The classification of profits as ordinary income or capital gains can be a controversial issue, even for professional securities and financial professionals. Recently, Renaissance Technologies, a New York hedge fund, found itself embroiled in tax controversy with officials from the Internal Revenue Service over this very issue.
There is a potential profit motive behind the distinction, of course. Capital gains are taxed in a lower tax back. If the event resulted in lost income, characterizing that downfall as a capital loss may also have tax benefits. In addition, a capital loss might have carryback potential to the three taxable years before the event or carryover to the five years following the loss year.
Yet the issue can also affect — and confuse — individual taxpayers. Investment gains or losses usually qualify as capital gains or losses. However, taxpayers may wonder how to characterize other sources of income, such as income from a rental property or sole proprietorship.
The Internal Revenue Code has definitions for many different sources of income, but often there are conditions that must be present before a certain type of income or loss can be characterized under its corresponding statutory definition. If an audit results in a dispute over the characterization of certain income, a tax attorney might prove to be a valuable resource.
Historically, the rate of audits has been low. However, audit rates have risen by more than 25% in recent years, and that trend may continue as the federal government looks for more revenue sources and IRS officials try to ride out recent media accusations of biased audit investigations.