Small Business Taxes & ManagementTM--Copyright 2019, A/N Group, Inc.
The IRS doesn't reveal what issues it focuses on in audits, but one can infer what they are from Tax Court and Federal court cases. In the discussion below the issues are in roughly the order of frequency, with the most commonly occurring ones first. Most cases don't involve esoteric provisions of tax law, but rather mundane issues.
Accuracy Related Penalty
The penalty is assessed for a substantial understatement of income, substantial valuation misstatement (e.g., valuation of a charitable gift), transactions lacking economic substance, and several other reasons. The penalty is generally 20 percent of the amount of the tax and is assessed if the understatement of the tax is the greater of $5,000 or 10 percent of the tax required to be shown on the return. The reach here is broad--take deductions that are disallowed or have unreported income--or a combination that causes the tax to exceed the threshold and you could be liable for the penalty. And the IRS routinely adds it to the deficiency. There aren't many excuses. The only one that is availed of with any frequency is reliance on a tax professional. But even then you've got to meet several requirements.
Trade or Business Expenses
This one covers a multitude of sins. If you take a deduction you're not entitled to or can't substantiate the deduction it'll be disallowed. Few of the issues involve a questionable deduction from a tax law standpoint. Rather they involve deducting personal expenses or failing to substantiate a deduction. And when it comes to what deductions are disallowed, the majority involve auto and truck expenses and travel and entertainment. In both cases taxpayers fail to keep an adequate log or receipts. The law is very specific with respect to both categories and if one of the required elements isn't there, the deduction will be disallowed. Moreover, the courts have virtually no leeway in ruling on these issues. If you don't have a receipt and canceled check for the office furniture you purchased you may be able to substantiate the purchase with alternate means. In some cases the court will allow estimates--but don't count on it. Many taxpayers go to court without the required documentation and are frequently wasting their time.
Underreporting of Income
This one is sometimes as straightforward as a taxpayer failing to report capital gain or 1099 income, but also involves taxpayers receiving cash payments in their business that are not reported. In the case of unreported business income, the IRS reviews bank statements comparing deposits to reported income. But it uses an number of other techniques.
This one takes two forms. First, more than a few taxpayers "pad" their charitable contributions. They may have contributed $350 but put down $650 on their return. Or they made $650 in contributions but only have documentation for $350. The rules for charitable contributions are clearly defined and the courts enforce them strictly. No documentation, no deduction, it doesn't matter how small. The second issue has been charitable contributions of property such as real or personal property, easements, conservation land, etc. There are a number of subissues. The first is valuation, an area always open to fights between a taxpayer and the IRS. The second is the strict requirements, and there are several of them. Run afoul of any one of them and the deduction will be denied.
Collection Due Process Hearings
After the IRS assesses a tax deficiency it must collect it. That's no automatic. You can request a hearing before levy, commonly called a collection due process hearing (or CDP). At that time you can make an offer-in-compromise to settle the debt for less than the full amount, request an installment agreement, or another collection alternative. An IRS settlement officer (SO) will ask for financials and check to make sure you're current on your other tax obligations. Your request for a collection alternative can be rejected by the SO for failure to provide requested information, because you haven't filed returns, paid the tax on recent returns, etc. or your income or assets are substantial enough to pay the full amount of the tax. The settlement officer has to follow a set procedure and criteria, but can reject your requested alternative. Taxpayers who have been rejected often challenge the decision. In most Tax Court cases the IRS's decision has been sustained because the taxpayer was not current or failed to provide the requested financial information.
Failure to File or Pay Penalty
There are three penalties involved here--failure to file, failure to pay, and failure to pay estimated tax. Most involve failure to file. A failure to file includes filing a return that is not processable, that is one with all zeros, or a return that's not signed. Outside of being extremely ill there aren't many excuses that will allow you to escape these penalties.
It's not always that easy to figure out if a child or relative is your dependent. If you're single and have a dependent you could qualify to file as head of household, with its beneficial tax rates. With a qualifying child you can claim the child tax credit and you may qualify for the earned income credit. In the past you could also get an exemption amount based on a qualifying child or relative.
Innocent Spouse Relief
If you file a joint return both you and your spouse are liable for the full amount of the liability. If you later get divorced and your spouse can't pay, the IRS will look to you for the full amount. You may be able to escape your spouse's share of the liability if you can meet the requirements. The rules here can be complicated and the facts can be critical. Generally you must show that understatement of tax was attributable to your spouse, you didn't know about the understatement when the return was filed and it would be unfair to hold you responsible. The last item could be a problem if you benefitted from the understatement. This can frequently become a complicated issue. There have been a number of court decisions that can provide guidance.
Responsible Party and Employment Taxes
Failure to make deposits for employment taxes is another recurring issue. It's easy for withheld taxes to account for 30 percent or more of gross payroll and a temptation to use the deposit for a business with cash flow problems hoping for a reversal of fortunes and making up the deposit shortfall before the IRS catches on. That's often not the case and the IRS will hold an officer, shareholder, employee, or other party responsible and seek to collect the shortfall from them personally. The numbers here can quickly add up. It's not unusual for a business with 10 employees to owe $100,000 at the end of two quarters of nonpayment.
Real Estate Professional
You can generally deduct deduct only $25,000 rental real estate losses against other income. That amount may be reduced as your modified adjusted gross income exceeds $100,000 and the exemption is completely phased out at $150,000. There's a special exception for "real estate professionals". They can deduct losses without restriction. The law has a specific definition here. You must spend more than one-half of your personal services in trade or business involving real property and you must perform more than 750 hours in such businesses where you materially participate. The provision has been on the books for some time, but cases have only surfaced within the last five years or so. Claiming to be a real estate professional on your tax return was deceptively simple, check a box and you're done. But on audit the IRS will ask for proof of material participation for more 750 hours and the more than one-half of your time working was met. That means keeping detailed logs. In all but a few cases the courts have rejected taxpayers' recordkeeping of time spent.
Some taxpayers continue to try to deduct hobby losses--horse breeding, farming, auto racing, yacht or airplane charters, etc. as well as activities not normally considered a shelter. While not as common as they once were, taxpayers win only infrequently because they haven't made a sincere effort (based on the IRS's and courts' list of factors) to conduct a profitable business. If you're considering such a move, get good advice from a tax professional and heed it carefully.
Approval of Penalty
In order for the IRS to assess most penalties, the examiner's supervisor must approve the penalty in writing. Apparently the IRS has been lax in many situations. In the last year or so a number of taxpayers have challenged the penalty based on the lack of supervisor's approval. This is one area where taxpayers have been relatively successful.
Points to Consider
If you read enough cases you realize many of them should never have gone to court. The courts routinely dismiss inadequate car or travel and entertainment logs, reject charitable contributions for no or inadequate documentation, deny business expenses that are highly questionable or likely personal, etc. If there's one takeaway it's that it makes little sense to go to court with inadquate documentation. And read up on what the court considers adequate. Your impression and the court's can vary widely.
Many taxpayers go to Tax Court without an attorney. The Tax Court takes that into account and provides some leeway on procedure, but that's not carte blanche. If the dollar amounts involved are significant, consider securing an attorney. While not cheap, your chances may improve considerably, particularly if the case involves disputes over the law, not just the facts. But you should also get two opinions and/or consult your CPA.
Copyright 2019 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. The information is not necessarily a complete summary of all materials on the subject. Copyright is not claimed on material from U.S. Government sources.--ISSN 1089-1536
--Last Update 05/04/19