One of the many provisions of President Joe Biden’s recently passed Inflation Reduction Act has received a lot of attention: about $80 billion will be allocated to the IRS over a 10-year period, potentially adding 80,000-plus employees to the rolls of everyone’s favorite agency. Will more Internal Revenue Service eyes lead to more tax audits? We put the question to some accounting and tax insiders and asked how business owners can keep a low profile.
“A lot of people are asking us about the new IRS agents under the Inflation Reduction Act, but I think the real question is how many people will actually want to work for the agency,” observed Louis Miele, a partner with Aprio. “Even if more employees are hired, IRS has lost a lot of people during the past decade, due to retirement, so some of the new hires will just help the agency catch up on its backlogged workload.”
Businesses that want to avoid an audit should start by “remaining compliant with rules and regulations, and make sure that your tax filings are in order,” he said. “Don’t give the IRS a reason to look at you.”
In one case, a client mistakenly gave American Express his social security number instead of his tax ID for his merchant processing account, Miele recalled. “In due course, Amex reported more than $700,000 of transactions on his 1099-K (merchant card reporting form) using his social security number. When the receipts were not reported on his personal tax return, the IRS initiated an audit that could have been avoided if he had given Amex the correct ID number to begin with.”
And a business’ bottom line that swings a lot from year to year could also attract IRS auditors, added Steven Podobinsky, Aprio tax director. “There could be a legitimate reason for profits to swing to losses from one year to the next, but the IRS may notice this, so a business owner should be able to document his or her changes,” he cautioned. “Also, consecutive losses from one year to the next could attract attention and, in the case of a sole proprietor filing a Scheule C return, could run the risk of being disallowed as ‘hobby losses.’ The best defense is keeping a good set of books, along with receipts and other documentary evidence.”
Sax LLP Senior Tax Max Manager Mathew Giordano thinks the concerns may be overblown. “To begin with, it’s difficult to tell just how many of the new hires will be allocated to audits,” he said. “It’s doubtful they will all go to enforcement. Even the portion that does will, in part, be to replace a retiring audit workforce within the IRS. Some will likely go to customer service, because at this point it’s difficult for practitioners and taxpayers alike to get through the phone lines with questions.”
But businesses should not breathe a sigh of relief, since “there is likely to be some level of step-up in the volume of tax examinations,” he said. Still, they’re likely to be concentrated in a couple of key areas.
“In general, Schedule C, or sole proprietorship tax filers tend to be audited at a higher rate, compared to other flow-through entities like partnerships, S Corporations, or multi-member LLCs,” according to Giordano. “I think IRS assumes that Schedule C filers tend to be less sophisticated and may mix business and personal bank accounts and expenditures. So, it may be useful to speak with an accounting or tax advisor about restructuring a sole proprietorship as a partnership, or multi-member LLC – and file a Form 1065, U.S. Return of Partnership Income instead of a Schedule C – by giving a one-half of a percentage point ownership to your wife, significant other or someone else you trust. S Corporations filing Form 1120-S U.S. Income Tax Return for an S Corporation are also a viable option. Different entity types offer different advantages and disadvantages from both a tax and legal perspective. Choose wisely.”
It’s also a good idea to document any deductible business expenses, and to keep away from pushing the limits of business deductions, he added. “High T&E (travel and entertainment) expenses, or high automobile expenses may raise a red flag, since IRS may think you’re taking non-deductible family members on your trips and funneling them through the business,” he cautioned. “A taxpayer – who was not a client – that we represented employed a person who maintained their home and claimed the salary and other employment costs as a business expense. It turned out the taxpayer’s business was audited, but we managed to keep the auditor’s attention away from that issue so that deduction, at least, flew under the radar. But you’re playing IRS roulette with tactics like that.”
The image of hordes of IRS agents invading businesses in search of more revenue may be somewhat overstated, said Wiss & Co. LLP Senior Tax Manager Nicole DeRosa. “Even if IRS does somehow find that many competent new hires, the agency still has to train them. And the fact that the IRS typically lags a few years on its audit selection process means that the 2021 tax year is likely to be earliest tax year they’ll audit.”
She suggested that a business owner, or any individual for that matter, who is notified of an audit should not go at it alone. “Tax audits tend to be comprehensive, and IRS agents may go on ‘fishing expeditions,’ where they hope a taxpayer will inadvertently alert them to something that’s not quite right,” DeRosa explained. “A CPA can act as a buffer between the individual and their business, and the IRS, and we ensure that the taxpayer only answers what is absolutely necessary.”
Of course, it’s better not to get singled out for an audit in the first place. While some unlucky businesses get selected on a random basis, others may paint a target on their backs by taking aggressive deductions or trying to hide revenue, she warned. “The IRS has beefed up their revenue-matching investigations, including matching 1099-K and 1099-MISC forms [which report certain payments to independent contractors and others] against incoming revenue reported on tax returns.”
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Some business owners also improperly deduct personal expenses as business-related costs. “One consulting company tried to pass off personal purchases of alcohol, designer clothes and other expenses as legitimate business write offs,” DeRosa recalled. “But the IRS auditor caught them and disallowed about $80,000 of the deductions. We always … advise that personal expenses should not be comingled; and extravagant expenses, although perhaps business-related, may not be tax deductible.”
Fudging around with tax returns is never a good idea, echoed Michael Karu, senior member of Levine Jacobs & Co. LLC. “Generally, the IRS has three years to audit a return, but in some cases that can be extended to 10 years,” he noted. “Concerns about more audits due to the planned increase to IRS’ budget may be overblown, though. For one thing, can the agency even attract 80,000 employees? The starting pay is relatively low, and there’s a national shortage of accountants anyway. People usually go where the money and benefits are good. The federal government has good benefits, but the money usually doesn’t match up what’s offered by the private sector.”
Sticking to the basics can do a lot to reduce the chances of being selected for an IRS audit, observed EisnerAmper Partner and National Tax Controversy Leader Miri Forster. “Small- and mid-sized taxpayers should gather all Forms W-2; Forms 1099 reporting interest, dividends, retirement distributions, and other miscellaneous income; and Schedules K-1 received from pass-through investments and report the amounts reflected on those forms on their tax return,” she counseled. “The IRS receives copies of these forms and matches them up with the tax returns filed and will send a notice if any items of income are omitted.”
Smaller companies shouldn’t sweat too much about any new IRS hires, she added. “The additional IRS funding is expected to result in increased enforcement of high-income taxpayers. The funding is also anticipated to be used to improve phone coverage and modernize IRS systems, both of which could benefit small- and mid-sized taxpayers when dealing with the IRS.”v