By Mark Battersby
Although the risk of a federal tax audit remains low, the IRS’s still-secret audit selection process has proven quite effective. Every snow and ice management professional has good reason to fear an audit—if he or she is unprepared.
The IRS recently released data that reveals that slightly more than 1% of all tax returns filed were audited. The audit figures for the almost 10 million business returns filed in fiscal year 2009, at least those that included a sole proprietor’s Schedule C, was only .58%. Audit percentages ranged between .38% for partnerships and S corporations (.40%) to .85% of small corporations (less than $10 million in assets).
Good news? Not really, since 11% to 15% of all audits reportedly result in “no change,” and the IRS collected almost $49 million from the relatively few returns audited. Even worse, the IRS’s enforcement efforts resulted in more than 4.4 million levies, liens and seizures—up 7.6% over the previous year. Fortunately, there are ways to reduce the possibility of an audit, minimize the potential damage from an audit, and successfully do battle with IRS auditors.
Who is a target?
There are still a number of misconceptions about what triggers an audit and how to avoid one. For instance, because a refund check has been received doesn’t mean that an audit is out of the question. Audit determination is usually made long after the refund check is issued.
The IRS checks each return for accuracy. Using a computer model as a basis for an average return, computers “flag” any unusual items, including high income; large or unusual deductions; self-employed business owners, professionals and independent contractors; or even unusual types of businesses. Depending on how busy IRS auditors in a given area are, tax returns are selected by the number of flagged items for future review.
It is at this point that the unsuspecting snow and ice management professional’s actions can reduce the possibility of a more extensive examination. If the tax return is accompanied by documentation to support flagged items or other questionable deductions, the tax return may be returned to the system with the examiner’s questions already answered. Others will result in a form letter requesting documentation or explanation of the questionable deductions or discrepancies.
Avoiding an audit
Fortunately, there is some legitimate maneuvering that may help reduce the odds of being targeted for an audit. Remember, however, that the best time to prepare for a potential IRS examination occurs when the tax return is prepared.
In addition to providing supporting documentation, another way to avoid an audit is to point out any “oddball” items on the tax return. Attach a note, a brief statement, documents and explanations for all unusual transactions.
For large transactions that may fall into one of the innumerable “gray areas” of the tax laws, the IRS has Form 8275, “Disclosure Statement.” Inclusion of this form with the filed tax return may help avoid penalties by disclosing questionable deductions, positions or investments. Few experts think using this form will increase the chance of being audited.
Thanks to the IRS Restructuring and Reform Act of 1998, the IRS is no longer permitted to conduct so-called “lifestyle” audits. The IRS is generally prohibited from asking for extensive information about financial status, standard of living and other information that would make it easier for them to discover unreported income. The IRS can only ask for personal information in situations where they have a “reasonable indication” that there is a likelihood of unreported income based on the tax return and/or information reports from third parties.
Among the more important rights given any snow management professional whose return is targeted for further examination is whether to be represented by a tax professional or whether to attempt to answer the IRS’s questions alone.
Another important consideration is where to hold that meeting. Should the meeting be in the accountant’s office where all of the working documents are easily accessible? Should it be at the snow management company’s place of business where all the records are kept? That might be the best strategy to prove that the snow and ice management operation is legitimate. It can also demonstrate to the auditor that there is nothing to hide. Or, should the snow management professional and/or his or her representative trudge down to the IRS office armed only with the specific documents and information requested by the auditor? There is no one right answer.
When offense isn’t enough
What happens if, despite your best efforts, the IRS requests your presence to review the tax returns for your business or for yourself? It goes without saying the worst thing that any business owner can do is to ignore an audit notice.
If the snow and ice management business has kept organized records—including bills, receipts and canceled checks—and has a system of internal controls, there is little need to worry. The IRS may interpret the operation’s situation differently, but there is no crime in having differences of opinion. Until a snow management professional agrees with the IRS, the appeals process can continue. Most importantly, from the initial screening for accuracy that each return receives up to the final appeal has been exhausted, mistakes in the favor of the taxpayer are discovered in about 25% of all cases.
The IRS is usually quite sympathetic to honest mistakes and is willing to discuss underpayment of taxes. They’ll sometimes negotiate the amount of tax due. But, they don’t like fraud. The majority of snow and ice management professionals file honest returns, and it is only occasional misinterpretations or honest disagreements that result in additional tax assessments at the audit level. Should the snow management professional question additional assessments or any findings by the auditor, appeal is possible within the IRS.
A disagreement over an auditor’s findings is usually referred to the appellate level of the IRS, where representatives are usually more knowledgeable and empowered to be more lenient. Of course, even here, the snow and ice professional does not have to agree. Naturally, while the additional taxes demanded by the auditor go unpaid, the interest and any penalties continue to accrue, but further appeal is still possible.
The main purpose of the U.S. Tax Court is to review deficiencies asserted by the IRS for additional income, estate, gift or self-employment taxes. The Tax Court is the only judicial body from which relief may be obtained without the payment of tax.
The Tax Court maintains relatively informal procedures for the filing and handling of cases where neither the tax deficiency in dispute nor the amount of claimed overpayment exceeds $50,000. Usually, taxpayers represent themselves, although they may be represented by anyone authorized to practice before the IRS.
Unfortunately, decisions by the small tax case division of the U.S. Tax Court can neither be used by others in similar circumstances, nor can the decision be appealed. If you lose in the regular Tax Court, you may appeal the case to the U.S. Court of Appeals, but the free ride ends with the Tax Court’s ruling. If the Tax Court decides in the IRS’s favor, future appeal requires an appeal bond guaranteeing payment of any tax deficiency that may be determined.
Back to basics
Changes to our tax laws have resulted in tax professionals generally taking a more conservative approach to the tax advice they render and the tax returns they prepare. If the IRS discovers a transaction has been mislabeled or incorrectly structured, and if the tax laws were ignored, the professional also will face penalties.
Despite the ultraconservative position now taken by many tax professionals, no snow and ice management business should forego or ignore valid tax deductions. Disclosing those transactions or deductions on the tax return will often be enough to pass the scrutiny of the IRS, eliminating a full-blown audit. At worst, disclosure may help avoid the levy of numerous penalties for taking a “frivolous position,” or claiming deductions that result in “accuracy-related” penalties.
Honesty and clarity can go a long way toward preventing and dealing with an IRS audit. As illustrated, the audit of a snow and ice business’ income tax return need not be the end of the world. If that examination results in an assessment of additional taxes, appeal after appeal is possible until compromise is reached or the snow and ice management professional is satisfied. SB