-By Mark Battersby-
According to the Chairman of the House Small Business Committee, Steve Chabot, R-Ohio, the IRS audits the tax returns of far more small businesses than corporations. “Our current system is working against these small businesses, when it should be working for them,” Chabot said.
The IRS agrees, stating the highest number of audits for 2014 of individual tax returns with business income was in the lowest range of business returns, i.e. $200,000 to $400,000, amounting to 50 percent of all audits of upper-income individual returns. In other words, small proprietorships are in the audit cross hairs with the odds of a Schedule C business being audited nearly twice as great as a small incorporated business being audited.
Although the best time to prepare for a potential IRS examination is when the tax returns are prepared, there is some maneuvering room that may help reduce the odds of a rural building business—or its owners—being targeted for an audit.
Depending on what the examiner finds, more tax may be owed or the operation may be in the clear. Just because a tax return is selected for audit does not always suggest that an error has been made.
The steps that any building business owner or self-employed professional can take to avoid an IRS audit include:
Hiring a professional. It’s easy for anyone to make mistakes if they try to prepare the tax returns themselves.
Be honest. While some find it tempting to fib about income or expenses, it could come back to bite them.
Review the numbers. Obviously, entering the numbers incorrectly will throw everything off. Thus, even with professionally prepared returns the numbers should always be reviewed.
Watch the deductibles. Taking deductions can be tempting, especially for those who own their own business or are self-employed. If nor done correctly, honestly, or if they are not legitimate they can be a huge red flag that leads to an audit.
File electronically. When tax returns are filed electronically the risk of errors is greatly reduced. It helps to streamline the process and ensure that the information provided is recorded without any changes.
The Taxpayers Bill of Rights, part of the IRS Restructuring and Reform Act of 1998, requires the IRS to provide a written statement detailing the taxpayer’s rights and the IRS’s obligations during the audit, appeals, refund and collection processes.
Among the more important rights given any building business—or its owner—whose returns are targeted for an audit, is whether to be represented by a tax professional, or whether to attempt to answer the IRS’s questions alone. Another important consideration for everyone in business being audited 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 builder or contractor’s place of business, the place where all the records are kept, to demonstrate to the IRS auditor that there is nothing to hide and that the building operation is a legitimate one? Or, should the builder or contractor and/or the operation’s representative trudge down to the IRS office armed only with the specific documents and information requested by the IRS auditor? There is no one right answer.
Be aware that the IRS’s training manuals tell auditors not only what they should look for but also provides information about the results of audits of similar businesses within the same field. In other words, if the building business is audited, the IRS will likely investigate issues such as:
- Failing to file and pay taxes on time
- Forgetting about estimated tax payments
- Keeping poor records
And, other potential trouble spots such as:
- Are auto expenses claimed for the owner’s only car? Personal use of a business-deducted vehicle is so common that auditors expect to find it. If the car is operated for both business and pleasure and a high percentage of that use is claimed for business usage, good records (preferably a mileage log) are a necessity.
- Were all of the building operation’s receipts or sales reported? Failure to report significant business income—$10,000 or more—means you should strongly consider hiring a tax pro to handle the audit.
- If the auditor finds evidence of large amounts of unreported income and it looks intentional, the IRS’s criminal investigation team may be called in. However, if there is any kind of halfway plausible explanation (“Someone must have forgotten to record September’s sales”), jail will not be a worry. The auditor will probably just assess the additional tax that should have been paid in the first place, plus interest and a 20 percent penalty.
- Are payroll tax returns being filed and tax payments made for the operation’s employees? Employment taxes are a routine part of every audit of small enterprises.
- And last but not least, if the building operation uses “independent contractors,” are they really employees? The IRS routinely conducts audits of businesses that hire independent contractors, because of the tax savings possible by calling workers “independent contractors” rather than the “employees” they should be labeled as. Similarly, a builder or contractor may find him- or herself re-labeled as an employee.
Any builder or contractor agreeing with the audit findings will be asked to sign the examination report or a similar form depending upon the type of audit conducted. If the findings are not agreeable, there are several avenues to appeal.
Among the appeal steps is the IRS’s “Fast Track Settlement” (FTS) program that offers Small Business and Self-Employed taxpayers an opportunity to resolve tax disputes early in the examination process. Once an application is accepted, the IRS’s goal is resolution within 60 days.
With FTS, a trained mediator attempts to reach agreement between the IRS auditor and the taxpayer. The builder or contractor being audited retains full control over every decision made during the FTS process. In addition to using mediation to facilitate a settlement, the Appeals mediator has the authority to propose other settlement offers. Either party may agree to or deny the Appeals mediator’s settlement proposal.
Surprisingly, from the initial screening for accuracy that each return receives until the final appeal has been exhausted, mistakes in the favor of the taxpayer are discovered about 25 percent of the time. The IRS is usually quite sympathetic to honest mistakes and willing to discuss underpayments of taxes that may result from the many so-called “gray” areas of our tax rules. They’ll frequently negotiate the amount of tax due but, they don’t like fraud.
Generally, all income taxes must be assessed within three years after the original return is filed. Unfortunately, tax may be assessed—or a court proceeding to collect tax may be commenced—at anytime if (1) the return is fake or fraudulent, (2) there is a willful attempt to evade tax or (3) no return is filed.
Honesty and clarity go a long way toward preventing, dealing with and surviving an IRS audit. Naturally, every builder and contractor should have a strategy for avoiding audits as well as for dealing with an IRS auditor. A fallback position should also be in place in case those strategies fail.