The Biden administration wants to increase the Internal Revenue Service budget by $80 billion, claiming that would let America’s favorite federal agency hire more auditors to go after tax cheats and bring in an estimated $400 billion in extra revenue over the next decade. Right now Congress appears unlikely to release the funds, but the question remains: Will an energized IRS mean more audits for small- and medium-sized businesses?
Either way, entrepreneurs and other taxpayers can take some steps to reduce the chance of an audit — or to increase the likelihood of coming out unscathed, said Miri Forster, a tax partner and leader of the Tax Controversy Practice at Eisner Advisory Group LLC.
One recommendation: “Taxpayers should make sure that all information returns — like form W-2, form 1099 and schedule K-1 — are received and that all income is reported,” she said. “The IRS gets copies of these forms and matches the information with the recipient’s tax return that is filed.” Any discrepancies can raise a red flag with the IRS.
In addition, “[t]axpayers that claim large non-cash charitable deductions should make sure to obtain the proper documentation for the deduction,” Forster noted. “As a general rule, IRC Section 170 requires that deductions for non-cash contributions of more than $500 are supported by contemporaneous, written acknowledgement by the donee organization of the non-cash contribution received, a qualified appraisal by a qualified appraiser that sufficiently details the donated property, and a Form 8283, Noncash Charitable Contributions, which is properly completed.”
Red flags for small- and medium-sized businesses
Some business deductions fall into a “gray area,” where they might be legitimate but will probably cause the IRS to sniff around, according to some tax experts. Others are just begging to be investigated.
Lipton CPA Associates LLC Senior Partner Rich Lipton has been practicing for more than 30 years, but he still gets surprised at some of the tax deductions that some clients suggest.
“One of them asked if he could claim the family dog as a deduction, ‘since we provide more than half of his living expenses,’” Lipton recalled with a chuckle. “I told the client, ‘first you have to get a Social Security number for your pet.’”
A more-frequent question has to do with “IRS Roulette,” or taking a dicey deduction and hoping it’ll slide by due to the sheer volume of tax returns. “Some clients say, ‘I’ve heard that IRS only audits an average of 1% of returns — is it worth trying my luck?’” relates Lipton. “My answer is pretty simple. I ask them, ‘If you happen to be audited, do you think the IRS will only examine 1% of your return?’ That sets them straight.”
Some “strategies” definitely raise red flags with the IRS, he added. “Generally, pass-through entities like limited liability companies and partnerships don’t pay income taxes at the entity level — instead, the owners generally are taxed on their personal return,” Lipton said. “Some people think that if they don’t take a salary — are instead tak[ing] a distributive share of the profits — they may be able to avoid Social Security and other payroll taxes. The problem is that bells are likely to go off if the IRS sees a company is turning a healthy profit, but no owners are taking a salary.”
Lipton thinks the problem isn’t that people are inherently dishonest, but that they feel they’re being taxed unfairly. “If President Biden wants to hire more IRS auditors to catch tax cheats, that’s fine,” he said. “But do it without raising taxes, because every time you increase the tax burden, you find that more people look for a way around it — legally or otherwise.”
No Fly Zone
When it comes to chancy deductions, “Airplanes are a big issue,” said Grassi Tax Services Partner Robert Tobey. “A successful businessperson who buys an airplane, a boat, or art and other collectibles, including high-priced cars like a Ferrari, and then puts it on the company’s books — so it can be depreciated — is basically asking for an audit. We advise clients to steer clear of that maneuver unless there’s a legitimate business reason to do so.”
A business that reports a lot of revenue, but very little profit may also raise a red flag, cautioned Ted Carnevale, a Grassi partner and co-leader of the New Jersey Market. “Another is an S-corporation with no salaries and all draw, a tactic that is generally designed to avoid payroll taxes. Another attention-getting scheme is a highly profitable C-corporation with high salaries but no dividends, which may indicate a desire to avoid double taxation.”
Some individuals try to play the “IRS audit lottery,” where “they insist on taking a questionable deduction in the hopes that it’ll slip past an audit,” added Carnevale. “Some years back I represented a new client whose prior-year return was being audited. As I was reviewing the already-filed return I noticed his business travel and entertainment deductions seemed to be pretty high. It turned out he had deducted the sizable expenses of his daughter’s wedding as a business expense. I asked him how he justified it, and he quickly responded, ‘marketing expense.’ I told him it would be difficult to defend if the auditors picked it up.”
Did they? “He got lucky,” said Carnevale with a smile. “They missed it.”
Other CPAs also say that taxpayers who keep their nose clean don’t have to worry too much. “Pass-through entities like S corporations, partnerships and LLCs [where profits generally get taxed at the owners’ level, and the company itself is not taxed] have been vilified by some politicians, but I just don’t see that,” said Ted Carnevale, a partner and co-leader of the New Jersey Market at the accounting and advisory firm Grassi. “Shareholders get K-1s, and they get matched up by IRS to individuals who have to report them. So it’s similar to W-2 statements.”
Grassi Tax Services Partner Robert Tobey thinks the IRS is likely to go after “low-hanging fruit, like cryptocurrency reporting. It’s very complicated because the rules are very thin on cryptocurrency, and in the agency’s 2021 criminal investigation annual report, IRS reported seizing $3.5 billion of cryptocurrency, or 93% of all seizures for the year.”
Carnevale also pointed to “a lot of discussion about ultra-wealthy individuals who borrow money against their assets — while taking little or no salary — to minimize their tax bite. It’s particularly attractive during a low-rate environment like we’re seeing now, and some reports have called it the ‘Buy, Borrow, Die’ strategy But the fact is there’s generally nothing illegal about it. If Congress wants to change their behavior, the tax laws will have to be changed.”
Don’t Be Outrageous
Not all deductions are permitted for tax purposes, Forster cautioned. “Recently, in Geiman v. Commissioner, T.C. Memo 2021-80, the Tax Court disallowed deductions claimed by an electrician for a concert ticket, ski lift tickets and for a suit and tie to attend a holiday work party. The burden is on the taxpayer to prove that expenses claimed are valid business expenses rather than non-deductible personal expenses. The taxpayer failed to demonstrate that the expenses were ordinary and necessary in connection with his work as an electrician.”
“[The IRS is likely to go after] low-hanging fruit, like cryptocurrency reporting. It’s very complicated because the rules are very
thin on cryptocurrency, and in the agency’s 2021 criminal investigation annual report, the IRS reported seizing $3.5 billion of cryptocurrency, or 93% of all seizures for the year.”
– Robert Tobey, Grassi Tax Services Partner
In another case, Lucas v. Commissioner, T.C. Memo 2018-80, “the Tax Court disallowed deductions claimed for legal and professional fees incurred by an investment advisor-taxpayer for his own divorce proceedings,” she added. “The taxpayer claimed that the fees were incurred to defend a claim for distributions from his business. The court disagreed, ruling that the legal and professional fees were non-deductible personal expenses as they would not have been incurred but for the taxpayer’s marriage and related divorce proceedings.”
Finally, in Vest v. Commissioner, 119 AFTR2d 2017-2043, “the Fifth Circuit affirmed the Tax Court’s determination that deductions claimed for expenses incurred to investigate the death of the taxpayer’s father were non-deductible,” Forster explained. “The taxpayer owned an internet dating and advertising business and wished to turn his father’s death into a book or movie. The fees were held to be non-deductible personal expenses because the investigation lacked a profit motive. The court determined the investigation was not run in a business-like manner, the taxpayer generated years of losses without any profit, the likelihood that the assets used in the investigation would appreciate in value were small, and there were strong personal reasons for the investigation.”
The bottom line: Regardless of what happens to the IRS funding, playing by the rules will improve your chances of escaping an audit.