a tax refund.
It's also one of the most misinterpreted credits. Initially, you must have received earned income, like wages. If your income is only from pensions, Social Security, unemployment, public assistance or child support / alimony, you do not qualify. Additionally, you must meet a comprehensive set of rules depending on if you have qualifying children or not.
If you claim EITC and the IRS later determines that you were not legally qualified to do so, you will not be able to claim the credit on a subsequent year until you send in your return with Form 8862, Information to Claim Earned Income Credit After Disallowance.
Check your eligibility for the credit ahead of time by using the IRS EITC Assistant.
Failing to file a tax return
OK, so if a return is not filed with the IRS, how can I owe taxes? Because the IRS has the authority to assess the tax against you. This is called a Substitute for Return. Section § 6020 of the Internal Revenue Code grants permission to the IRS to assess a tax balance via a proxy 1040. This becomes a legal assessment that the IRS will begin to collect on.
When a return is assessed against the taxpayer, there is no consideration given to any dependents, credits or other exemptions or deductions to tax. Based on the income reported to the IRS from all payers, the IRS will assess an aggregate tax using a tax rate that is not beneficial to the taxpayer.
This is a collection action that is done in order to encourage taxpayers to file their own tax return in a timely manner. Once an assessment is made, if a taxpayer files their own return, the IRS will reconsider the assessment in lieu of the actual 1040.
Failing to report investment losses
If you engage in the sale of stocks, bonds, property, or other assets subject to capital gains tax, you may know that you took a loss, but the IRS does not.
Brokerages are required to report stock transactions to the IRS using Form 1099-B. However, all that gets reported to the IRS is your sale price, not your purchase price or any other paper expense that factors into your cost basis.
You may have transacted hundreds of thousands in broker or barter income, but ultimately ended up with a loss. Yet if you fail to file a tax return to show this loss, or fail to file a Schedule D to account for your cost basis, the IRS will audit and assess the tax assuming a cost basis of zero.
Underreporting or leaving out income sources
Employers and payers have until the end of January to mail out tax statements to taxpayers. Of course, this does not always occur timely. Equally as obvious should be the fact that this does not exempt you from including the income.
If you have not received your W-2, first of all, contact the payer. If you have done that and are still unsuccessful, let the IRS know so that they can help you prepare a Substitute W-2.
Ensure that you have reported all your wages, as well as all other income sources, such as interest and dividends, pensions, Social Security (a portion may be taxable if you have other income), unemployment, alimony, and all self-employment as reported to you on form 1099-MISC.
The IRS has three years to review and assess all unreported or underreported income sources. By that time, penalty and interest will have been assessed. If you realize you have left out an income source, immediately amend your tax return using Form 1040-X.
Failing to include taxable canceled debt
If a lender cancels or writes-off an outstanding line of credit, then the amount canceled is likely taxable to you. The lender will send you a Form 1099-C showing the amount of the loan that was discharged. In most cases, this amounts needs to be added into your taxable income.
Typically, cancellation of debt arises from two things. If unsecured debt is abandoned, such as in the failure to make credit card payments, and the debts become charged off, then the unpaid amount becomes taxable. Also, in the case of secured debts like a car loan or a mortgage payment, if you fail to make payments and the lender reacquires the collateral through repossession or foreclosure, then there may be an amount left over on the original loan that becomes taxable.
If the lender cannot recoup the amount due by selling the asset, then they will charge off the difference and send you a 1099-C.
This type of "income" often arises when taxpayers choose the instrument of a bankruptcy petition to absolve their debt. The loan balances may be discharged, but the tax still must be accounted for. Many are not aware of this, and ultimately get audited for not including this on their return.
Not contacting the IRS to make timely resolution
One of the biggest mistakes taxpayers make is not being proactive about their tax situation. Most individuals are reactive; they think they need to get notices in the mail from the IRS before they call to address their tax balances. By this time, the IRS has assessed quite a bit of penalty and interest.
If you realize you are about to file a tax return but cannot make full-payment, first of all, do not delay the filing. The IRS charges a Failure to File penalty that accrues at 5 percent of the tax due per month, for 5 months.
For example, if you owe $3,000 on your tax return, but cannot make payment and you do not file timely, you will owe up to an additional $750 for failing to send it in on time. To say nothing of the IRS Failure to Pay penalty or the compounded interest.
Send in your return with Form 9465, Installment Agreement Request. If the amount you are requesting to pay each month is within IRS guidelines, and if you are current in your tax filing obligations, the IRS will establish an immediate payment plan for you.
Filing a frivolous tax return
This is restricted to a small group of ambitious non-taxpaying individuals who enjoy poring over the minutiae of the tax code searching for seemingly convoluted loopholes. Filing a tax return that purports a frivolous argument immediately earns a Civil Penalty up to $5,000.
Un-taxing or de-taxing schemes are littered all over the internet. Don't fall for any of these erroneous and flippant squabbles. The IRS has litigated on, and debunked, all such frivolous contentions. Trying to save money by taking a dismissive position will cost you ten times as much in tax, penalties, fees, liens and court costs.
The IRS demystifies all such positions in their publication The Truth About Frivolous Tax Arguments.
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