The 2021 Tax Season, which started about a month ago, is off to a bumpy start. According to the most recent filing season statistics released by the IRS return processing is down by 30% over last year while website traffic is up almost seventy percent! There are increasing calls for the IRS to delay tax day, AGAIN, and Congress has just finished passing legislation with several significant changes for both the 2020 & 2021 tax years.
In a tax season fraught with uncertainty, and tax day fast approaching, there are several tax surprises out there ready to cause trouble for taxpayers and tax pros alike. Here’s a look at a few that may result in some unexpected tax bills this filing season.
The IRS has slowly, but surely, been placing increased focus on ensuring cryptocurrency transactions are reported. This includes hiring cryptocurrency experts, creating databases for collection & exam personnel, and the creation of ‘Operation Hidden Treasure’, a dedicated program for tracking those who fail to report. The new 2020 Form 1040 moved a reporting question from Schedule 1 on 2019 right onto the front page of the 1040 ensuring every taxpayer must now answer this question and the IRS can continue building a database for further tracking. For tax pros this means you must now ensure you are asking about your clients about any involvement they have in cryptocurrency.
Bitcoin, created in 2009, is the original and most well-known cryptocurrency however there are over 6,000 different altcoins on the market. 2020 was a good year for bitcoin, and cryptocurrency in general, as values jumped to a three year high. There has also been increased mainstream and corporate confidence in cryptocurrencies, proving once and for all that they are here to stay. Any sales of bitcoin, whether a loss or gain, must be reported on a taxpayer’s tax return, although purchase just requires self-reporting on page 1 of the 1040. Failure to report will result in a nasty tax surprise down the road.
In the wake of the great recession the side hustle and gig economy took off and has become a large part of the American economy. Gig work is almost synonymous with technology, and even the IRS defines gig work as income earned “often through an app or website.” Whether that App is Etsy, Uber, Doordash, Ebay, or Instacart (just to name a few) the income is almost always 1099, with no taxes withheld. As part of a side hustle the effect on a taxpayer’s bill is often negligible, or manageable, with W-2 withholding offsetting the additional tax. They also may not have been making enough in the past to be concerned about tracking expenses like mileage or Cost of Goods Sold (COGS).
As unemployment swept across America many looked to make their side hustle a full time job and others took up gig for the first time. If 2020 was their first experience with gig work, chances are they were not aware of the tax implications and could be looking at an unexpected tax bill. A lack of Estimated (ES) tax payments and/or incomplete records will make it even more painful!
2020 unemployment claims peaked the week of May 9th with over 27 million claimants, approximately 19% of the eligible workforce. Many recipients didn’t know that unemployment benefits are taxable, and even if they did, their financial situation at the time may have left them needing every penny of that unemployment check. The new stimulus bill aims to diminish this tax surprise by allowing the first $10,200 in unemployment benefits to be exempt from income tax for certain qualified individuals. However, many may still be staring down a potential tax bill when they file 2020 taxes.
According to the Department of Labor the average weekly unemployment benefit is $378 per week and most states have 26 weeks of coverage, do the math on that and the new stimulus bill would likely exempt the entirety of that income but this is only the tip of the iceberg. The CARES Act, and its successors, have repeatedly extended unemployment benefits and covered additional weekly benefits. Any recipient who maxed out both benefits could very easily end up over the exemption amount, combine that with other household income and they could be looking at a surprise tax bill.
Last, but not least, COVID 19 related retirement distributions. Section 2202 of the CARES Act waived the early withdrawal penalty on retirement distribution for individuals who experienced a qualified hardship caused by the pandemic. However, individuals will still be required to pay income tax on those distributions. If they failed to withhold, or under withheld, they will likely find themselves with, surprise, a tax bill. Even more concerning, what if they don’t report it? Unreported retirement distributions are a leading cause of Automated Underreporting (AUR) audits.
As if that wasn’t enough the CARES Acts enacted a few special provisions that present challenges for both tax professionals and taxpayers. The first is allowing taxpayers to repay the distribution within 3 years and potentially avoid the tax altogether, however if they fail to do so then it becomes taxable. If they forget to report it (3 years is a long time to remember), then there is the possibility of an audit down the road. Secondly, the CARES Act also allows for the taxpayer to claim as income in 2020 OR spread it out to 2020, 2021, and 2020 tax returns. This creates a planning landmine for tax preparers and sets up a tax trap for taxpayers who may fail to be consistent in their reporting over the three year period. Either way you look at, taxpayers who took COVID related distribution face potential tax surprises for years to come.
What can you do to limit the impact of these surprises? Well first, make sure you update your tax preparation questionnaires to address these COVID tax surprises. Asking the questions will help you spot the surprises before they can spring on you and the taxpayer and might save you from an E&O claim in the future. Secondly, set yourself up for success by using a transcript download software, like Tax Help Software, to track income discrepancies and IRS activity. Staying ahead of the IRS is half the battle in helping your client.
Lastly, make sure you have options for your clients who end up with a surprise tax bill. The IRS has several programs available for taxpayers who can’t pay their bill, but it often takes a tax professional to determine the best option. Tax Mentor membership offers customized consultations and training focused on tax resolution; helping you bridge the gap and ensure you are providing top notch representation to your clients.