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IRS to make more Audits
01/07/2013

As we move closer to winter, the IRS has announced that it is turning up the heat on small business operations. This isn't surprising in light of recent IRS analysis indicating that under-reporting by small businesses is responsible for 84 percent of an estimated $450 billion "tax gap" between the tax revenue that is owed and the amount that has been collected.

At national and regional tax forums held earlier this year, the IRS pinpointed eight specific areas that it considers ripe for abuse. Here's a brief rundown.

Company Cars - An IRS study on employment tax compliance revealed that employers frequently don't report the taxable benefit that employees receive from their personal use of company-owned cars. In addition to other fringe benefits, the IRS plans to focus on the use of company cars, especially "luxury" models, in its next series of audits.
High Income Taxpayers - The IRS defines a high-income taxpayer as someone who brings in a certain amount of "total positive income" (TPI) -- gross receipts and sources of income before expenses and deductions are claimed -- for the year. Continuing a recent trend, the tax agency will aggressively pursue self-employed taxpayers with a TPI of more than $1 million. In 2011, the IRS audited 12.5 percent of all individuals with incomes of more than $1 million (up from 8.4 percent in 2010).
Form 1099-K Matching - Despite the recent reprieve from merchant credit card reporting on business returns, the IRS will institute Form 1099-K matching next year. It will be launching a new pilot program that will match up payee statements with receipts.
Health Insurance Credits - Under the Patient Protection and Affordable Care Act (PPACA), a qualified small business may be eligible for a credit for the health insurance it pays for employees. The credit first became available in 2010 returns. Now, the IRS will examine employers and nonprofits to determine eligibility under the PPACA credit.
Foreign Transactions - In recent years, the IRS has stepped up efforts to uncover assets that are being secretly stowed away by U.S. taxpayers in overseas accounts. It will continue to focus on offshore transactions made by individuals and businesses.
Partnerships - Abuses involving these pass-through entities have largely escaped detection in the past, but no longer. Specifically, the IRS aims to target partnerships that have reported large losses or have suspicious transactions on the books.
S Corporations - Similar to partnerships, S corporations are increasingly being targeted for in-depth audits. The IRS wants to see if S corp losses in excess of basis are reasonable and if unreasonable compensation is being paid to owners and officers. As part of these audits, IRS examiners will review basis computations to determine if taxpayers are meeting due diligence requirements before deducting losses on Form 1040. Another key issue is the use of S corporation distributions to avoid payment of Social Security tax.
Worker Classifications - There are several incentives for employers to classify workers as independent contractors instead of employees. Mainly, an employer isn't responsible for payroll taxes or fringe benefits for outside contractors. This has been an on-going issue for decades, but now the IRS intends to tighten up compliance of the rules.

Now that you know where IRS audits of small businesses are likely to lead, you may want to take appropriate steps to reduce your exposure in these areas.

However, just because a return is selected for audit does not mean that an error has been made. Some returns are randomly selected or chosen based on a statistical formula. For example, IRS computers compare income and deductions on a return with what other taxpayers report. If an individual deducts a charitable contribution that is significantly higher than what others with similar incomes report are, the IRS may want to know why.

Returns can also be selected for audit when they involve issues or transactions with other taxpayers who were previously selected for audit, such as a business partner or investor.

An audit can be conducted by mail or through an in-person interview and review of a taxpayer's records. The interview may be at an IRS office or may be a "field audit" at the taxpayer's home, place of business, or accountant's office. The IRS will tell you what records are needed.

Important point: Even if your return is audited, an IRS examination may be nothing to lose sleep over. In many cases, the IRS asks for proof of certain items and "closes" the audit after the documentation is presented.

Still afraid of an IRS audit? You probably don't have to attend. You can stay home and designate your tax adviser to act on your behalf. The outcome may be far better. Getting tax and legal advice up front can result in significant savings. Consult with your tax adviser about your situation.

Perennial Audit Red Flags

Not reporting all income. The IRS is adept at "matching" income reported about you by employers, banks, and brokerage firms against what is reported on your tax return.
Self-employment. If you work for yourself and file Schedule C, you have a greater chance of an audit. The IRS is especially suspicious of businesses that look like hobbies.
Dealing in cash. IRS auditors are trained to search every nook and cranny of the cash-based financial world to detect cheating.
Out-of-line figures. IRS computers compare returns with those filed by taxpayers with similar incomes. If deductions are significantly higher, you may be asked why. Of course, this doesn't mean you shouldn't claim every deduction you are entitled to. You just need to be aware of how audits work and hang onto the proper records.
Large travel and entertainment deductions.
Being a "tax protestor." Some people refuse to pay because they claim taxes are unconstitutional. The IRS has little patience for these arguments.
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