Mortgage Interest Audits

As many individuals are not complying with the mortgage interest deduction rules, there has been an increase in audits in this area. Qualified residence interest is paid during the year on acquisition debt or home equity indebtedness. Qualifying acquisition debt is debt incurred in acquiring, constructing, or improving a home, and the debt is less than one million. It is based on the balance of the debt and cannot be increased unless the proceeds are used for improvements. A loan has to be secured by the home also.
Home equity indebtedness is other debt secured by home, is $100,000 or less, and does not exceed equity in the home. If the interest deducted is $75,000 or more, it may indicate that the taxpayer is not in compliance and can be subject to an audit. Upon audit, copies of Form 1098, loan and refinancing documents, and line of credit will have to be provided. Interest on home equity indebtedness is deductible for regular tax but not deductible for AMT taxes. If one is in AMT, this may not provide any tax benefit.

Reasonable Compensation to Business Owners

“C” Corporation Compensation Issues: Business owners need to pay attention to the amount of compensation they receive for working for their corporations. A “C” Corporation is a tax paying entity. That means the corporation will pay corporate taxes on the net income. If owners take an addition bonus at the year end to “zero out” the corporation income, then the corporation has zero taxable income and owes no corporate income taxes. The IRS may look at the reasonableness of owners’ compensation. If it is excessive, it can be reclassified as dividends, which are taxable to owners but not deductible to the corporation.

“S” Corporation Compensation Issues: One way to avoid double taxation is to make “S” selection. Then the net corporation income flows to shareholders on K-1s and is reported on the shareholders’ 1040. Also, K-1 income is not subject to self-employment taxes. There is a general tendency to take a low salary to avoid paying self-employment taxes and have a larger K-1 income. In an audit, the IRS or FTB may conclude that compensation is not reasonable and increase the same, driving up Social Security and Medicare taxes.
Corporate Minutes: To avoid these issues, regular meetings of shareholders and directors should be held; document the compensation and reasons of high and low compensation as part of those minutes. If compensation is high, then minutes may say that the reason for high compensation is to make up for prior years sacrifices, assuming that is the case.

Independent Contractors vs. Employees

If the payer has the right to direct and control, whether or not exercised, then the worker is an employee under common law. Revenue Ruling 87-41 identifies 20 factors to be evaluated in determining the status of a worker. The 20 factors are the so-called “common-law” criteria for classifying workers. All evidence of control and independence in the relationship should be considered and these fall into three categories: Behavioral Control, Financial Control, and the Type of Relationship itself. Common law employees are subject to all federal and state payroll tax withholding rules. If reclassified as employees, there are substantial penalties involved.

Parveen Maheshwari is a Certified Public Accountant. His Burlingame office can be reached at 650-340-1400 or