Author: Jim Payne

Jim Payne, a Florida Certified Public Accountant (CPA) since 1976, offers candid insights on getting square with the IRS — with the least pain, and at the lowest cost — with (or without) the help of a tax representative. Mr. Payne is a former IRS agent and expert in business profitability, IRS audits, IRS payroll tax, and IRS non-filer issues. As a Tax Representative, his goal is clear: " I will speak on your behalf to all IRS agents, so you never have to, and I'll guide you in executing a strategy to resolve your IRS problem so you can get back to enjoying life."

What is Considered ‘Reasonable Compensation’ for S Corp Owners and Why It Matters

For S corporation owners, reasonable compensation is crucial for staying compliant with the IRS. As both shareholders and employees, owners must pay themselves a fair salary based on their work. This is important because shareholder-employees receive funds through wages (subject to payroll taxes) and distributions (not subject to payroll taxes). If the IRS believes an owner is underpaying themselves in wages while taking excessive distributions, it can lead to audits, penalties, and back taxes.

But what exactly is considered reasonable compensation, and why does it matter?

How the IRS Defines Reasonable Compensation

The IRS defines reasonable compensation as pay reflecting the value of services provided by the shareholder-employee. The salary should match what the company would pay someone else for the same duties. When determining reasonable compensation, the IRS considers several factors:

The Role and Duties Performed: Different jobs require different levels of compensation. For example, someone handling administrative tasks, like scheduling, would earn less than someone responsible for strategic planning or overseeing finances. The more complex and critical the role, the higher the pay should be. If an owner shapes the company’s vision or manages large teams, their salary should reflect that.
Industry Standards: The IRS compares the owner’s pay to what others in the same role, industry, and region earn. Owners can use salary surveys to ensure their pay aligns with typical compensation for similar duties.
Business Size and Financial Health: The IRS examines company revenue, profits, and size. Larger, profitable businesses are expected to pay higher salaries. A highly profitable S corporation that pays a modest salary but takes large distributions may raise red flags for the IRS.
Time and Effort: An owner’s time in the business also matters. An owner working full-time in a key role should receive a higher salary than someone working part-time or doing less critical tasks.

Why Reasonable Compensation Matters

Avoiding IRS Scrutiny: The IRS monitors S corp owners who pay themselves low salaries while taking large distributions, which avoids payroll taxes. If they suspect underpayment of wages, it can lead to an audit.

Tax Compliance: Payroll taxes fund Social Security and Medicare. If the IRS reclassifies distributions as wages, the business will owe back payroll taxes, interest, and penalties.

Ability to Borrow: Reporting a fair salary helps when applying for loans or working with investors, showing that the company complies with IRS rules.

Conclusion

Understanding reasonable compensation is vital for S-corp owners to avoid IRS scrutiny. Pay should reflect the role’s complexity, align with industry standards, and consider the company’s financial condition. By balancing wages and distributions, owners can protect their businesses from penalties and keep operations compliant.

What Situations Are Most Likely to Trigger an IRS Audit?

While the thought of an IRS audit can be stressful, the reality is that only about 0.4% of individual tax returns are audited each year. However, certain red flags can increase your chances. Understanding these triggers can help you avoid mistakes and reduce your audit risk. Here are the most common situations that could lead to an IRS audit:

1. High Income Levels

The IRS is more likely to audit higher-income taxpayers. According to IRM 4.1.5.4, the IRS prioritizes cases where significant tax revenue is at stake. While the overall audit rate is low, those with incomes over $500,000 have a 1.1% chance of being audited. This jumps to 2.6% for individuals earning $1 million or more.

2. Unreported Income

Failing to report all income is a quick way to get the IRS’s attention. The IRS matches your tax return with the W-2s and 1099s they receive from employers and other sources. Any discrepancy, like income from freelancing or side jobs, could result in a CP2000 Notice, signaling a potential audit.

3. Large or Unusual Deductions

Claiming deductions that seem large relative to your income can raise red flags. For example, reporting $80,000 in income but claiming $40,000 in charitable donations may lead to scrutiny. Similarly, large deductions for business expenses or home office use could be questioned. The IRS uses DIF scores to identify unusual return patterns (IRM 4.10.5.2).

4. Claiming the Earned Income Tax Credit (EITC)

The Earned Income Tax Credit (EITC) is a valuable tax break for low-income families but is also heavily audited due to frequent errors. 1.2% of returns claiming the EITC are audited, which is higher than the general audit rate. If you claim the EITC, ensure that all information is accurate and supported by documents like proof of income and household size.

5. Self-Employment Income

Self-employed individuals are likelier to be audited because the IRS knows there’s more opportunity to underreport income or inflate deductions. High deductions for business expenses or home office use are common triggers. Keep detailed and accurate records to avoid issues.

6. Foreign Accounts and Assets

U.S. taxpayers must report foreign accounts if their value exceeds $10,000 at any point during the year. Failing to do so can trigger an audit and severe penalties. The IRS partners with foreign governments to find unreported foreign income, so compliance is key.

7. Round Numbers on Your Return

Filling out your return with rounded numbers, like exactly $5,000 for business expenses or $10,000 for donations, can look suspicious. While rounding to the nearest dollar is fine, avoid numbers that seem “too perfect.”

While the overall audit rate is low, knowing what behaviors increase your risk can help you avoid being flagged. By keeping accurate records and filing a precise, honest return, you can reduce the likelihood of facing an audit.

Defending the Schedule C “Hobby Loss” Exam

If you run a small business and report income and expenses on a Schedule C, the last thing you want is for the IRS to categorize your endeavor as a hobby. Why? Because hobby losses aren’t deductible, while business expenses are. The IRS scrutinizes businesses that consistently report losses, and if they suspect your business is more of a “hobby,” you could find yourself facing a Schedule C “Hobby Loss” examination. Here’s what to expect and how to defend your business if you’re audited.

What is a Hobby Loss Exam?

The IRS uses the “hobby loss” rule under IRC Section 183 to prevent taxpayers from deducting losses from activities that aren’t conducted to make a profit. If your business hasn’t generated a profit in three of the last five years (two out of seven for horse-related activities), the burden of proof to show your profit intent moves from the IRS to you. In that case, the IRS may challenge the legitimacy of your deductions. This triggers a “hobby loss” examination, where they’ll determine if your business is a legitimate for-profit activity.

Proving Your Business is Not a Hobby

If you’re facing a Schedule C audit, the burden of proof is on you to show that your activity is a business with a profit motive. The IRS looks at several factors, including:

Business-like Manner: Do you keep accurate books, maintain separate bank accounts, and professionally conduct your activity? The more you treat your business like a serious venture, the better your chances.
Time and Effort: Do you spend significant time and effort in the business, or is it more of a casual pastime? Documenting your working hours and your attempts to grow and improve the company will help bolster your case.
Expertise: Do you have knowledge or expertise in the industry? Showing that you’ve sought advice, attended relevant training, or engaged with professionals in your field strengthens your claim.
History of Income and Losses: While reporting losses is not unusual for new businesses, a pattern of profitability, even if sporadic, helps demonstrate intent. You don’t have to show profits every year, but consistent and serious efforts to make the business profitable are crucial.
Appreciation of Assets: If your activity involves assets that appreciate over time (like real estate or collectibles), it suggests a potential for profit, even if income isn’t immediately apparent.

Preparing for the Exam

Gather and organize your financial records if you receive notice of a Schedule C exam. Documentation like receipts, invoices, contracts, and tax returns are essential. In addition, prepare a narrative that explains your efforts to make a profit, any challenges faced, and your future business plans. It’s also helpful to work with a tax professional experienced in defending hobby loss exams, as they can provide guidance on specific documentation the IRS may request.

Conclusion

While facing a Schedule C “Hobby Loss” exam can be stressful, being proactive and organized in demonstrating your profit motive can turn things in your favor. By treating your business seriously and documenting your efforts, you can defend your deductions and keep your tax bill in check.

The Problem with IRS Auditors Using Outdated Industry Statistics in Indirect Methods: Cash vs. Credit Card Deposits

When IRS auditors examine a business, they often use indirect methods to estimate income. This is especially common when records are incomplete or inconsistent. One method compares a business’s cash and credit card deposits to industry averages. However, a growing problem is that the IRS sometimes uses outdated industry statistics. This can lead to inaccurate conclusions and inflated tax bills for businesses.

The Lag in Industry Statistics

The IRS uses industry data that is often a few years behind. This can be a problem in fast-changing sectors like retail and food service. Payment methods have shifted rapidly in recent years. More businesses now rely on digital payments and credit cards, while cash transactions are declining. The COVID-19 pandemic sped up this shift as people moved to contactless payments.

Despite these changes, IRS auditors sometimes use old benchmarks. Comparing a business’s cash-to-credit ratio to data from five or ten years ago could lead to errors. Back then, cash payments were more common. Using those figures now may falsely suggest a business is underreporting its income. As a result, businesses could face unjust penalties based on inaccurate data.

Cash vs. Credit Card Deposits: A Changing Landscape

The cash-to-credit deposit ratio is a key metric in IRS audits using indirect methods. Auditors compare this ratio to industry averages to estimate total receipts. However, if these averages are outdated, audit results can be misleading.

Many industries, especially restaurants, bars, and small retail businesses, now handle mainly credit card payments. If an auditor uses old data from when cash was more common, it can look like a business is underreporting cash income. This issue is worse for businesses in areas where digital payments are more popular, as they have shifted even more away from cash.

The Impact of Outdated Data

Outdated industry statistics can seriously harm businesses. If an audit relies on old data, it may wrongly suggest that the business is handling more cash than it is. The IRS could then conclude that cash income is being underreported. This may lead to inflated tax liabilities, costly disputes, and unnecessary penalties.

Businesses in rapidly changing industries or areas are especially at risk. For example, a restaurant in a city where contactless payments are standard may be compared to outdated data from cash-heavy regions. Similarly, businesses with tech-savvy customers may see most payments come via credit cards or digital wallets. These patterns won’t match older statistics that assume a larger reliance on cash.

The Need for Updated Industry Statistics

For IRS audits to be fair, they must use current data that reflects today’s business practices. The payment landscape is evolving quickly, and using statistics that are several years old can disadvantage businesses. Relying on outdated industry averages forces businesses to defend themselves against data that no longer applies.

Conclusion

Using outdated industry statistics in IRS audits, especially when comparing cash and credit card deposits, is a major challenge for businesses. The lag in updating benchmarks means audits may rely on figures that no longer reflect how businesses operate today. As industries shift toward digital payments, IRS auditors must use up-to-date data. Without it, businesses risk facing unfair tax assessments and lengthy disputes based on an outdated view of their industry.

How Best to Utilize IRS Collection Appeals

Knowing how to use the IRS Collection Appeals Process (CAP) can help protect your rights if you’re facing IRS collection actions like levies or liens. CAP lets taxpayers challenge IRS enforcement actions. It may also delay or prevent those actions while your case is reviewed. Here’s a guide on how to make the most of IRS Collection Appeals:

What is the IRS Collection Appeals Program (CAP)?

The Collection Appeals Program (CAP) lets taxpayers appeal IRS collection actions. CAP covers liens, levies, installment agreements, and property seizures. It’s faster than other appeal processes, often resolving cases within five days.

When to Use CAP

There are several situations where CAP can help:

Lien Filings: If the IRS places a lien on your property, you can appeal it through CAP. This gives you time to devise another solution, like an Installment Agreement.
Levies: If the IRS plans to seize your wages or bank accounts, you can file a CAP appeal to stop or reverse the levy.
Installment Agreement Rejection: If your request for an installment agreement is denied or an existing one is modified or terminated, you can appeal through CAP. This is useful if the IRS is misjudging your ability to pay.
Seizure of Property: If the IRS is about to seize your property, CAP can force the IRS to reconsider before taking your assets.

How to File a CAP Appeal

To file a CAP appeal, complete Form 9423 (Collection Appeal Request). Send it to the IRS office that took the collection action. File your appeal quickly since you can only request a hearing before the action occurs—except for liens and levies, which you can appeal after they happen.

Tips for Success

Act Quickly: The CAP process is fast. File your appeal as soon as you receive notice of a collection action. Once the action occurs, you have fewer options.
Provide Strong Documentation: Support your appeal with financial documents, hardship information, or reasons for unfair action. This can boost your chances of success.
Seek Professional Help: Consider working with a tax professional experienced in IRS appeals for complex situations. They can help present your case effectively.

Conclusion

The IRS Collection Appeals Process can stop aggressive collection actions. You can potentially reverse liens, levies, and more by acting quickly, filing an appeal, and providing solid documentation. Getting professional help can also improve your chances of a successful outcome for tricky cases.

Exploring the Taxpayer Advocate Service: A Lifeline for Taxpayers

Dealing with the IRS can be frustrating, especially when problems aren’t resolved through normal channels. The Taxpayer Advocate Service (TAS) is here to help when things go wrong. But when should you turn to TAS? Here are key situations where they can make a difference:

1. Financial Hardship or Imminent Adverse Action

TAS can intervene if an IRS action, like a lien or levy, is causing you severe financial distress or facing an immediate threat of a levy or seizure. They can work to resolve the issue quickly or delay the action while your case is reviewed.

2. Unresolved Issues Despite Repeated Attempts

If you’ve tried multiple times to fix a tax problem but keep hitting a wall, TAS can help. TAS can break through the red tape, whether it’s a persistent error or communication breakdown.

3. Unreasonable Delays

If the IRS takes too long to address your issue, causing hardship, TAS can intervene. They can push the IRS to prioritize your case and prevent further complications.

4. Incorrect Interpretation of Tax Law

If you believe the IRS misinterprets tax law or its procedures, TAS can help challenge this. They ensure the law is applied correctly, so you aren’t unfairly penalized.

Conclusion

TAS is there when standard IRS processes fail. Whether it’s financial hardship, delays, or incorrect application of the law, TAS provides the help you need. If you’re stuck with an unresolved tax issue, contacting TAS could be your best step toward a fair resolution.

What is an “Equivalent Hearing”?

When dealing with IRS collection actions, it’s crucial to know your options for appealing or disputing those actions. One such option is a Collection Due Process (CDP) hearing. But what happens if you miss the 30-day deadline to request a CDP hearing? Fortunately, the IRS offers another option known as an “Equivalent Hearing.” Let’s explore what an Equivalent Hearing is, how it works, and how it can still provide valuable opportunities to resolve your tax issue.

Understanding the Equivalent Hearing

An Equivalent Hearing is similar to a CDP hearing but is available if you miss the 30-day deadline to request a CDP hearing. You can request an Equivalent Hearing within one year of receiving either a Final Notice of Intent to Levy or a Notice of Federal Tax Lien. Although an Equivalent Hearing doesn’t offer all the same protections as a CDP hearing, it still provides a formal process to appeal IRS collection actions.

Key Differences Between CDP and Equivalent Hearings

While an Equivalent Hearing closely resembles a CDP hearing, there are important distinctions:

No Automatic Halt to Collection Actions: Unlike a CDP hearing, an Equivalent Hearing does not automatically stop IRS collection actions, such as levies or liens. The IRS can continue pursuing collection activities while your case is being reviewed.
No Access to Tax Court: One of the biggest drawbacks of an Equivalent Hearing is that it doesn’t preserve your right to take the case to U.S. Tax Court if you disagree with the outcome. This limits your legal options if the decision doesn’t go in your favor.
Timing: As mentioned earlier, you have 30 days to request a CDP hearing from the date of the IRS notice. For an Equivalent Hearing, you have up to one year to make the request. This extended window gives you more time if you initially missed the CDP deadline.

Why Request an Equivalent Hearing?

Even though an Equivalent Hearing lacks some of the protections of a CDP hearing, it’s still a valuable opportunity. You can present your case to an independent Appeals officer who will review the IRS’s proposed actions and consider any alternative resolutions you propose. You might be able to negotiate an installment agreement, Offer in Compromise, or Currently Not Collectible (CNC) status.

In addition, an Equivalent Hearing allows you to raise similar arguments that you would in a CDP hearing. You can dispute the validity of the IRS’s actions or demonstrate why their collection methods would cause financial hardship.

How to Request an Equivalent Hearing

To request an Equivalent Hearing, you must file Form 12153, the same form used for a CDP hearing. Be sure to indicate on the form that you request an Equivalent Hearing. After submitting the form, you’ll work with an Appeals officer to review your case, discuss your options, and possibly reach a resolution.

Final Thoughts

An Equivalent Hearing is a useful backup option if you miss the deadline for a CDP hearing. Although it doesn’t automatically stop collection actions or provide access to the Tax Court, it still allows you to challenge the IRS and propose alternative solutions. If you’ve received a notice and missed the 30-day window for a CDP hearing, don’t lose hope—an Equivalent Hearing can still be a valuable tool in resolving your tax issue.

The Benefits of a Collection Due Process Hearing

If you’ve received a notice from the IRS about a lien or levy, you might feel overwhelmed and unsure of what to do next. Luckily, the IRS offers a key safeguard called a Collection Due Process (CDP) hearing. This hearing lets you appeal actions like liens, levies, or a denied installment agreement. Let’s explore how a CDP hearing can benefit you and help you manage your tax situation.

What is a Collection Due Process (CDP) Hearing?

A CDP hearing is a formal process where you can challenge the IRS’s proposed collection actions. You can request a CDP hearing after getting certain notices, such as a Final Notice of Intent to Levy or a Notice of Federal Tax Lien. Once you receive one of these notices, you have 30 days to file a request using Form 12153. During this time, the IRS typically pauses most collection actions. This pause gives you valuable time to figure out a solution while your case is under review.

Key Benefits of a CDP Hearing

Halt to Collection Actions

One of the biggest benefits of requesting a CDP hearing is that it stops IRS collection efforts. Once you submit your request, the IRS generally can’t proceed with liens, levies, or garnishments while your case is being reviewed. This break gives you extra time to work on a resolution without fearing your assets being seized.

A Fair Review by an Independent Officer

Your case is handled by an Appeals officer who wasn’t involved in the original decision. This independent officer reviews the facts, listens to your side, and determines whether the IRS’s actions are justified. A fresh perspective often leads to more reasonable solutions that the original enforcement team may have overlooked.

Explore Alternative Resolutions

A CDP hearing isn’t just about disputing the collection action. It’s also a chance to propose alternative solutions. You can request options like an installment agreement, Offer in Compromise, or Currently Not Collectible (CNC) status. The Appeals officer can decide if these alternatives fit your financial situation, giving you a key opportunity to negotiate better terms for settling your tax debt.

Preservation of Your Rights to Appeal in Tax Court

If you’re unhappy with the outcome of your CDP hearing, you still have the right to take your case to the U.S. Tax Court. This extra layer of protection ensures you have every chance to argue your case and seek relief. The CDP process is one of the few pathways that preserves this important right.

Preparing for a CDP Hearing

Preparation is key to achieving the best outcome. Gather all relevant documents and be ready to explain why the IRS’s actions are too harsh or unnecessary. If you’re proposing an alternative resolution, like an installment agreement or Offer in Compromise, ensure you have detailed financial records to support your proposal.

Final Thoughts

A Collection Due Process hearing is a powerful option for taxpayers facing aggressive collection actions. It gives you time to find a solution and ensures that an independent officer reviews your case fairly. By taking advantage of this process, you can avoid severe actions like levies and liens while working toward a manageable resolution with the IRS. If you receive a notice qualifying you for a CDP hearing, don’t miss out on this chance to protect your rights and explore better options for resolving your tax debt.

The Role of Tax Compliance in IRS Appeals

When navigating a dispute with the IRS, one of the best moves you can make is taking your case to the Office of Appeals. It’s a chance to resolve disagreements without the expense and stress of court. However, one critical factor that can greatly influence the success of your appeal is your level of tax compliance. Maintaining compliance isn’t just about filing returns—it’s about showing the IRS that you’re serious about resolving your tax matters fairly.

Why Tax Compliance Matters

The IRS is more likely to negotiate with taxpayers with a history of complying with tax obligations. Being up to date with your filings and payments signals that you’re acting in good faith, which can work in your favor during the Appeals process. Conversely, if you have a history of non-compliance, it can be a major obstacle. Even if you have a legitimate argument, non-compliance can make the IRS less willing to work with you.

What Does “Being in Compliance” Mean?

For IRS purposes, compliance usually means that you’ve filed all required tax returns for at least six years. The IRS uses this key benchmark to assess whether you’re meeting your obligations. So, if you’re missing returns from earlier years, they generally won’t be a problem as long as the most recent six years are fully filed.

Being in compliance also means you’re making any required tax payments on time, including estimated payments if you’re self-employed. Even if you can’t pay off everything you owe, showing a commitment to keeping current with new obligations can help your case.

Compliance in Collection Appeals

Your current compliance status is even more critical if your appeal involves collection actions—like disputing a lien or levy. The IRS is less likely to grant relief if you still miss recent tax returns or fail to make payments on time. In fact, the IRS often views non-compliance as a sign that the appeal is more about delaying collections than resolving the dispute.

Compliance is non-negotiable for taxpayers seeking relief through an Offer in Compromise or Currently Not Collectible (CNC) status. The IRS will not even consider these options unless you’re fully current with your tax filings for the past six years.

How to Get Compliant Before Appeals

If you’re not currently compliant, here are some steps you can take before your Appeals conference:

File Any Outstanding Tax Returns for the Past Six Years: Even if you can’t pay the full amount owed, it’s crucial to file all required returns.
Set Up a Payment Plan: If you owe back taxes, consider entering into an installment agreement. Showing that you’re working toward paying your tax debt helps demonstrate good faith.
Make Your Estimated Payments: If you’re required to make estimated payments, ensure they are current. This is especially important for self-employed individuals.

Final Thoughts

Tax compliance is key in determining how the IRS Appeals Office approaches your case. The goal of Appeals is to reach a fair settlement, but your compliance history plays a big role in building trust and credibility. By ensuring you’re fully compliant with your tax filings for the last six years and staying on top of current obligations, you’ll put yourself in a much stronger position to achieve a favorable outcome.

Resolving Your Tax Case at Appeals

Dealing with a tax dispute can be stressful, but the IRS Office of Appeals offers a path to resolve issues without needing a court battle. If you’ve received an IRS decision you disagree with—whether it’s about an audit, penalties, or collection actions—you might find that Appeals is a smoother, less formal way to get things settled. Let’s break down how the process works and what you can expect.

What is the IRS Office of Appeals?

Think of the Office of Appeals as a neutral party within the IRS. Their job is to review tax disputes fairly, helping both sides—taxpayers like you and the IRS—find a middle ground. Importantly, Appeals officers are separate from the folks who made the original decision on your case. So, you’re getting fresh eyes to look at your situation.

When Should You Consider Going to Appeals?

If you’ve been audited, hit with penalties, or received a notice of collection actions like a lien or levy, and you don’t agree with the IRS’s decision, you might be eligible to take your case to Appeals. Typically, this starts when you get what’s called a 30-day letter. This notice allows you to challenge the decision before it becomes final. You must submit a written protest within 30 days if you want your case to be reviewed.

What Happens Once You Request Appeals?

Once you’re in the Appeals process, you’ll work with an Appeals officer who will review your case. The process is usually pretty flexible—you might have a phone conference, exchange letters, or even meet in person. The goal here isn’t just to rehash the facts but to figure out a resolution that works for everyone.

Appeals officers are allowed to consider more than just strict legalities—they’ll weigh things like the risk the IRS would face if the case went to court. This opens the door to potential compromises, like reducing what you owe, arranging payment plans, or finding other creative solutions.

How Can You Prepare?

Being prepared is key. Here are a few tips:

Know Your Stuff: Brush up on the tax laws and guidelines relevant to your situation. It helps to know the rules inside and out.
Gather Your Proof: Collect all the documents and records that back up your position. The more organized and clear you are, the better.
Be Clear About Your Disagreement: In your protest letter and during your conference, make sure you explain clearly and confidently why you disagree with the IRS’s decision.

Wrapping It Up

The IRS Appeals process is there to help you resolve your tax dispute without the hassle of going to court. It’s a less formal, more taxpayer-friendly way to address disagreements. If you feel like the IRS has gotten something wrong or just want to avoid the stress and expense of litigation, Appeals could be the right move for you. Just make sure you’re prepared, know what you’re arguing for, and are ready to negotiate toward a fair solution.