Imagine this scenario: there's an office retirement party, and everyone is giving money for a going-away present. It's time to pay, but you don't want to give twenty bucks if everyone else is only coughing up five, right? Taxes work the same way: we all have to pay them, but no one wants to pay more than is required.
You hear about all these deductions for home offices, dependents, and charitable donations, but how do you know if you can take that deduction or if you're inviting an IRS tax auditor? Here's a quick checklist so you know where you can avoid taxes and when you're crossing the line into tax evasion.
Tax Avoidance: There really is no way to avoid being taxed on income. If you made money somewhere, you need to report it to the IRS. Don't forget about interest, income and alimony; not reporting alimony is a major audit trigger.
Tax Evasion: If you think the IRS won't know you made that money, you're wrong; whoever paid you interest, income or alimony is deducting it on their end, and the IRS will match it with your tax return. Report all your income; there will be opportunities for you to make deductions later. (Tax rates are going up, so it pays to find sources of income that the tax collector can't touch. Here are 20 of them in Earn Tax-Free Income.)
Exemptions and Earned Income Credit
Tax Avoidance: Have kids? Congratulations, you just got yourself a tax break. You can claim them as exemptions, as well as yourself and your spouse if you're married. Each of your children may also give you an additional child tax credit, as well as Earned Income Credit (EIC) if you qualify.
Tax Evasion: Don't claim more exemptions than you're allowed. If you share custody for instance, make sure your former spouse is not claiming your child as an exemption too. Claiming children as exemptions can qualify you for EIC, if you meet the certain requirements.
Overstating your exemptions on your tax return (by falsely claiming a child as a dependent, say) will trickle down into deductions for EIC, which is why it's so important to get your exemptions right. EIC claims are one of the most common IRS audit triggers, so double-check your exemptions before filing. (Be sure to double check your federal income tax return for these common mistakes that could cost you time and money. Learn more in The 10 Most Common Tax-Filing Mistakes.)
Small Businesses and the Self-Employed
Tax Avoidance: Owning a business or being self-employed can be a great way to generate income, but it comes with its share of expenses. Thankfully, the IRS allows you to deduct those office supplies, mailing expenses and brochures you printed for clients.
Make sure you keep good records of deductable expenses and that your business is a profit-making venture instead of an income-generating hobby. The rule of thumb for the IRS is that your endeavors should deliver a profit three out of five years in operation.
If you drive a car as part of your business, you can deduct this expense too. Just make sure you keep a log of the miles you drove, and the purpose of your trip. The more detailed your records, the happier the tax man will be.
Tax Evasion: Think you can deduct that office you work out of? Be careful - home office deductions are one of the most common IRS audit triggers, because so many people claim this expense without qualifying.
Here's the truth about home office deductions: the only time you can deduct an office as an expense is when it used solely for business. If you have another office you work out of, or if you also use the space as a guest room or living room, forget taking the deduction. You don't qualify, and claiming the deduction equals tax evasion.
Tax Avoidance: Charitable donations are a great way to do something nice for your community and get a tax break at the same time. Even those garage sale leftovers you're hauling to Goodwill are tax-deductable, as long as you have a receipt. Make sure you keep good records of these donations, as they're a common IRS audit trigger.
Tax Evasion: Think your late Aunt Emma's china collection you donated is worth five hundred dollars? You'd better back that up with some records, because the IRS will want to see them. Any time you donate a big-ticket item make sure you have a fair market valuation to support your claim.
Cars and collectors' items are common donations that will need records - don't fudge the numbers, or you'll be sorry when you get audited. (Being generous can be financially rewarding! Learn more in Give To Charity; Slash Your Tax Payment.)
The Bottom Line
Be sure to check with the IRS (http://www.irs.gov/) for more details on the specifics of these and other deductions. It's important to keep your records for seven years as required, just in case the tax man decides it's your turn for an audit. With these tips, you'll be sure to pay the taxes you have to and not a penny more - without getting in trouble with the IRS.