New Year's Prep

It finally dawned on me that blog posts about IRS audits may not exactly reflect the holiday spirit – but somewhere in between glasses of eggnog it also occurred to me that this is good material for formulating valuable New Year’s resolutions.  With that thought in mind I’ll move on to this week’s focus for avoiding audits – the areas of your tax return that can trigger extra attention.

Charitable deductions top the charts of almost all “likely audit trigger” lists.  Charitable contributions that are inconsistent with your income level are a red flag.  The IRS releases information about what the US averages are (which I’ve included below).  Please let me emphasize here that if you have good documentation then you should take deductions even if they invite scrutiny.  That’s better than paying extra taxes .  Charitable contributions of more than $250 require acknowledgement from the charitable organization, and there are special provisions for non-cash donations.

Right behind charitable giving on the IRS hit parade is the home office deduction.  Historically many people who claim expenses for work at home really aren’t eligible in the first place.  It’s only allowed if you use the space exclusively and on a regular basis as your principal place of business.  If you’re not self employed the home office use can only be claimed if your employer doesn’t give you work space. 

Next to your home, your most expensive possession is your car – again an area where the IRS often finds deception.  If you use your car for your business more than half of the time you can deduct the business use.  However, if you claim you use your car exclusively for business and you don’t have another car, the IRS won’t believe you.  Again, if it’s legit take the deduction.  Just make sure you can prove the business use. 

Schedule C, the portion of an individual return that’s used for sole proprietors is another area where the IRS has had much audit success.  Often the sole owner doesn’t have time to keep good records, so even without fraudulent intent can end up flunking an audit exam.  The first safety tip is -- expenses in line for like-sized businesses in similar industries.  If your meals and entertainment stand out from the usual that’s even worse.  If your industry is one where some people do it just for fun, you have to make sure you turn a profit within a reasonable amount of time.  If you don’t meet their standards the IRS will consider it a hobby instead of a business.  You can still take losses, but not beyond your gains. 

Gosh, you’d think I’d be done with this topic, but unfortunately more goodies to come.  At least this should get you started on some resolutions and hopefully help you pay less taxes ( avoid penalties) in the  New Year.

Search Audit Optimization

For anyone who gets a headache thinking about the latest in Search Engine Optimization, I've got news of a migraine headed your way.  While the odds of being audited remain low, the IRS is working diligently to better identify audit targets who are likely to produce unpaid taxes. We’ve already discussed the study being done on payroll taxes and how that adds thousands of tax compliant businesses to the pool of people who will get audited.  The IRS has determined that small businesses (less than $250,000 in assets) are filled with non-compliant tax payers, so they’re launching a new random study to find areas where this alleged non-compliance occurs more often.  This adds another 2,500 companies into this year’s pool.  Results from all these studies are destined to fall into the IRS version of the Google algorithm, presumably generating more yield per auditor.

While I’m being snarky in my comments here, the fact is the IRS auditors are getting more productive.  According to my Kiplinger letter subscription, Treasury inspectors say their average tax deficiency per exam is up 58% in the past five years.  However, they acknowledge that in fact the increase is mostly driven by whistle blowers.  (The past 5 years have been tough on employer / employee relations.)  About a third of companies selected for audit get through without paying a penny.  However, before you get too happy about that, (also from Kiplinger) the number of penalties assessed and their size is growing.  In the same 5 years accuracy penalties assessed to individuals went up 800% and businesses saw that number triple.  (Yes, that could be a reason why you need a good accountant.)

As if all this isn’t enough, the IRS is asking Congress to expand its power to levy  as a way of getting money it believes is owed.  Part of the argument is that taxpayers can effectively slow the collection process under the current procedures, and in 93% of cases studied by the IRS, the levy was warranted.  First of all that’s just one sample -- and as we know from mortgage backed securities, how the sample is picked really matters.  Also getting back to those accuracy penalties assessed on individuals – 25% of the $1 billion assessed in 2010 was later reversed by the IRS.  Oops. 

Audit I Forget..?

While many tax payers are done for the year, the question lingers.  What are the odds the IRS will put you on the “A” list –  as in to be audited?   Last week, the IRS released its tally sheet of who was audited in their 2010 fiscal year.  In general  the rates were up.  Also generally, the recipients of additional IRS attention were the usual suspects:  individuals with income between $200,000 and $1 million, businesses with gross receipts of more than $25,000 and individuals claiming the earned income credit.  Higher income puts you at the top of the class.  Corporations with assets of $100 million or more had a 14.5% chance of an audit, vs. those with $250,000 to $1 million at a 1.3% chance of getting a notice.  Give the IRS some credit; they go where the money is.

So if those are the odds you’ll be investigated, what are the chances it’ll cost you?  According to the  data book, the IRS assessed financial penalties against 27.1 million individuals last year.  More than half of those were for failure to pay tax.  Only a little more than 1.1 million businesses suffered the same fate, with 42% of the assessments related to failure to pay.  If the IRS decides to look at criminal investigations, the numbers get more serious.  Of the roughly 3,000 cases referred for prosecution, more than 2,000 resulted in conviction.  Almost 82% of those convicted were incarcerated (home confinement with an electronic bracelet is included in those numbers.)  Don’t say I didn’t warn you.

Speaking of warnings, the IRS does have a special program started in 2010 to audit businesses for payroll taxes.  (For more detailed discussions about the program specifics, you can go to my post “Going Where the Money Is”).  Word is the issue they’re most focused on for these audits is whether employees are properly classified as “employees” or "independent contractors”.    While at a high level the idea of someone who has more discretion on how the work gets done is usually contractor material, there are lots of grey areas.  For sure you don’t want the IRS discussing the topic with you.  It’s worth asking a trusted advisor who knows about this type of thing if you are operating in shades of grey.  If so – move into black and white territory as fast as you can.   It’ll beat wearing an orange jumpsuit. 

Going Where the Money Is

Even if you’ve not been impacted by Justice Department’s investigation of insider trading, here’s a new potential notice to worry about.  The IRS is in the process of launching it’s Employment Tax National Research Project.   The research plan is to audit 6,000 companies selected at random on the general topic of the compliance characteristics of employment tax filers.  In case you’re wondering why this is a priority, the taxes collected through employers come to $1.7 trillion a year.  This is almost 72% of the annual revenue of the US treasury.   So yes,  it appears the study is worth doing “because that’s where the money is” .

The first 2,000 “lucky” companies have gotten their audit notices already.   This will be an annual event for the next two years, so you still may be selected.  The stated goal of the study sound reasonable.  The IRS estimates a “tax gap”, which they define as the difference between the amounts taxpayers should pay and what they actually send in as payment.  The IRS typically targets audits hoping to reduce this tax gap.  There is a concern that in the 25 years since the IRS last looked at likely causes of “tax gap” associated with employment taxes much has changed in how companies process these payments.  So the first goal is to determine if current estimates of this tax gap on target, and then, perhaps more importantly to figure out what areas of employment tax lead to the most compliance problems. 

While the agency indicates that the audits are going to be comprehensive, there are apparently four areas that will be targeted for scrutiny:  worker classification (this goes to the question of whether you’re an employee or contractor), executive compensation, fringe benefits and payroll taxes.  According to the Thompson Bulletin, law-abiding companies who are included in these random samples will have to provide significant amounts of information and will need to allocate specific resources to meet the IRS requirements for data.   Compliance Week  passes on the following:

  In its alert to employers the IRS advises companies to plan their response carefully should they receive a letter initiating an audit under the research program. The IRS says companies should form an internal team consisting of representatives from payroll, accounts payable, accounting, human resources, internal auditing, general counsel, and outside tax professionals.

If you’re not getting scrutiny on this topic now, it’s worthwhile to add doing some internal due diligence on the area of employment tax compliance as a New Year’s resolution.   Better to catch your issues yourself rather than have the IRS do it for you.