California Combo Tax Attorney & CPA for Passive Income Audits
Not all income is viewed the same in the eyes of the state of California and federal tax code. Passive income, which a taxpayer derives without actively earning it, but merely investing money, is treated differently than other forms of active “earned through labor” type income. Within passive income, there are two categories: income from rental properties and other income sources in which the taxpayer does not actively participate.
Identifying and classifying your sources of income correctly is critical because mistakes in reporting passive income can lead to a state or federal government audit. If the government finds that you have erred in your return regarding passive income you could find yourself facing massive amounts of additional tax penalties and interest and in truly egregious cases where willful conduct can be proven, criminal tax exposure.
If you are faced with a government audit concerning your passive income sources and past reporting, the best step that you can take for yourself is enlisting the help of a seasoned California dual licensed Tax Attorney and CPA. The Tax Law Offices of David W. Klasing can provide you with competent advice and representation no matter where you find yourself in the process. To find out more, call us at (800) 681-1295 or schedule a reduced rate initial consultation online HERE.
Passive Income Tax Reporting Issues Lead to Audits
Passive “investment” activity income is treated entirely different than active ordinary income from “trade or business” activity, for federal tax purposes. If you invest in passive activities, such as renting real estate, you must be aware of – and take careful steps to comply with – the applicable IRS tax rules which serve to prevent passive losses from offsetting active income or misclassifying active income as passive to illegally absorb passive losses. Otherwise, you are at risk of making an avoidable reporting error, needlessly exposing yourself to the risk of a costly and damaging civil tax audit. If the IRS believes you have taken willful steps to avoid reporting and paying taxes on passive income, or to purposefully mischaracterize active as passive or passive as active income or loss you may be criminally investigated for tax fraud – potentially in tandem with a tax audit, which is known as an “eggshell” or “reverse eggshell audit.” If there is sufficient evidence to indict you, an IRS criminal tax investigation could eventually lead federal prosecutors to file misdemeanor or felony charges against you.
At the Tax Law Office of David W. Klasing, we routinely represent real estate professionals and other taxpayers in real estate tax audits or other audits involving passive income, including criminal tax audits and investigations. In addition to extensive legal experience, founding attorney David W. Klasing has over a decade of experience as a public auditor, and nearly three decades of tax controversy experience giving our team an inside perspective on IRS tactics and strategies. Whether we are preparing you for a tax audit, disputing the outcome of an audit through IRS appeals and tax litigation, defending you against criminal tax charges, or assisting you with tax planning and income tax preparation, we dedicate ourselves to providing an unparalleled level of service, support, and satisfaction.
What is Passive Income?
Most taxpayers think of “income” as earnings, such as tips, wages, commission, or salary, that are obtained by working full-time or part-time, whether as an employee, contractor, or freelancer and trade or business income. However, some taxpayers have alternative or supplementary sources of income, known as “passive” income streams, that are subject to unique tax regulations.
In contrast to income that is earned by working a job, performing a gig, or completing a project, passive income is earned through activity in which the taxpayer passively (inactively) participates. For example, the taxpayer might earn passive income by renting rooms, placing ads on a vehicle or website, providing storage space, purchasing real estate investment trusts (REITs), or simply depositing money into a savings account or investing in securities through a brokerage account. The concept of “passive income” should not be confused with the separate concept of “unearned income,” which, according to the IRS, refers to “investment-type income such as taxable interest, ordinary dividends, and capital gain distributions.”
In its Passive Activity Loss (PAL) Audit Technique Guide, the IRS broadly splits “passive” activities into two categories: “Rentals, including equipment leasing and rental real estate; and… businesses in which the taxpayer does not materially participate.” The latter category “includes activities on Schedules C or F and from partnerships, S corporations and LLCs.”
Government regulations around passive income are contained under U.S. Code § 469 (also written “IRC § 469” or simply “IRC 469”), pertaining to passive activity losses and credits. For more information about IRC 469 regulations and how passive income is taxed, you may be interested in the following tax FAQs:
- Do passive losses receive special treatment under IRC 1041 in a divorce?
- How are passive activity expenses and losses characterized?
- Is there a special allowance for rental real estate activities?
- What are passive loss limitation rules?
- What are some tax basics around real estate and divorce?
- When can real estate professionals deduct real estate rental losses?
For passive income that a taxpayer derives from an overseas source, there are separate reporting guidelines that the taxpayer must meet. If you receive a total exceeding $100,000 in a single taxable year from your inheritance through a foreign estate or a gift from a foreign person, you must report the gift on a form 3520 or face draconian penalties. U.S. taxpayers are taxed on their world wide income which means that offshore inherited investments generate taxable income that must be reported or risk criminal charges for income tax evasion.
If, you inherit a foreign financial account, you will need to file a Report of Foreign Bank and Financial Records (FBAR). The IRS is strict about FBAR requirements and imposes harsh penalties for failing to comply. Simply forgetting to file the form can cost you a civil penalty of $10,000 per tax year. If your FBAR non-filing is deemed willful, a fine of up to 50% of the total value of the unreported overseas assets or $100,000, whichever is greater can be assessed. If you inherit and hold offshore income generating assets and businesses, the Tax Law Offices of David W. Klasing can help you meet your offshore tax and information filing obligations.
Foreign Nationals with U.S. Property or Holdings
If you have invested in United States real estate but are not a U.S. citizen, you are still taxed on the U.S. source income from that holding. Foreign investors are subject to U.S. tax obligations for limited situations where they derive specific income from their U.S. holdings.
This includes certain types of U.S.-based income, such as interest, dividends, rents, annuities, and any other “fixed or determinable annual or periodical income” (FDAP). Additionally, foreign investors must report and pay tax on income effectively connected with a U.S. trade or business. This income is known as Effectively Connected Income (ECI).
FDAP income is taxed at a flat 30% rate unless a lower treaty rate applies. ECI is taxed at whatever graduated rates apply to U.S. citizens. If a foreign national has ECI in a taxable year, the earner must file a Form 1040-NR with the IRS to report the income. Within the 1040-NR filing, the taxpayer may take certain available deductions or claim treaty benefits where they apply. However, deductions and treaties do not alleviate your responsibility to file, even if they ultimately leave you with no tax liability for your ECI.
Some exceptions may apply that could render FDAP income or ECI free from U.S. taxation. For more information about these complexities in the U.S. tax code as they apply to foreign nationals, seek counsel from a dual licensed Tax Attorney and CPA like those at the Tax Law Offices of David W. Klasing.
Passive Income IRS Tax Audit Attorneys + Accountants
If you have misclassified passive income and have been chosen for a tax audit, the best step you can take is to contact a reputable and experienced tax defense attorney for assistance. Our IRS tax lawyers and CPAs can ensure that your rights during a tax audit are upheld; that the IRS follows proper protocols; that you are not improperly assessed tax, penalized or charged interest; and that you are fully aware of your rights to appeal and challenge improper findings if you disagree with the outcome of an audit. To dispute an auditor’s findings successfully, you must provide your legal and/or factual reasons for disagreeing with the findings, and must adhere to brisk timelines that, generally, allow mere months or weeks for the taxpayer to act.
The purpose of an audit is to determine whether the taxpayer accurately reported and/or if tax penalties and interest are owed to the IRS where the taxpayer did not do so. If the return contains misstatements the question becomes if the taxpayer willfully concealed or distorted their tax reporting information to the IRS’s detriment. If the taxpayer acted “willfully,” or intentionally, he or she has engaged in tax fraud, which is a crime punishable by prison time. While our office approaches every case with the goal of minimizing criminal and civil tax financial exposure and avoiding criminal tax prosecution first and foremost, our tax evasion defense lawyers are prepared to defend your case vigorously on the outside chance that criminal tax charges are ultimately filed as the result of, or alongside, a tax audit.
California CPA + Tax Lawyer for Passive Income Audits + Appeals
Whether you are preparing to be audited, wish to dispute an auditor’s findings, are worried about the prospect of a tax fraud charges being pursued, or have general questions about tax compliance and preparation, look to the Tax Law Office of David W. Klasing for answers you can trust. Contact us online right away to arrange a reduced-rate tax consultation or call our main office in Irvine at (800) 681-1295. Our offices are located throughout Northern and Southern California to provide convenient support to taxpayers statewide.
Note: All our satellite offices, other than our main office in Irvine California, are by appointment only.
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Will it cost me more to hire the Tax Law Offices of David W. Klasing, who’s main office and the vast majority of the firm’s staff is located in Irvine California, but an appointment only Satellite office is close to my location, as opposed to a local company? Absolutely not! See our policies that address this issue here