IRS

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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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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Don’t Be Embarrassed if You Have Financial or Tax Problems

There is a stigma attached to having financial and tax problems, but it doesn’t have to be that way or it may make the problems worse. Sometimes these problems develop as you become more successful, which easily happens with both celebrities and business owners. Other times they develop due to a quick downturn in business, withdrawing money from retirement accounts early, losing your job, health issues, or any other negative event. Even some very successful people have had financial struggles and then bounced back, including:

Donald Trump: Although he never filed bankruptcy personally, his casinos and hotels have. He is now president of the United States.

Mark Victor Hansen: One of the co-creators of the “Chick Soup for the Soul” book series.

Walt Disney: He had financial struggles early on.

Jim Rohn: Entreprenuer, author and motivational speaker who went broke after a business expansion went bad. He is credited with the business success of many and some of his talks can be listened to on YouTube.

Also, the number of celebrities that have financial and tax issues is too long to list . . .

What should you do if you find yourself in trouble or better yet, how can you avoid problems? Here are a few ways:

Hire competent professionals and heed their advice: As your success increases, you need to work closely with advisors that can guide you in the right direction to minimize risks, strengthen your finances, and reduce your tax burdens. If you view and treat professionals as purely costs, then you will not only hire the wrong ones, but you will not seek their advice, which is usually worth more than their cost.

Too much leverage, not enough cash: There are those that are 100% against any types of debts, and I can definitely see how this can be a smart strategy to keep you out of trouble. However, there are many times that you will never realize an opportunity if you do not take upon some debts and risks in a wise manner. Having a reasonable cash cushion will also help to thwart many smaller financial setbacks.

Know the tax consequences: Virtually every financial transaction has a tax consequence and it is prudent to seek professional advice to minimize negative consequences. Having a good year in business, followed by a not so good year can easily cause a tax issue if taxes were not properly planned and paid for. Another tax catastrophe is withdrawing from your retirement accounts and not accounting for income taxes and early withdrawal penalties.

Don’t be so hard on yourself or delay seeking the advice of a professional or your problems will just get worse.

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Did Your Tax Balance Catch You by Surprise?

What should you do if you file your tax return and then realize that you now have a large liability that can’t pay? First, don’t panic as there are several options for you:

Installment Agreement: An installment agreement can be a good option for you, which can sometimes be requested when you file your tax return. Interest and penalties will still accrue, but now you do not have to worry about levies. You may also request an extension of time to pay for several months if you expect to be able to pay off your balance quickly.

Offer in Compromise: Pennies on the dollar! We’ve all heard this advertisement from tax resolution companies. There is some truth to this, but it is greatly overstated. The way it works is that the IRS will accept an amount that is less than the amount of your tax liability. However, a majority of the offers are not accepted by the IRS.

Currently Not Collectible: This option allows you to postpone making any payments towards your tax balance and essentially places all collection activities on hold. However, the IRS may reassess your situation in the future to determine your ability to pay. Penalties and interest will still accrue.

No matter which payment arrangement you make, the caveat is that going forward you must always file your returns timely and full pay your balances. If not, then any arrangement that you have in place can default. Additionally, you generally need to submit financial information to the IRS for them to determine eligibility of an arrangement.

Prevention: How can this be prevented going forward? The first way is to make sure that you are properly planning how to minimize your tax liabilities before the year is over with proactive tax planning. The second way is to project your tax liabilities during the fall to estimate what your tax liability will be, which will make you aware of how much you will owe and give more time to figure out a good solution.

The LLC Trap

Operating a business as a limited liability company, or “LLC” is very popular among small business owners. LLC’s have been around for several decades and can be formed in every state. There can be several benefits, but several major drawbacks.

The Benefits of an LLC:

Less Administrative Burden: If you operate as a single-member LLC, you generally do not have to file a separate tax return. You also may not need to have worker’s compensation insurance, which can save on expenses.

Liability Protection: By having your business operate as an LLC, you will separate your business liabilities from your personal assets, which can offer protection of your personal assets.

Now, for the Drawbacks:

No Tax Withholdings: Since you usually do not draw a paycheck as an LLC member, you will not have taxes withheld from a steady paycheck. This requires you to remit estimated taxes quarterly, but in reality, many business owners miss some payments, make partial payments, or skip them altogether. This is how tax problems develop.

High Potential Audit Risk: Many LLC’s only have one owner and do not have to file a separate income tax return for the LLC. Rather, the activities from the LLC are reflected on Schedule C of their individual tax return. This is easier than having to file a corporate return, but at the same time, it increases your chances of being audited significantly.

Self-Employment Tax Shock: Since you usually have to pay self-employment tax as an active member of an LLC, this can double the amount of social security and medicare taxes because you have to pay both the employee and employer portion.

You need to carefully structure the way you operate your LLC in a manner so that you can reap the benefits, while at the same time reduce any downside. This should be performed with the assistance of a tax advisor that is well-versed in business structures.

The IRS Called Me Yesterday

That’s not strange because as a CPA I speak to the IRS quite often. However, they called my cell phone and left a prerecorded message about tax fraud. It was a scam of course, and I am posting this to warn you that the IRS does not call taxpayers initially without sending a notice, nor do they threaten you with an arrest. If you have received a phone call like this and are not sure if it is legitimate, then please contact our office.

Here is the message:

“Hello, this call is officially a final notice from IRS, Internal Revenue Service. The reason of this call is to inform you that IRS is filing a lawsuit on your name because you had tried to do a fraud with the IRS, Internal Revenue Service, and we are taking a legal action and we are issuing an arrest warrant on your name. To get more information regarding this case just call us back on our department number 202xxxxxxx. I will repeat it 202xxxxxxx. Thank you.”

By the way, the IRS will not ask you for credit card numbers over the phone or ask you to purchase a prepaid debit card.

Frivolous Tax Arguments

I don’t know anyone who likes to pay taxes. But, you won’t win with these arguments:

Filing tax returns are voluntary: Filing tax returns are not voluntary.  The IRS uses the word voluntary to mean that you determine your own initial tax liability by filing your own tax returns, and not have the government determine your liability for you. Actually, if you do not file a tax return, the IRS will give you notice, and may eventually file a “substitute for return” and assess a tax liability. This is fairly common.

Filing tax returns are not constitutional: All you need to do is read the sixteenth amendment. Actually, it is not a bad idea to read the constitution every so often anyway. There are many court cases that support this.

The Internal Revenue Service is not an agency of the United States: The Secretary of the Treasury has full authority to administer and enforce the internal revenue laws and has the power to create an agency to enforce such laws.

If you want to minimize your tax liability, there are many legal ways, otherwise there are penalties and possible criminal prosecution if you try to make these arguments.

I Received a Notice from the IRS – Now What?!

If you receive a letter in the mail from the IRS, the first thing you should do is open it! It might not be as bad as you think. The most common notice I see is that a client forgot to include interest, dividends, or wages from a W-2 on their income tax return and now they owe additional taxes, interest, and penalties.

Just because you receive a notice that you owe money doesn’t mean the notice is correct. You want to see why there is an increase, and compare the figures in the letter to your tax return. Then you want to see what the proposed changes are. I have seen notices that have actually showed incorrect W-2 wages.

Usually you have 30 days to respond to the notice before additional interest and penalties will be assessed. There are several options to take at this point.

The first option, if the notice is correct and the additional penalties and interest are very insignificant, should be to pay the amount due as soon as possible. If the notice is correct and you have a valid reason for not including a portion of income, you should then include payment of the taxes and interest on those taxes only. Additionally, you will need to respond to the notice to state why the penalties should be removed. The IRS will remove penalties if you have a justifiable reason. As a caveat, if the penalties are not removed then you will owe not only penalties, but possible interest on the penalties as well. The cost/benefit has to be weighed carefully. If the notice is completely wrong, then you should not send any payment, but include an explanation in your written response to the IRS, along with any supporting documents to show why you do not owe additional taxes, interest, and penalties.

As you can see there are several options when receiving a notice from the IRS or one of the state taxing authorities. Do not hesitate to contact our office if you receive a notice. We can clearly explain it to you and guide you through the next step to take.

An Overview of IRS Audits

There are different types of IRS audits. The first and least complex is the correspondence audit, next is the office audit, and lastly and most complex, the field examination. I highly recommend to anyone who receives a letter from the IRS, or even the State of NJ, to contact their tax advisor as soon as possible.

The correspondence audit is the most commonly used audit of all three types of audits. It starts with a letter issued from the IRS stating that a change has been made to your tax return, such as for investment income that you failed to report. Assuming in this case the IRS is correct, you will need to submit the additional tax assessed on the unreported income, along with interest to the IRS. If the IRS is not correct and you disagree then you will need to provide an explanation to prove that you do not owe additional taxes. Sometimes the notice is partly right, and the best course of action may be to file an amended return or complete the appropriate forms.

Since correspondence audits are very cost effective for the IRS, they also send letters for specific deductions, such as charitable contributions, to request substantiation for your deductions. This is why it is extremely important to keep all receipts for your deductions, because without any proof that you made donations, your deduction will be disallowed and additional taxes and interest will be assessed.

The next audit, the office examination, takes place at one of the field offices of the IRS by a local agent. Although more complex than a correspondence audit, the agent usually focuses on a select number of items. It is very important to be very prepared for this type of audit because it can lead to the agent broadening the scope of the audit.

Lastly, and most in-depth, is the field examination. This involves an IRS agent visiting your place of business or possibly your home. The agent requests much more information and asks a lot more questions. Again, it is very important to be well-prepared for this audit. It is also crucial to communicate with and work closely with your tax advisor.

After completion of an audit, there can be several outcomes. The first is an assessment of additional taxes, interest, and/or penalties, the second is no change to your tax liability, and third you may actually be due a refund (not likely, but that would be a great outcome)!