IRS Small Business Audit Areas

The IRS has announced selected business areas it is prioritizing for audit this upcoming fiscal year. The IRS is increasingly focused on small business underreporting, which it considers responsible for the majority of a $450 billion tax gap. Here are the areas:

1.      Fringe benefits, especially use of company cars

The IRS is finding that employers are not correctly reporting employees’ personal use of company vehicles on Forms W-2.

2.      Higher income taxpayers

The IRS will focus on self-employed taxpayers with gross receipts (that is, before expenses) of more than $1 million.

3.      Form 1099-K matching

Forms 1099-K report payments from credit cards and payment clearinghouses (such as PayPal). The IRS granted a reprieve for 2012, but it announced that it will start Form 1099-K matching in 2013.

4.      The small business employee health insurance tax credit

The IRS wants to make sure that small business employers and tax exempts are complying with credit eligibility requirements.

5.      International transactions

The IRS has announced its third voluntary foreign bank account initiative and intends to look for offshore transactions.

6.      Partnership returns reporting losses  

This is a new area of emphasis. Expect the IRS to look into partnerships reporting large losses.

7.      S corporations reporting losses and reasonable officer compensation

The IRS will be looking at S corporations claiming losses, looking for losses taken in excess of shareholder basis.

The IRS is also interested in profitable S corporations reporting little or no salary to officers.

8.      Proper worker classification

The IRS is interested in employer treatment of worker versus independent contractor status. The IRS thinks there is significant noncompliance in this area.

1099s and Weatherly v Commissioner

There are two new questions on your income tax returns this year:

·         Did you make any payments in 2011 that would require you to file Form(s) 1099?

·         If “Yes,” did you file or will you file all required Forms 1099?

Several points come immediately to mind:

·         Remember that you are signing this return as being “true, correct and complete” to the best of your knowledge.

·         I, as the preparer, have to exercise due diligence by also asking you this question.

·         What are the consequences of answering “No?”

Congress will be unsatisfied until it has combed your sofa cushions for loose change. This pressure unfortunately passes down to the IRS, and we are seeing the results in OVDI, FATCA, automated collections and taxpayer liens. Obviously they believe there is money to be found here.

This brings us to Jeremiah Weatherly v. Commissioner (TC Memo 2011-206). It’s a tax case having to do with Forms 1099.

JW operated a bailiff consulting business. These are people who perform evictions and serve process, for example. He hired daily workers to help out. He must have been doing relatively well, as he reported $177,925 of Contract Labor on his 2005 return.

He got audited. The IRS wanted his Forms 1099. JW provided the IRS with 64 Forms 1099.There was a problem, however. JW had not filed the Forms with the IRS.

                OBSERVATION: Really, JW?

The IRS now had no confidence in the 64 Forms 1099, so they requested JW obtain and submit Forms 4669 from the 64 people. Form 4669 requires the payee to report the amount of the payment and where it is reported on his/her return.

OBSERVATION: This is not going to go over well.

JW’s response rate was pretty much what you would expect: he got eight replies. The IRS bounced 2 of them, as the social security numbers were invalid. With the remaining six, JW was able to document $25,115 of his Contract Labor expense. The IRS simply disallowed the remaining $152,810.

JW appealed pro se to the Tax Court. He got schooled. Tax law and long-standing tax doctrine require a taxpayer to maintain records sufficient to establish the amounts of allowable deductions and enable the Commissioner to determine the correct tax liability. This is a two-step requirement: your records have to be good enough for you to prepare a correct return AND to allow someone to double-check your work.

The Tax Court asked for JW’s books and records. Nothing. The Tax Court asked for other evidence to substantiate that these amounts were actually paid. Nothing. The Court then wanted JW to testify about his bookkeeping practices. Nothing. Frustrated, the Court held for the IRS. JW got charged with additional tax of $67,436 and penalties of $29,425.

What can we learn from JW?

Let’s admit, JW should never have represented himself. All he accomplished was to aggravate the Court. It is possible that another taxpayer – more responsive and attuned – could have obtained a different result. The Court did try to help JW, even alluding to the Cohan rule where it will allow estimates as long as the Court is convinced that there truly was an expenditure.

Nonetheless, we can see the position the IRS can and may take if one fails to file Forms 1099. Perhaps your bookkeeping practices are different from JW’s, and you could have provided the Court with substantial and satisfactory alternative documentation. However remember that you would have engaged – and paid – a tax CPA to represent you at audit and Appeals before even arriving at the Court. And you would still be at the Court’s mercy.

This process seems expensive to me. Here is another idea: issue 1099s, especially since you are now required to affirmatively respond to the new questions on your 2011 tax returns. There is now one more reason for the Court to turn you down: you lied when you answered “No” to the first question.

Employee or Contractor? There Is a New IRS Program

One of my individual tax clients came in around ten days ago. He brought his 2010 tax information, including a cleaning business reported as a proprietorship (technically it is a single-member LLC). I noticed that his payroll stopped somewhere during quarter 4, 2010. This of course prompted the question: why?

I suppose I did not need to ask. I have heard it before: the payroll taxes, including workers compensation, were becoming expensive. He consequently moved everyone over to a “Form 1099,” figuring that would solve his problem.

Let’s go through the steps: (1) If you can control and direct them, they are not contractors – they are employees; [2] removing them from payroll does not make them contractors; [3] issuing a 1099 at the end of the year (which he did not do, by the way, because I would have done it) does not make them contractors; and [4] a very important person – the IRS – may disagree with your opinion that they are contractors. If they disagree, the IRS may want the payroll taxes from you anyway. You would have gained nothing except an IRS audit and my professional fee for representing you.

Yep, I got stern with my client. I do not like dumb, and what he did was dumb. Payroll tax problems can get very messy – and absurdly expensive - very fast. I told him to restart the payroll.

The reason for this story is that the IRS came out this month with a “Voluntary Classification Settlement Program.” The program allows employers a chance to reclassify independent contractors and limit their resulting federal payroll taxes. To participate one must have consistently treated the individuals as contractors (that would eliminate my client) and have filed all Forms 1099 (again eliminating my client). One cannot currently be under audit, as there is a separate program for those under audit. One also has to agree to extend the statute of limitations assessment period for each of the three years going forward.

In return, one gains a substantial tax break. Before explaining, I would like to review Section 3509 of the Internal Revenue Code:

3509(a)In General.— If any employer fails to deduct and withhold any tax  … with respect to any employee by reason of treating such employee as not being an employee for purposes of such chapter or subchapter, the amount of the employer's liability for—

3509(a)(1)Withholding taxes.— Tax … for such year with respect to such employee shall be determined as if the amount required to be deducted and withheld were equal to 1.5 percent of the wages…paid to such employee.

3509(a)(2)Employee social security tax.— Taxes … with respect to such employee shall be determined as if the taxes imposed under such subchapter were 20 percent of the amount imposed under such subchapter without regard to this subparagraph.

Let’s go over the math:

                                Employer share of FICA                             7.65%

                                Employee share of FICA                            1.53%  (i.e., 7.65% times 20%)

                                Employee federal income tax                  1.50%

                                                                                                      10.68%

So that reclassification is going to cost you an immediate 10.68%, plus penalties and interest.

The new program will allow one to

·   pay 10% of the tax otherwise due, which is 1.07% (10.68% times 10%)

·   limited to one year

·   no interest or penalties, and

·   the IRS will not conduct an employment tax audit with respect to one’s worker classification for prior years.

This is a pretty good deal.

Remember that the IRS’ new position (although they deny it) is that virtually anyone who does anything for anybody is an employee. Please remember to fork-over that social security tax, thank you. If you are “walking the line” on worker classification, please consider this program.