Has The IRS Noticed You?

My partner asked me today whether I thought we are seeing more tax notices. We are pretty keen on this issue, as tax notices – any tax notice – reflect badly on the quality of our work.  I would begin to question my dentist if I routinely received notices from the Internal Dental Service, the Ohio and Kentucky Departments of Dentistry, the Cincinnati Dentistry Division, …. You get the idea.

Have you heard about the IRS’ recent fishing expedition? It is called “Notification of Possible Income Underreporting.” There’s a name. Why don’t they just bash down your door and arrest you? 

What is causing this is the use of debit and credit cards. The payment settlement entities (think Visa) and third-party payers (think PayPal) are now required to relay financial data to the IRS via Forms 1099-K. The IRS has their nose into how much you are depositing into your business checking account. You can pretty much guess that the IRS is matching A to B and is sending out letters when they do not match.

There are four possible letters the IRS may send, each requiring its own response:

1. Letter 5035 – the softest of the letters. You do not need to respond.
2. Letter 5036 – you want to respond within 30 days as the IRS reserves the right to assess you.
3. Letter 5039 - you now need to complete yet another form – Form 14220 Verification of Reported Income. Lucky you.
4. Letter 5043 – if you believe that the return you filed is accurate, then you must provide the IRS with a written explanation of why you believe that. (Think about that sentence for a minute).  Again, failure to respond may trigger an assessment.

Now, a normal person would anticipate that the IRS would compare what a business reports as gross revenue to the 1099-K.  As long as the first number equals or exceeds the second, all should be OK.

Oh, to be young and naive.

That is NOT what the IRS is doing.

How can the numbers go awry? Well, a couple of very common transactions come immediately to mind: 

• The 1099-K “sales” will include sales taxes. Generally speaking, accountants do not include sales taxes in “sales,” primarily because sales taxes are not sales. A business collects sales taxes as an “agent” and is required to remit them to the state tax department. Does this sound like “sales” to you?
• The 1099-K includes cash draws by the customer. Say you buy something and take an extra $20 in cash. Again, most accountants would not report that transaction as a “sale.” Same reason as (1).

The IRS has created an alternate universe. How? Well, they did a study, apparently super-secret and better concealed than donor lists to Section 501(c)(4) nonprofit applicants or the tax records of the American Issues Project. This study has determined sales levels for different lines of business – dry cleaners, florists and so forth – as well as “average” proportions of debit and credit card sales to total sales. The IRS has one piece of this information – the debit and credit cards – so now it backs into expected sales (based on averages). If you report lower sales than that… BAM!... here’s your letter.

Why does this upset me?

(1)  This exercise is based on averages. The IRS is wasting a taxpayer’s time because somebody-who-knows-somebody-overheard-somebody-talking-about…. You get the idea. It would waste less time and possibly be cheaper for the government to just mug the taxpayer.

(2)  How much of a tax professional’s time – my time –are they wasting? Can I even bill for this nonsense? Last time I checked, the IRS is still not sending me a paycheck. Maybe I should start invoicing them.

(3)    Understand what the IRS is doing here: they are shifting an examination function onto the shoulders of the taxpayer and his/her tax advisor. The IRS can potentially ask for anything: maybe the name of the church you attend. It can then conduct a “study” to determine average donations to that church. Guess what? If you exceed that amount, get ready for a notice. Where does this end? If the IRS wants to examine you, then let them examine you! At least they would have skin in the game, as they would have to pay the examiner’s salary. Perhaps that would cool their heels a bit.  

(4)    The backbone of our tax system has been voluntary compliance. As the nation becomes increasingly bankrupt, the “voluntary” part is becoming laughable. The government – enforcing through the IRS – is forever wringing us for more information: for FBARS, for cost basis on the mutual fund you sold, for the tax ID number of your child’s day care, for foreign bank reporting (FATCA) on your account overseas.

Think about that last one. How would you feel if Japan required all U.S. banks to report to Japan on accounts owned here by Japanese citizens? And – to put the cherry on the sundae – slap a 30% tax on any U.S. bank obstinate enough to not comply with Japan’s decree? I tell you what I would do if I were a bank president: I would not accept accounts from Japanese citizens. Guess what foreign banks are doing to American expats. Congratulations, you are smarter than an average U.S. Representative or Senator.

Going back to my partner’s question: yes, we are seeing more notices these days, because almost every year the IRS finds new ones to send out.

Goodness knows what they will trot out next year.