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by Stephen Parezo

Smart Brief

Small business owners are advised to get the jump on tax planning so they’ll be prepared in case they’re targeted for an IRS audit. The IRS is paying close attention to filings from small businesses that tend to underreport incomes. Some smaller companies feel they are being unfairly targeted by audits that could penalize them for unintentional mistakes. Entrepreneurs flagged for an audit need to have a tax pro in their corner since there’s a lot at stake and the IRS has everything on its side. Hiring an expert to deal with the IRS can often delay certain actions by the agency since they know you’re dealing with a relative equal.

January 11, 2007—With the Internal Revenue Service stepping up its auditing of small businesses, tax professionals are advising entrepreneurs to get the jump on tax planning now so they will be better prepared in case they are targeted for an audit.

The IRS is paying close attention to the filings of small businesses that tend to underreport incomes. The agency reported a one-third increase during 2006 in the number of audits of S corporations, to nearly 14,000, the highest level since 2000. S corporations are small businesses that “pass-through” profits to the owners who report them on their personal tax return. Meanwhile, audits of flow-through returns for partnerships rose to their highest level in eight years.

While smaller companies feel they are being unfairly targeted by audits that could penalize them for unintentional mistakes, the IRS says small business owners have nothing to worry about as long as they do their best to report accurate numbers.

This week National Taxpayer Advocate Nina Olson released her annual report to Congress that identified the alternative minimum tax (AMT) for individuals and the federal tax gap as the most serious problems facing taxpayers.

The report indicates that the AMT symbolizes the broader problem of tax-law complexity since it threatens to capture millions of mostly married couples with children and incomes in the middle-to upper-incomes range because it’s hard for taxpayers to figure out if they owe AMT which imposes a higher bill than they would pay under the regular income tax code.

To make matters worse, if taxpayers find out they do owe AMT, they could be subject to a penalty for failure to pay sufficient estimated tax if they didn’t count on having to pay the AMT.

‘Gotcha’ taxation’

Writes Olson: “Gotcha’ taxation is not good for taxpayers or the tax system” so she recommends lawmakers repeal the AMT as it applies to individuals. But given the high cost of repeal that’s estimated at about $1 trillion over 10 years, it’s seen as an uphill battle.

The tax gap also remains a high priority since noncompliance by some taxpayers requires every compliant taxpayer to pay, on average, more than $2,200 in extra tax each year to subsidize that noncompliance.

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To close the gap, Olson suggests several options including a move toward fundamental tax simplification, greater third-party information reporting and better IRS compliance efforts that respect taxpayer rights.

Enforcement by the IRS, which often takes the form of audits and computerized document matching, is aimed at narrowing the taxes due the IRS that don't get paid voluntarily which reaches $290 billion each year.

According to the IRS, a major chunk of the tax gap involves underreporting of income by individuals, typically small businesses that are not organized as corporations; these are individuals filing Schedule C for an unincorporated business.

IRS Commissioner Mark Everson says that the lack of a paper trail can enable individuals to hide small business income because for some businesses such as a small retailer, home improvement contractor or hair stylist, there is no equivalent to the W-2 form that alerts the IRS to the wages and salaries earned by ordinary employees.

Dealing with gray areas

Gene Polley, a senior business advisor in Fiducial’s San Diego, CA, office believes the IRS is conducting these audits of smaller companies to see how bad things actually are.

“There’s been an increased focus on small businesses, especially S corporations, which has been a gray area for a number of years as to what is reasonable compensation for an S corporation owner where you’re a shareholder and employee,” said Polley.

Key issues here, Polley says, center on the following questions: If there’s a reversal in the company’s fortune are you permitted to drastically cut your wages? If you’re an owner and there are not significant profits, wouldn’t you cut back on salaries until there were profits? And would you run the corporation into the ground and pay ‘competitive salaries’ when the profits aren’t there?

Bob Sperling, a tax attorney who helps man Fiducial’s Tax Hotline at the company’s Technical and Administrative Support Center (TASC) in Columbia, MD, noted that if a controlling shareholder works long hours for too small a salary, is the small salary made up for by taking distributions from the S corporation?

“If so, the IRS may reallocate the ‘distributions’ to salary and assess payroll taxes, penalties and interest,” said Sperling.

Since IRS publications are quiet on this issue, Polley finds tax professionals have had to make assumptions over the years as to what is appropriate regarding these gray areas.

“My understanding is that at some point in time the IRS was going to issue more detailed guidelines on what was appropriate for S corporations but they haven’t done it yet,” he said. “Some of the scrutiny of S corps dealt with reasonable compensation in those cases where no wages were being paid or low wages were being paid.”

Polley disagreed with industry watchers that claim revenue raised from small business audits means smaller gains and less bang for the agency’s buck.

There’s a lot at stake

“Historically there is a significant bang for your buck with small businesses because of the gigantic marginal tax bracket these small businesses are in,” he said. “At a minimum they are in the 24% tax bracket with just the most modest of profits and self-employment taxes. As sole proprietors, it can easily get up to 42% with just $72,000 in profits and it’s even more in California and Oregon that have higher taxes.”

That means for every dollar of disputed deductions or questionable income, there’s a 50-cent return.

“That has to be a goldmine for the IRS,” he said.

This underscores the urgency for entrepreneurs to have a tax pro in their corner if they’re ever flagged for an audit because there’s a lot at stake and the IRS has everything on its side.

“Hire an expert to deal with the IRS on your behalf,” Polley said. “Just hiring someone can often delay certain actions on the part of the IRS. At least they know they’re dealing with a relative equal rather than fish in the barrel.”

Dale Ellery, district manager of Fiducial’s Detroit, MI, region, tells clients that if the IRS could collect from everybody that owes taxes and is supposed to file returns, it would cut the rest of the tax liability in half.

“There’s always been that knowledge that the IRS is not collecting from everybody which puts a burden on the rest of us,” said Ellery. “They should all applaud these audits. It’s going to help us.”

Stephen Parezo is the Media Manager for Fiducial

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