By Mark Battersby -
Although the risk of a federal tax audit remains low, thanks to the Internal Revenue Service’s still-secret audit selection process, every rural building business owner and manager has good reason to fear an audit – if, that is, they are not prepared.
Data recently released by the IRS revealed that slightly over 1 percent of all tax returns filed were audited. Although the number of S corporations has almost doubled over the last 10 years, the audit rate remains at 0.43 percent. Partnership audit rates hovered at the 0.40 percent level, while small corporations (assets under $10 million) had an audit rate of 1.02 percent in 2011.
Good news? Not really since the IRS collected almost $49 million from the relatively few tax returns that were audited. Even worse, the IRS’s enforcement efforts resulted in more than $3.7 million levies, liens and seizures – up almost 4 percent over last year’s performance.
Fortunately, every contractor and building business operator can legally reduce the possibility of an audit, minimize the potential damage and successfully do battle with the IRS’s auditors.
As soon as received, all income tax returns are usually checked for accuracy. Then using a “model” as a basis for an average return, the IRS’s computers “flag” any unusual items, high income, large or unusual deductions, self-employed builders and contractors, or even unusual types of businesses. Based on the total number of flagged items, and depending upon how busy IRS auditors are in a given area, tax returns to be audited are selected.
There is some room for legitimate maneuvering that may reduce the odds of being targeted for an audit, although the best time to reduce the potential of an IRS examination remains when the annual income tax return is being prepared. One strategy for avoiding an audit is to give the IRS the answer before they ask the question.
A tax return that is accompanied by a note or documentation to support flagged items or other questionable items, may be returned to the system with the examiner’s questions already answered. When it comes to large transactions that may fall into one of the innumerable “gray areas” of our tax laws, yet another tax form, Form 8275 Disclosure Statement, may help avoid penalties by disclosing questionable deductions, positions or investments.
The IRS is no longer permitted to conduct so-called “lifestyle” audits. Thanks to the IRS Restructuring and Reform Act of 1998, the IRS’s ability to conduct so-called “lifestyle” or “economic reality” audits is greatly diminished.
Today, the IRS is generally prohibited from asking for extensive information about anyone’s financial status, standard of living, or other information that might be used to determine the existence of unreported income. The IRS can only ask for that information if it has a reasonable indication that there is a likelihood of unreported income based on the tax return and information reports from third parties.
Among the more important rights given any building business – or business owner – whose returns are targeted 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 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’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 their 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.
What happens if, despite your best efforts, the IRS requests your presence to review the tax returns for your business – or you? It goes without saying the worst thing that any business owner can do if they receive an audit notice is to ignore it.
A building business that has kept organized records, including bills, receipts and cancelled checks, and one that has in place the proper internal controls, has little need to worry. The IRS may interpret the operation’s situation differently, but there is no crime in having differences of opinion.
Until agreement is reached with the IRS from the initial screening for accuracy that each return receives until the final appeal has been exhausted, the process remains open. Even better, mistakes in favor of the taxpayer are discovered in about 25 percent of all cases.
The IRS is usually quite sympathetic to honest mistakes and more than 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 taxes due. But they don’t like fraud.
A disagreement over an auditor’s findings is typically referred to the appellate level of the IRS where the representative is usually more knowledgeable and empowered to be more lenient. Of course, even here the building business owner does not have to agree. 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 disputed taxes.
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, the builder or business owner represents himself or herself, although they may be represented by anyone authorized to practice before the Internal Revenue Service.
Unfortunately, decisions by the small tax case division of the U.S. Tax Court neither set a precedent which can be used by others in similar circumstances nor can the decision be appealed by either the building business, its owner(s) or the IRS.
Naturally, any business that loses in regular tax court may appeal the case to the U.S. Court of Appeals merely by filing a notice of appeal. But the free ride ends when the Tax Court rules. If the Tax Court decides in the IRS’s favor, future appeal requires an “appeal bond” guaranteeing payment of any tax deficiency finally determined.
No contractor, builder or building business should forego or ignore valid tax deductions. Every builder and contractor should keep in mind that although the IRS may occasionally disagree, the courts strongly back every taxpayer’s right to choose the course of action that will result in the lowest legal tax liability.
Fortunately, the returns of most builders and contractors fall between these two extremes. Honesty and clarity can go a long way toward avoiding and dealing with an IRS audit – and the potential consequences. As illustrated, the audit of a building business’s income tax return need not be the end of the world. If that examination does result in an assessment of additional taxes, appeal after appeal is possible until at some stage compromise is reached, or the building business owner or manager is satisfied. RB
Mark Battersby is an expert in tax and financial matters. With more than 30 years experience in small business issues, he lectures and writes extensively on business topics. Contact him at 610-789-2480 or MEBatt12@earthlink.net