8 Red Flags That Could Trigger an IRS Small Business Audit

My colleague, Brad Paladini, has granted me permission to post this article that was originally posted on his blog: 

Last year, the Internal Revenue Service (IRS) audited just over one million returns. That’s a lot less than the 1.74 million returns they audited in 2010, but it’s still no fun for the millions of taxpayers that had to go through the process!

Overall, the IRS audits only about 1 in 200 returns. But some returns attract much more scrutiny than others. The IRS doesn’t want to waste its time getting blood out of a stone, and so they focus their investigative efforts on those returns and taxpayers that are statistically more likely to have discrepancies, such as small business owners.

Common Red Flags

Here are some of the major ‘red flags’ that can increase the likelihood of attracting IRS attention in the form of a small business audit:

1)  Higher Personal Income

While the average taxpayer has a 1-in-200 chance of getting audited in any given year, those with incomes of over $1 million are looking at odds of 1-in-20. That is, if your income is greater than $1 million, the probability of your return being selected for audit is ten times greater than it is for the average taxpayer.

At the same time, if you have an income of less than $200,000, the chances of your return being audited falls to just 1 in 154, based on 2016 numbers. But if your income was above $200,000, your chances of being audited increase to 1.70 percent, or 1 in every 59 returns.

So, if you’re showing an unusually high personal income, you are more likely to face an IRS small business audit. If you own a flow-through entity, such as an S-Corporation or LLC, the audit is likely going to extend to your New Jersey business as well, and any other business interests you own.

The same is true of partnership income. If you are showing substantial income from a limited or general partnership, and the IRS flags you for an audit, the audit very well may extend to the partnership – especially if you are the managing general partner in a limited partnership and your K-1s are showing a lot of suspicious losses.

2)  Owning an All-Cash Business

Owners of businesses like restaurants, food trucks, convenience stores and other businesses that deal a lot in cash sometimes fall to the temptation to take cash transactions “off the books” in order to conceal income. Your credit card processor submits a 1099-K to the IRS detailing the credit card payments they’ve made to your business account. The IRS has a pretty good feel for how much of a business’s receipts are going to be in cash vs. credit cards, checks and other forms of payment. If your numbers are way out of whack for similar businesses in your industry, you can expect some additional IRS scrutiny.

3)  Suspiciously Low Salary Income for Corporation Owners

This is a common red flag for New Jersey business owners. Some business owners try to report as much income as possible as dividend income and little or no salary income in order to sidestep FICA taxes. The IRS is wise to this trick, and will often look closely at business owners who report W-2 salary as suspiciously low, compared to the size and profitability of their businesses.

Some people fill out their Schedule C (Business Profit and Loss) forms to show just enough income to qualify for an earned income tax credit or other lucrative tax credit, but not much more. This also attracts IRS scrutiny.

4)  Large Cash Transactions

Merchants must report cash transactions in excess of $10,000 to the IRS. Banks also report these transactions. Failure to report these transactions, or repeated transactions just below the threshold, could trigger IRS interest.

5)  Reporting Net Losses in Multiple Years

Reporting net losses in more than two years out of any given five-year period may attract a small business audit – especially for sole proprietorships, and any time business owners are trying to flow-through those losses to their personal income tax returns.

To qualify as a bona fide business, as opposed to a hobby, your enterprise needs to show a profit in at least three out of five years. The IRS presumes that if you can show a profit at least three out of five years, you are running a bona fide business set up to make a profit. Otherwise, the IRS will look closely at your claimed deductions, and you could run afoul of hobby loss rules, and get some deductions disallowed. See IRC 183 for more information.

6)  Net Operating Loss Carrybacks or Carry-Forwards

Business losses can be carried back or carried forward to apply against income in other years. But the IRS is interested in these transactions. Be sure to document any such carrybacks or carry-forwards carefully to withstand an IRS small business audit.

7)  Excessive Deductions for Vehicle Use

The IRS looks closely at 100 percent business deductions for car expenses.

First, you can deduct the IRS standard mileage rate for business use – 54.5 cents per mile for tax year 2018 (as of this writing, the 2019 mileage deduction has not been released yet.) Alternatively, you can deduct your actual vehicle operating expenses, including fuel, maintenance, repairs, and upkeep. You cannot deduct both. If you try, you may attract IRS scrutiny.

Secondly, be sure to carefully document the miles you drive and their purpose, and make sure the mileage you claim is genuinely deductible. For example, you can deduct expenses attributable to miles you drive to meet a client at a remote location, but you cannot deduct for mileage incurred driving from home to your office. That’s a personal commuting expense, not a business expense.

8)  Suspiciously High Rental Property Expenses or Rental Loss Claims

Rental losses are unusual and attract IRS attention. The IRS may look carefully at any deductions you make for depreciation, and at attempts to deduct improvement and renovation expenses entirely in the first year, rather than spreading these deductions out over a period of years under MACRS rules.

You can deduct repair expenses that are designed to restore the property to a functional condition in the year in which you incur them, but you cannot take a first-year deduction for improvements and renovations designed to enhance the value of the property. These you must deduct over a period of years, depending on the project.

Labor expenses on capital improvement projects must also be amortized over the life of the repair. Failure to adhere to these rules can trigger IRS scrutiny.

Facing an IRS Small Business Audit?

If you’ve received a notification for a pending small business audit from the IRS, the tax attorneys at Paladini Law are ready to work for you. Attorney Brad Paladini has spent his entire career helping individuals and businesses solve complicated tax problems. Brad is highly trained to negotiate and fight with the IRS on your behalf. Schedule a consultation to have your case reviewed and explore your legal options. Contact Paladini Law through our online form, or call (201) 381-4472 today.

Be Careful When Making Online Payments to the IRS

We usually recommend that taxpayers make their tax payments online to the IRS and states. Here are the benefits, but a few caveats to watch out for:

Benefits: When making payments online, your payments are generally credited on the day that you make the payment. Additionally, you can clearly apply your payments to a prior tax year, current tax year, or for estimated tax payments. This helps to minimize errors when the IRS receives your payments, such as applying them to the wrong tax year and the date the payment was made.

Beware of these issues: Recently, we discovered that it is imperative to use the primary taxpayer’s social security number when making payments online to the IRS, otherwise your payment may sit in limbo and not be applied to your account. Other tips include:

  1. Make sure that you specify the correct year that a payment should be applied to.
  2. Double-check your banking or credit card information to ensure that your payment actually gets processed.
  3. Save the confirmation that you paid your taxes as a pdf document or print it out

Overall, we have seen a much lower number of issues when clients make their payments online. Just make sure to adhere to the tips above.

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Is It Better to Pay Off Debts or Invest?

Almost everyone has some sort of debt and economic data shows that this is the case. Between mortgages, student loans, credit cards, business debts, and auto loans and leases (yes, a car lease is debt), many people find themselves allocating large portions of their income towards debt payments. When you are in a position to start paying off debts, should you do so or invest your extra funds? Let’s take a look at the pros and cons of each.

Pay off debts: Pros: Paying off debts with your extra cash will help you to decrease your liabilities, save interest, which can be significant with credit card debts and some business loans, and eventually enable you to free up cash flow. A non-conventional way to pay off debts is to start with the smallest balance debt to get the momentum going.  Cons: If you focus solely on paying off debts while ignoring investing then you will have no assets for long-term or short-term needs. If a short-term emergency arises, then you will be forced to incur debt to pay for it.

Invest your extra funds: Pros: Investing and savings will hopefully produce a much larger amount of assets over time and enable you to take care of emergencies that arise. Keep in mind that funds for emergencies should be kept very liquid, and a reasonable amount to set aside should be 3 to 6 months of expenses. Cons: Your liabilities will decrease slowly, interest expense will remain high, and you most likely will earn less on your investments especially when factoring in risk, then if you were to pay off debts.

Alternative: The decision to pay off debts or invest does not have to be an either or. Some well-known experts advocate at both ends of the spectrum. Why not do both? Assess your debts and savings to see where you will get the most bang for your buck. For example, let’s say you are able to allocate 6% of your income to savings or investments, then you can use 2% to pay off high interest debts, 2% to save for short term needs, and the remaining 2% can be used to save for retirement.

What if you don’t have extra funds?: The solution is simple, but not easy. Assess your lifestyle to see where you can cut expenses while working to increase your income. If you spend everything that you make currently and work to increase your income by 3% and decrease your expenses by 3% then you will now have extra funds. If your situation is more extreme, such as expenses that are higher than your income, then you will have to take stronger action. For smart ways to cut expenses, then type “expenses” in the search function of this blog.

The mature approach: If you have large excess funds then don’t incur more debts and pay off existing debts quicker once your savings rates are much greater than needed. You can be the only one on your block that doesn’t have debt and no one has to know. I am sure that the quality of your sleep will improve!

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How to Successfully Start a Second Business

Quite often entrepreneurs want to start a second business or even possibly a third, fourth and so on. What are the ways to make this successful, especially without selling or potentially harming your existing business(s), and what are some alternatives?

Similar or complementary business: Instead of say, an attorney, starting a restaurant, they may consider developing software to help other attorneys manage their practice better. Since they already have the experience of being a practicing attorney, they can transfer this knowledge into helping other attorneys and ideally use it in their own law practice.

Business with similar customers: Some businesses also serve your customers with a different product or service. To determine the other business that your customers use, observe which products or service providers your customers are also using and see if there is a pattern. Also, look to see who you are referring your customers to. For example, a landscaper may constantly refer their clients to a lawn sprinkler company, pest control business, or tree removal service.

Have a foundation in place: Make sure that you have a foundation in place for your existing business(s) so that they do not suffer as you develop other businesses. This usually takes years, but the main goal is to make your current business less dependent on you with everyday tasks. If your business suffers when you are not there for a few days then you are not ready.

Alternatives to starting another business:

Add a location: If you are successful in one location and have a good business model, then it is much easier to repeat this with another location. This can include second or third offices for a medical or professional practice, additional restaurants, and additional sales offices.

Purchase an existing business in the same industry: Having a strong foundation is important because you can easily absorb another business in the same industry as long as you have all of the infrastructure in place. This can include capital, space, employees, technology, and operating procedures.

Operate a business within your existing business: Instead of creating a distinctly separate business you can operate the additional business within your own business as a separate service offering or division. This can work well if the service offering is very similar to your existing business. Legal and tax implications should always be considered.

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3 Ways to Turn Around a Struggling Business

After the Great Recession there are still some businesses that may be struggling and don’t know what to do about it. Here are a few ways to turn around a struggling business:

Upgrade: The rate of change nowadays seems to be accelerating at a pace that has not existed in the past. This includes technology, competition, lifestyles, behaviors, and preferences. Although business principals never change, everything else around us does. Questions to ask are:

  1. Is my service or product still relevant and in demand? A perfect example is Blockbuster and department stores.
  2. Are delivery methods of your product or service in sync with customer preferences, lifestyles, and behaviors? Another closely related question is, “How easy is it to do business with you?”
  3. Have demographics changed?

Your business may need to upgrade/change any of the following: location, technology, including website capabilities, payment processing, scheduling, and communications with customers, turnaround times, product and service offerings, the type of customer you are servicing, and so on.

Marketing: Marketing methods have changed dramatically over the last 10 years. Are you marketing your business to keep up with these changes? If you relied heavily on newspaper or phone book advertising in the past, then I would make a bet that it is not very effective anymore. Even businesses that serve very local customers need to have a strong Internet presence. The best products and services still need to get the word out. Rationally, they shouldn’t have to, but this is just not true.

Analyze and take action: Take a fresh look at your business and seriously consider hiring a consultant to point out your blind spots. Most likely you are not recognizing what needs to change or possibly you do but do not know how to go about making changes. The next step is to actually implement changes.

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So You Want to Flip Homes?

Buy a house, put in a few improvements, and then sell it for a much higher price. Do it again and again. It sounds so simple, but here are a few pointers to keep in mind if you want to succeed with house flipping:

Experience: If your experience in real estate is performing repairs on your home during weekends, then you do not have the required experience. Ideally, you should have experience in both residential construction and real estate sales.  Experience as a general contractor will help you to determine the amount of time and costs to improve a potential flip, while experience in real estate sales will help you to locate a property, determine the market characteristics, and eventually sell the property.  Both are extremely important because you want to maximize your profit by investing your time and money in the right house and the smartest improvements. If you do not have this experience then you need to spend the time to learn as much as possible before purchasing a flip to minimize costly errors.

Know your costs and potential selling price: Before purchasing a property you need to estimate your cost of purchasing the property, the necessary improvements, and carrying costs such as real estate taxes, loan payments, utilities, and insurance. Just as important is the estimated selling price. If you underestimate your costs, overestimate the selling price, or underestimate the time to improve and sell the property, then your chance of profit will be greatly decreased. The formula is simple, but not always easy to accomplish; profit = the selling price minus all costs. With this in mind you want to make sure that you leave enough wiggle room to make a profit in case your estimates are off.

Capital: If you don’t have the necessary capital to purchase a fixer upper, make improvements, and pay the carrying costs, then you need to either obtain a loan or partner with someone who has the necessary capital. Make sure that you have a cushion just in case your estimates are wrong.

Time and opportunity cost: Let’s say that you are a contractor and are looking to flip a house. Make sure that you estimate that you will make more money on the time spent with your flip than during your regular construction activities. The same goes for anyone else trying to invest their time and money in a flip.

Start small: If just starting out then make sure that your first slip does not have the potential to decapitate you financially. Just think back to what happened to many house flippers about a decade ago.

Taxes: Most likely your profit will be taxed at ordinary income tax rates and possibly self-employment taxes vs. long-term capital gains rates. This is due to the fact that you are usually considered to be a dealer with the intent to buy, improve, and sell a home in a short time frame.

Alternatives: An alternative and close cousin to house flipping is to rehab a rental property, rent it out, and hold it for the long term. It is not as exciting as house flipping, but it can be very worthwhile, while also carrying less risk.

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5 Financial Truths

There is a lot of information out there about finances, and it’s hard to figure out what is exactly true or not true. Always seek the truth, especially from someone that is not trying to sell you something. Here are some examples:

College: We are led to believe that all of our children must go to college to be successful and make a lot of money. While I am a big believer in education and college, it is not the only route and it is not for everybody. With the high cost of college, the decision to attend college should not be automatic. There are alternatives, such as becoming a tradesman, learning a special skill that does not require college, starting a business, sales positions, military or government positions that do not require college, stay at home parent (yes, this is a vocation), etc.

Retirement savings: Saving for retirement is a good thing, however, it should be balanced with both short and mid-range needs. For example, if you allocate virtually all of your savings towards retirement accounts and ignore having a cash cushion, then your risk of financial catastrophe increases. If a financial crisis arises or a large purchase needs to be made, then you will have to withdraw from your retirement accounts, which is one of the worst financial decisions to make due to both income taxes and penalties on the withdrawals. Furthermore, if you do not have withholdings taken from your distributions, then you will probably end up with a tax problem once you file your return. The prudent action is to have a cash cushion of 3 to 6 months of expenses for emergencies and to save for mid-range goals, such as a house purchase.

Debts: Debt truly is a double-edged sword. There are some who advocate staying away from debts at all costs and others who encourage you to leverage yourself to make more money. The truth is that debt should be used wisely and sparingly, if necessary and as a last resort, and it should not cripple you. If you are able to avoid debt, then that is excellent, as debts increase your risk and they also encourage risky behavior and increased spending in many cases.  To prove this point, why do you think McDonald’s started to accept credit cards, why do auto loans have 7 year terms, and why can young adults take out massive loans for college?  It is to get you to spend more than you would have otherwise.  As you mature financially you should seek to decrease your debts.

Most people would not be able to afford a house without obtaining a mortgage, and if they waited to purchase a house and rented instead, then they would most likely be worse off financially over the long term. Also, some businesses may need to incur debts to purchase expensive equipment, inventory, or improvements that would not be possible if they did not incur debts. To emphasize, it should be used wisely and sparingly.

Expenses, income and savings: Most likely your expenses are way too high. If you are able to save 15- 20% of your income and have no debts then spend whatever you want. Otherwise, set aside money towards savings to steadily increase the percentage that you save each time you get paid. This way you will spend whatever is left over. If you are not able to do this then you need to take a serious look at decreasing your expenses and increasing your income. The truth is that it is really not that hard, but most people have a hard time doing this. As Yogi Berra said, “Baseball is ninety percent mental. The other half is physical.”

Home and health = wealth: In the quest for success, don’t ignore your most valued relationships or your health. Nothing can cripple your finances as quickly as health or family issues, such as divorce. With either of these issues your expenses increase exponentially while your income suffers at the same time. Make sure to prioritize.

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A Few Tax Scams to Be Aware Of

The IRS posts a list of tax scams each year that you should be aware of:

Phishing: This is when fake emails are sent claiming to be from the IRS, however, the IRS never initiates contact with taxpayers via email about a bill or tax refund. You’ll see more of these during tax season.

Phone scams: I have even received some of these calls on my cell phone. Criminals, many times calling from overseas, will state that they are from the IRS and then threaten that you will be arrested, deported, etc. if you do not immediately pay a tax balance. By the way, the IRS will not do this, and they especially will not ask you to purchase gift cards from CVS or to wire them money to take care of your balance.

Identity theft: You usually find this out when your tax return gets rejected because it has been filed already. This is because your identity was stolen and criminals filed a return using your social security number to obtain a fraudulent refund. Always try to protect your personal data when you can to help to minimize this risk.

Fake charities: The IRS says that fake charities may even have similar names as national organizations. Make sure the charity is legitimate, and you can even check out the status of a charity at the IRS website. By the way, when I first started my practice years ago, I came across someone who started a fake charity and solicited donations to help people after 9-11. Supposedly, they used the money to pay for expensive vacations instead. Know your charities.

Abusive tax shelters: These are schemes that are promoted to avoid paying taxes that are illegal. If it sounds too good to be true, then it probably isn’t true.

Other scams include: return preparer fraud, inflated refund claims, excessive claims for business credits, falsely padding deductions, falsifying income to claim credits, frivolous tax arguments, and offshore tax avoidance.

Most of these scams can be avoided just by using a competent and trusted tax preparer.

 

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Where Are all of the Young CPA’s and Why Should You Care?

I was at another continuing professional education seminar recently, which is very often as CPA’s are required to have 120 hours of continuing education every three years. One of the observations that I make each and every time is that I am one of the youngest CPA’s in the entire room. This is true now and was true 10 plus years ago when I became a CPA. Unfortunately, I have been jumped past the young man status, so it has nothing to do with being a “young” CPA. Why does this matter and why should you care?

Some details: When looking around the room this time and every time, It appears that approximately 5% of the CPA’s are younger than 50 years old, with the majority being older than 60. Could it be that older CPA’s attend the seminars that I happen to attend or is this true throughout the profession. When digging deeper, I found out that according to the AICPA, approximately 75% of CPA’s are expected to retire in the next 15 years, so my observation applies throughout the entire profession, and not just Bergen County.

More accountants, less CPA’s and CPA firms: Studies are showing that although there are more accounting graduates, less are becoming CPA’s. There are numerous reasons why including greater education requirements, time requirements, and the expense of taking and studying for the exam. Also, although I do not have a statistic on the age of CPA’s that own small firms, I do not know, even casually, one CPA firm owner that is younger than me. Just to reiterate, I am not a spring chicken anymore.

Negative impact on clients: CPA’s are the main business and tax advisors to small business owners and many individuals, so who will fill this void? I can only make several guesses to the alternatives, which are not very good for clients. Alternatives include: using non-CPA business advisors and preparers (whom generally lack the education, expertise, and training of CPA’s), using larger firms (along with much higher prices and less attention to the “little” guys), and doing everything yourself (ie. QuickBooks, however you need to be an accountant to actually get the numbers correct, along with not receiving guidance that saves business owners more than they actually pay their CPA). Another negative aspect is that there will be less CPA’s to collaborate with as peers. As a side note, the CPA’s that I know have been the most generous, helpful, and supportive people to me professionally.

General trends: There has been a generally trend for less people to start their own businesses, which has been the case for decades, according to a 2017 report by the Kauffman Foundation, titled, “The Entrepreneurship Deficit.” Several reasons are cited, including demographic changes, technology, and geographic changes. It appears that the CPA profession is not immune to these general trends, and as a result there are less small CPA firm owners.

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IRS and NJ Taxation Highlights

 

Yesterday I attended a continuing professional education seminar with speakers from both the IRS and the State of New Jersey. Here are some highlights after all of the recent Federal changes and also many New Jersey changes that most people are not aware of:

Your paycheck may be under withheld: After the new Federal tax law changes, many people have seen an increase in their take home pay due to the tax cuts, but it is quite possible that too little has been withheld. If you want to be safe then ask your employer to increase your withholdings, and you can also use the withholding calculator at irs.gov. Beware that it is really meant for simpler tax situations versus being self-employed, having rental income, and investments. If you are one of our business clients that we already prepare a year-end tax projection for, then we will take care of this for you.

Private debt collectors: The IRS uses private debt collectors, and the State of New Jersey has already been doing this for years through Pioneer Credit Recovery. This can cause concern especially with all of the fraud that is taking place nowadays. By the way, the IRS will not ask you to drop off cash somewhere, send a money order, or purchase gift cards to settle your debts.

New Jersey tax amnesty: There are many unknowns to all of the changes that NJ has made, including the start date of a tax amnesty program. The program will likely start on November 15th of this year and end on January 15, 2019, and allows a reduction of interest charged and elimination of penalties for old tax debts from February 1,  2009 through September 1, 2017. You should receive a notification on this program if you have old debts, but you can file and pay your old debts even if you do not receive a notice from the State.

New Jersey property tax deduction increase : The property tax deduction on your New Jersey tax return has been raised to $15,000 from $10,000.

Penalties for not having health insurance in New Jersey: New Jersey now requires residents to have health insurance or they have to pay a tax penalty. New Jersey has taken the opposite approach of the Federal government.

Increased pension exclusions in New Jersey: This will be phased in over the next several years, however, there is an income limitation of $100,000, which has not increased.

There are many, many more changes related to New Jersey, including reinstatement of Urban Enterprise Zones, increased tax rates on income over $5,000,000, taxes on ride sharing, taxes on liquid nicotine, and changes to payments plans.

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