An Insider’s Guide to the Tax Tangle
A tax audit is a certain fate for many small-business owners, but with some common sense (and great legal advice), you can breathe easy when the auditor knocks.
One morning, a small-business owner opens his P.O. box and finds an IRS notice of audit. Said small-business owner feels heart drop into his shoes and begins to sweat. Then, he speed dials his accountant.
At least, he should.
That’s exactly what one Tallahassee entrepreneur did.
“I play by the rules; I don’t want any trouble from the IRS. I never said, ‘I’m gonna chisel the IRS on this one,’” he says. “So I didn’t expect any trouble, but I was unnerved when I received that letter.”
Without a doubt, a notice of federal tax audit is high on the Things That Terrify Business Owners list. And with good reason — small-business owners (SBOs) are the largest source of uncollected taxes for the U.S. and state governments.
Unintentional tax stinginess on the part of SBOs includes everything from sales tax delinquency to misclassified employees. These infringements — averaging more than $20,000 per field audit for back taxes alone — can add up to a real emergency for the company coffers.
While small businesses have always been a major target for IRS auditors, the efforts to uncover tax problems in this sector are actually on the rise. Knowing this, experts agree no SBO should go it alone in the tax world.
Brian Compton, a certified tax resolution specialist based in California, explains, “For 2010, we can expect the number of IRS audits to continue to rise for small-business owners. With the recent economic crisis, tax authorities at both the federal and state levels are pouring more money and personnel into cracking down on tax cheats — large and small — to cut into their growing budget deficits.”
As soon as you receive a letter of notification that you were selected for an IRS audit, begin getting ready. And call your CPA and tax attorney if you suspect you’ll need help.
“You’d be surprised how many people ignore that letter,” says Jim Buttonow, a former IRS field auditor who now runs easyIRS.com. “Because most audits are correspondence audits and many people ignore the letter, and I’m called in after additional assessments are made by the IRS, and they now owe back taxes.”
The IRS has many tools for its examinations, including onsite “field audits” and the more common correspondence examination, also called a mail audit. While both can be serious (and a mail audit may trigger an onsite visit), it’s the field audit that is the most intense.
Tallahassee-based tax attorney Robert Pierce, a shareholder with Ausley & McMullen, P.A., points out that while SBOs should be on point when the auditor arrives, they should not be scared. “They are not going to throw you in jail unless you’re doing something bad or cheating. If you just make a mistake, no. This stuff is very complicated,” he explains. “The penalties are usually monetary — penalties, interest, back taxes.”
All experts agree that getting the right help during an audit is the key to your survival strategy — and your sanity.
“The most important advice to surviving an audit is to not take any chances when dealing with the IRS,” Compton advises.
The Chosen Ones
The IRS understands that tax law is very intricate and the shifting sands of tax regulation can easily mire a business owner. But they do expect folks to figure these things out and render unto Caesar what is his. Of course, mistakes will happen. And the IRS has a very sophisticated strategy for sampling each year’s returns with an audit.
The IRS may examine your return for a variety of reasons. In fact, a computer program called the Discriminate Inventory Function System (DIF) assigns a numeric score to each individual and business return and selects for examination the returns with a higher likelihood (score) of being erroneous.
Pierce outlines the most common red flags to trigger federal audits as: large tax return changes from year to year, having a high proportion of expenses to revenue and requests for refunds. Of those with these red flags, the IRS will choose the returns with the greatest potential for additional tax to be collected.
In addition to these tip-offs, Buttonow points out the IRS may also receive “credible information” from an informant (called an “Informant Report”) or they may have a particular industry or transaction type involved in a special audit project.
For instance, a 2001 tax study group identified the self-employed as one of the largest sectors of tax non-compliance. This triggered a focus of examinations on SBOs.
In 2011, the focus on under-reporting income and avoiding taxes altogether will reach new heights with a presidential and IRS-sanctioned uptick in audits.
So if you end up with a “tag-you’re-it” letter, know it may have absolutely nothing to do with you personally and is likely the (bad) luck of the draw.
The truth is, tax law — on both federal and state levels — is more like rocket science than accounting. A doctorate in tax law might just be what you need to understand why one cookie is tax exempt but six are not; why the guy who owns the air pump at the gas station has to pay tax on the “rent” he pays for the 2 square feet of concrete he’s using; why water is untaxed but ice is not. The examples are endless, and seemingly there is no rhyme to the reason.
That’s why it’s worth it to get expert advice to determine what’s changed in your industry and how evolving tax law affects the regulations and filings you’re expected to complete.
The Tax Man Cometh
When Uncle Sam does arrive, be prepared. The average amount a small business or sole proprietorship owes at the end of a field audit is $26,000, not including interest and penalties, — almost 20 percent higher than all examined individual returns, according to Buttonow.
While the government may want its due, it doesn’t want to take very long to get it. You can expect the auditor to be at your office for about two to three days (longer for larger businesses), and then to return periodically to review documents and interview employees with operations and financial transaction knowledge. In Buttonow’s experience, from start to finish, the IRS wants an audit cleaned up within six months.
In the case of our entrepreneur, the auditors kept coming back.
“I was surprised at how long they stayed with me. It was about five visits for one to three days each,” he remembers.
During this time, they will often review internal IRS records for consistencies and unreported items, and they will also interview third parties about your business.
“They check property records and other public information on the business and its owners to determine if there is unreported income and transactions on the return,” Buttonow said.
Exactly how far back the IRS can dig into your records is tricky.
A taxpayer can’t claim a refund if three years have passed on a return. In the same vein, the IRS has three years to audit your return. Once you are in an audit, there are statutes of limitations that govern how far they can reach — unless certain extraordinary things have occurred.
“It’s three years unless it’s a large amount of money you left out compared to what you paid,” Pierce says. “If they find an extenuating circumstance, the IRS can go back five years. If they find fraud, there’s no limit.”
In Case of Emergency, Seek Help
All experts agree that the No. 1 priority when the audit begins is to have representation on your side — from both your CPA and a qualified tax attorney.
“If you owe payroll taxes and intend to go it alone without expert representation against the IRS, you are way out of your league,” warns Compton.
A professional not only can explain what’s going on, but they speak the tax language and have a big-picture view. Pierce encourages his clients to maintain a cool head.
“It’s an information process when the auditor comes in,” he explains. “The IRS does an assessment and says, ‘You owe us this.’ The burden is on the taxpayer to show them they’re wrong.”
In our entrepreneur’s case, he had followed his CPA’s advice to the letter when filing his tax returns. Turns out, it didn’t exempt him from mistakes.
“My business uses lots of barter transactions — vendors and I will trade service for service or something similar,” he says. “So, I was under the impression that things like gift certificates were to be used just like cash.”
Therefore, he didn’t keep tight records on the barter services he used. This oversight cost him two years of travel and entertainment expenses, which were disallowed — a big contribution to his tax bill. Now, when he takes a client out to dinner using a bartered gift card, for instance, he’s dogged about putting the client’s name and the topic of conversation on the back of every receipt.
In addition, he used to pride himself on being a generous gift-giver to employees. Thanks to the IRS, now not so much.
“I did things like ‘shopping days’ for all my employees — where I would give them $150 each and send them to the mall to buy work clothes,” he remembers. The advice from his CPA was that this was fine to do. Turns out, those “gifts” should have been taxed as wages — which would have been a hit to both employee and employer.
Finally, like many entrepreneurs, he had a perfect record of paying bills on time and being as good a customer as he was a boss and vendor. So, every December 31 he assessed the spoils of a good year and bonused himself a nice year-end gift. Unfortunately for him, the IRS thought this looked a lot like tax evasion (the personal tax rate was much less than the corporate one, and his business was not taxing this bonus).
“Of course, I wasn’t trying to evade anything. I paid taxes on those wages myself,” he says. “But the IRS said my business should have paid the taxes instead.”
Therefore, he had to refund two years of big bonuses back to his company and the company had to pay the corporate tax on the amount. After a blow like that, he was not able to recoup with the bonuses or the personal taxes.
At the end of the day, the corporate taxes, interest and penalties added up to $184,000 —which the IRS auditor wanted paid that day. Otherwise, more interest would have piled on.
Adding insult to injury, he paid this chunk of change just before the economic meltdown hit the South.
“My biggest lessons were these: document absolutely everything and make sure your CPA knows federal taxes inside and out,” he says.
Bad as a federal audit can be, Pierce knows they can be far-reaching and even branch out into brother or sister companies. One of his specialties is state tax law, which oftentimes can be linked to the IRS case.
“I had a taxpayer in a sales tax case who had three different businesses. And for whatever reason, they filed their federal income tax returns properly but they just didn’t pay all their income tax. They had an audit and realized they had a problem — effectively they had been collecting sales tax but not giving it to the state. That’s a real no-no. That’s a crime and they throw people in jail for that,” he warns.
So Pierce hired a tax consultant to go through the records and find where the bones were buried. They resolved the case by agreeing to payment of a certain amount and penalties, but he got them to hold off on criminal charges.
He advises clients to keep records as separate as possible as a matter of course, so that when the auditor comes onsite there is less chance of spillover.
“If they see another company’s books and records while auditing for one company, they can pull everything — look at all books and records,” he warns.
The Trickle-Down Effect
The bottom line is most small businesses are found liable for miscalculating income tax or not paying correct sales tax. A good rule of thumb is if you have corporate income tax on the federal side, you also have it on the state side.
And those Florida Department of Revenue (FDOR) audits can mean big numbers in terms of penalties and delinquent taxes. In fact, FDOR reports that their 503 auditors (along with 30 computer audit analysts) conducted 3,950 sales/use tax audits in 2009. They also have a team that audits only state tax refunds.
“On the federal side, most businesses are in the range of $30,000 to $50,000 in terms of back taxes and penalties,” Pierce reports. “I can tell you that at the state level the numbers can be very sizeable, because there are different kinds of taxes. The big numbers are in sales tax and corporate income tax. A typical mid-size business should collect 6 to 7 percent of total sales. So, these numbers can get huge — typically anywhere from $25,000 to $25 million.”
For example, if a company makes $2 million per year and has $1.5 million in expenses, its income is only $500,000. Federal tax would be levied on the income, but sales tax is on the entire $2 million — gross sales. If a business doesn’t collect the tax, where are they going to get it to pay the state?
According to the professionals, FDOR has much the same aim as the IRS: to bring to the state uncollected taxes and to increase filings for the future. In this way, both entities see audits as an educational opportunity. And many business owners do need a refresher in income and sales tax law.
“In our experience, audits revealing mishandling of taxes are mostly unintentional,” reports Michael Scott, a partner in the Panama City office of Carr, Riggs and Ingram, a CPA firm. “Whether clients didn’t understand the sales tax rules, had a different interpretation or were completely unaware that their specific transaction was subject to sales tax.”
Many clients think they have a good understanding of the sales tax rules and regulations, only to find at audit time that they misunderstood a portion or simply didn’t know about a rule that applied to them, he adds.
State audits are triggered by much of the same information and behaviors that trigger federal audits. In fact, they sometimes share information (although FDOR reports this to be true only 5 percent of the time) — a major reason to report as consistently as possible across filings. Another trigger for state audits is tax-exempt sales. And, by FDOR’s own admission, filing patterns, third party information and misuse of a resale certificate are other red flags.
“An example of the tax-exempt sales trigger would be a large amount of exempt sales reported in a particular month, where typically little to no exempt sales are reported. This can easily be true if, for example, a business owner made large sales to a tax-exempt customer,” explains Michael Kalifeh, a tax manager with Thomas Howell Ferguson P.A. in Tallahassee. “For this reason (among others), it’s important for taxpayers to maintain complete transaction documentation.”
One of the major fault lines, according to the experts, is a misinterpretation of Florida’s “sales and use tax.” State law provides that even if you bought that equipment outside Florida — in Texas, say — and you didn’t pay sales tax to the state of Texas, you still must pay the applicable Florida “sales and use tax” on the items. These “fixed assets” are typically business equipment and similar purchases. Truth be told, all Florida consumers should be remitting sales tax on out-of-state purchases if the vendor doesn’t collect them during the transaction. (A major reason proponents of a Florida Internet tax law want to implement the measure.) But Florida businesses, beware: FDOR expects you to pay your taxes — all of them.
“In FDOR’s view, if a company hasn’t paid sales tax on fixed asset purchases, it’s likely that they haven’t paid on other things as well,” says Scott. Therefore, FDOR sometimes uses fixed asset purchases as a “sampling” method to determine compliance. And penalties in a sales tax audit can be up to 50 percent of the tax liability.
Scott points out that, luckily, the state is usually easier on newbies to the tax audit.
“If you are a first-time offender, FDOR will waive penalty upon formal request. What we see is that the state is more concerned with proper compliance moving forward as opposed to punishing a taxpayer for unintentional wrongdoing,” he says.
Assessing the Damage
What the auditor finds in your records can determine your financial exposure. When it’s all said and done, taxes and penalties upwards of $75,000 can be typical, but it all depends on the situation. No matter what the cost, though, these are always big numbers to the business owner, because they cannot be recouped.
This is why it always pays to find out the facts and then devise a strategy. Sometimes, your tax attorney will want to hire a tax consultant to comb through records and give another opinion on the amount you owe. Other times, that strategy is simply to gulp it down.
Reviewing the audit trail worked well in at least one case for Thomas Howell Ferguson.
“Our office recently assisted a client who was audited for sales tax and the initial outcome was a tax deficiency of about $60,000,” Kalifeh explains. “Working with the client and FDOR, we provided additional documentation, additional facts and relevant tax law to reduce that assessment from $60,000 to $9,000.”
Pierce deals with very complex returns and high-earning taxpayers who sometimes want to fight tooth-and-nail. He warns this is not always the best tact: “Going to court can be time consuming and expensive.”
One of his clients had a $40,000 issue for refunds — which seemed worth litigating. But Pierce had another opinion.
“On a go-forward basis, it was hundreds of thousands of dollars and we would have had to go to court because of it. It was too big an issue. But it wasn’t absolutely clear that the IRS was wrong — it was a scenario that was just not all that clear,” he said.
Pierce maintains the IRS and FDOR are always looking for a compromise. “Most taxing authorities will grant a reduction in penalties if you agree (rather than appeal). That’s what they’re going for,” he explains.
Compromise Can Be Key
Once your IRS audit is complete, you have three options. You can go to tax court. You can pay your taxes and move on. Or you can have an informal appeals conference. Usually, the number of cases appealed is much larger than those that are litigated.
Generally, the appeals process is where tax attorneys such as Pierce get into the game. He recommends an appeal if it is clear the IRS was wrong or if there is a tax strategy in the bigger picture. Sometimes, getting the IRS to agree to a decision can have implications for the taxpayer down the road.
Much the same is true for state income tax audits, except FDOR offers free Technical Legal Advice, whose representatives are skilled at interpreting state tax law and applying them with no bias toward or against the taxpayer.
Pierce, when he was general counsel at FDOR, set up the state level appeals process to closely mirror the federal system.
“It’s changed a bit in terms of who does what and who their bosses are, but the process is substantially the same as the IRS’ appeals process,” he explains.
No matter the reason, the burden of proof during appeals is always on the taxpayer. Attorneys may take the audit report and offer up a compromise such as paying half the taxes and all the penalties or vice versa.
Pierce has seen audits that go on for 15 years, more or less continually. And if your tax attorney and CPA recommend going for an appeal, litigation can go on for years, as well.
At what point is it smart to say, “that’s the IRS,” and just let it go? That’s the purview of your tax attorney and CPA.
“Be sure what you agreed to is correct — once you agree to it, it’s done. On a go-forward basis, make sure your deductions are correct,” Pierce offers.
To anyone who deals with the IRS on a regular basis he advises: Have substantial documentation for all your deductions, pay your taxes and plan a strategy. But the No. 1 piece of advice may be to get professional help early on.
According to one expert, if you’re in business, you should expect that one day you will be the subject of an IRS audit. That doesn’t mean you’re guilty of anything. It just means your number is up. Protect yourself nonetheless.
The IRS should not be taken lightly — they can put you out of business. Theoretically, the tax could be too big for you to pay back and you could be done.
“The experts will handle all communications and correspondence, allowing you to continue on with your life,” Compton said. “It’s an investment that can pay off big for small-business owners, in terms of saving money and helping protect the future of their businesses.”
Common Tax Mistakes
The reality is, taxes are complex. Steer clear of these common mistakes:
- Writing off personal expenses as business expenses and unreported income. (Both commonly invoke a 20 percent penalty.)
- Misclassifying employees (i.e., independent contractor vs. employee) can have a devastating penalty.
- Not understanding new health care law and how it relates to federal taxes.
—Jim Buttonow, former IRS field auditor
General Tax Strategies to Minimize the Risk of Audit:
Find a tax-friendly business structure: The first step in reducing tax liability is to make sure your business is structured as a tax-friendly entity. Some forms of business entities require that the business pay taxes on the money it earns throughout the year AND that the business owner pay taxes on the income he or she receives. This results in a double taxation scheme that costs the business twice. Make sure you choose a form of business that will avoid this and help you meet your tax saving goals.
Plan ahead: Hiring an accountant to manage your taxes is a great idea and helps you itemize your expenses into the most tax-efficient filing. Accountants are trained in tax preparation and are knowledgeable about little deductions that may make a big difference when it comes time to file your return. In addition, a bookkeeper will help you budget appropriately, understand financial lingo and generally relieve some of the anxiety that money usually brings. Having someone with financial experience on your team allows you to focus on running other areas of the business, like earning a profit.
Become an excellent bookkeeper and learn your deductions: Whether or not you have a bookkeeper or accountant, maintaining extremely precise records and learning the potential business deductions is key to paying lower taxes and avoiding a tax audit. The combination of knowing what deductions are allowable and meticulous record keeping will make tax returns easier to manage.
Be on time and accurate: Make sure your taxes are done properly and paid on time. If, for some reason, you can’t have your taxes done before the deadline, file an extension as soon as possible before the deadline. Making estimated tax payments would also reduce the burden when it comes time to pay the whole bill.
Incorporation and LLC formation can minimize the risk of audit: Sole proprietorships are subject to the highest risk of audit out of all the business structures. By setting up an S Corporation, you become nine times less likely to be selected for a random IRS audit (your risk decreases from 2.7 percent to 0.3 percent, making it very possible to go your entire life without ever being audited).
— Deborah Sweeney, CEO, MyCorporation
Who Doesn't Know?
These Florida industries should realize they are in the (sales) taxable category:
- Advertising industry (certain circumstances)
- Repair/maintenance industry (generally)
- Commercial rental industry
- Janitorial services
- Convenience stores
- Independent bars/restaurants
- Other cash businesses
- Businesses’ or individual’s items for their own use from outside the state
- Purchases of large dollar items such as planes, boats, RVs
—Tisha Crews Keller
Audit Plan of Action
Statistics show the IRS finds an adjustment to a tax return almost 90 percent of the time. The IRS is very good at determining the returns with the most likelihood of penalty. Protect yourself:
- Do not undergo a Field Audit without professional help. Get a tax attorney and CPA.
- Be prepared. The best time is when you’re filing your tax return.
- Do not ignore the letter. Ignoring means you will owe.
- Have everything ready. The most efficient audit is the best audit for the taxpayer.
- Ask for everything in writing.
- Listen more, talk less. Provide what is asked for — no more, no less.
- Be cordial.
- The IRS agent is not the final answer. You have appeal rights; ask for them.
—Jim Buttonow, easyIRS.com