Category: IRS Audits

Receiving an IRS audit notice can feel overwhelming, but your steps will depend on the type of audit: correspondence, office, or field. Each requires a tailored approach, and professional representation is especially helpful in avoiding common missteps, like saying too much during in-person meetings.

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Correspondence Audit: Respond by Mail

This is the simplest type of audit, conducted entirely through mail and focused on a specific item.

1. Read the Notice: Identify the issue and deadline. Focus only on the requested items.
2. Gather Documents: Collect records, such as W-2s, 1099s, or receipts, that address the IRS’s concerns.
3. Respond Clearly: Write a concise cover letter explaining your position on each issue. Include supporting documents, and send everything by certified mail.

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Office Audit: Let Your Representative Handle It

In an office audit, the IRS requests a meeting to review specific items like deductions or credits.

1. Understand the Scope: Review the notice to identify what’s being questioned. Collect and organize related records for your representative to present.
2. Limit Your Involvement: Instead of attending the meeting yourself, allow a tax professional—such as a CPA or Enrolled Agent (EA)—to go on your behalf. They can answer questions, keep discussions focused, and prevent over-disclosures.
3. Trust Their Expertise: A representative knows when to say, “Let me check and get back to you,” instead of risking an inaccurate guess at the answer.

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Field Audit: Manage the Environment

A field audit is more comprehensive, often involving the entire return and conducted at your home or business.

1. Prepare Broadly: Gather all financial records for the years under review. Identify the potential big issues and be ready to defend your position on each.
2. Limit Access: Designate a specific area for the meeting and restrict access to unrelated documents or areas.
3. Hire a Professional: Have your tax representative manage the field audit directly. This ensures that conversations remain focused and reduces your risk of unintentional errors or over-sharing.

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Final Thoughts

Preparation and professional representation are crucial in any audit. Many taxpayers harm their case because they feel like they must answer every question, regardless of how long ago the transaction occurred. To avoid looking stupid, they often guess. The auditor could take these guesses incorrectly, leading to a more extended and detailed audit.

A representative does not have this problem. Nobody expects them to be able to answer every question, and they have an easy time saying, “I don’t know, let me get back to you on that.” Whether it’s a correspondence, office, or field audit, staying organized and trusting an expert to take the lead can ensure a smoother resolution.

The IRS’s Form 1099-K reporting requirements continue to evolve, with important changes for 2024. In IRS News Release IR-2023-221, the agency delayed the implementation of the controversial $600 reporting threshold for third-party payment platforms. Instead, a $5,000 threshold will apply for the 2024 tax year. Payment processors like PayPal, Venmo, and Stripe must issue Form 1099-K for payments exceeding this amount for goods or services. However, some platforms may issue 1099-Ks for lower amounts, adding to taxpayer confusion. Here’s how to manage these changes, address reporting issues, and stay compliant.

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Challenges with 1099-K Reporting

Even with the $5,000 threshold, challenges persist:

• Misclassified Transactions: Platforms may report personal transactions as taxable income.
• Processor Refusals to Correct Errors: If payment processors don’t amend a mistaken 1099-K, taxpayers must account for and document the discrepancy on their returns.
• Voluntary Reporting at Lower Thresholds: Some platforms issue 1099-Ks for amounts below $5,000, creating unnecessary complexity for occasional sellers or gig workers.
• Transcript Delays: Filing early without waiting for IRS transcripts, which may not be updated until late spring or early summer, can lead to discrepancies.

Why Filing an Extension Might Help

Filing an extension gives you until October 15 to file your return, allowing time to align your reported income with IRS records. The IRS typically updates income transcripts, including 1099-K data, after April 15 and sometimes as late as June. Waiting for these updates ensures that your return matches IRS records, minimizing the risk of discrepancies that could trigger audits.

How to Avoid IRS Audits

The best way to minimize the risk of an IRS audit when dealing with Form 1099-K is to address potential errors proactively and report income accurately. Here’s how:

1. Document Non-Taxable Transactions
   • If your Form 1099-K includes personal transactions or other non-taxable payments, gather documentation proving they are not business income. Examples include memos from the payment platform indicating the purpose of the transaction (e.g., “gift” or “reimbursement”) and bank statements showing corresponding payments to friends or family.
2. Correct Errors Directly with Payment Processors
   • If a 1099-K includes incorrect information, contact the payment processor to request a corrected form as soon as possible. While not all processors may comply, requesting the correction shows good faith effort and strengthens your position if audited.
3. Adjust Your Return for Errors
   • If the processor won’t issue a corrected 1099-K, report the full amount from the form as income but include an adjustment for the erroneous portion. For example, create a line item on Schedule C or other relevant forms labeled “Adjustment for Non-Taxable 1099-K Income” and subtract the incorrect amount. Keep detailed records to justify the adjustment.

Conclusion

With the $5,000 threshold for 1099-K reporting in 2024, taxpayers must carefully review forms, reconcile records, and address errors proactively. If a 1099-K includes non-taxable income that the processor won’t correct, document the issue, explain the discrepancy on your return, and maintain detailed records to support your position.

By taking these steps, including filing an extension when needed, you can stay compliant, avoid audits, and handle reporting challenges confidently. For complex cases, consult a tax professional to ensure accuracy and compliance.

If you’re a shareholder in an S Corporation, ensuring that your compensation is reasonable is crucial to avoid IRS scrutiny. But how do you calculate and document reasonable compensation? Follow this straightforward process to establish a well-supported, defensible compensation figure using publicly available data and clear documentation.

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Step 1: Download State Wage Data

The Department of Labor (DOL) releases annual wage data by state each May. This dataset provides a comprehensive breakdown of average wages for different occupations and industries in your area. Start by downloading this data and importing it into a spreadsheet. This will serve as your baseline for determining reasonable pay rates.

Pro Tip: Focus on your specific state to ensure your compensation aligns with local economic conditions. Bookmark the DOL website or set a reminder each May to update your data.

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Step 2: Identify Major Duties

Make a detailed list of your primary job responsibilities as a shareholder-employee. Most shareholders in S Corporations wear multiple hats, so aim to capture 4 or 5 major functions you perform regularly. For example:

• Sales and Business Development
• Operations Management
• Financial Oversight
• Customer Support
• Administrative Tasks

Defining your roles ensures you match each duty to an appropriate wage category.

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Step 3: Look Up Average Pay Rates

Using your spreadsheet of DOL wage data, find the average hourly rate for each of your identified duties. For instance:

• Sales and Business Development: $45/hour
• Operations Management: $50/hour
• Financial Oversight: $55/hour
• Customer Support: $25/hour
• Administrative Tasks: $20/hour

Make sure the rates reflect your state and industry. If necessary, adjust based on the experience required for the role.

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Step 4: Allocate Your Time by Duty

Next, estimate your time on each duty during a typical workweek. Break this down as a percentage, ensuring the total does not exceed 40 hours per week. For example:

• Sales and Business Development: 40% (16 hours/week)
• Operations Management: 25% (10 hours/week)
• Financial Oversight: 15% (6 hours/week)
• Customer Support: 10% (4 hours/week)
• Administrative Tasks: 10% (4 hours/week)

Allocating your time helps demonstrate how your compensation correlates with the value of your work.

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Step 5: Calculate Total Compensation

Now, multiply the hours spent on each duty by the corresponding hourly rate, then sum the totals:

• Sales and Business Development: 16 hours × $45/hour = $720
• Operations Management: 10 hours × $50/hour = $500
• Financial Oversight: 6 hours × $55/hour = $330
• Customer Support: 4 hours × $25/hour = $100
• Administrative Tasks: 4 hours × $20/hour = $80

Total Weekly Compensation: $1,730
Annualized Salary (52 weeks): $1,730 × 52 = $89,960

This total represents a well-documented, reasonable compensation figure that reflects your duties and local wage standards.

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Why This Approach Works

By following these steps, you’re creating a clear paper trail that aligns with IRS guidelines. Using third-party wage data, documenting job duties, and allocating time builds a solid defense if your compensation is questioned. It’s proactive and transparent and ensures you remain in compliance.

IRS Agents are used to seeing taxpayers with no documentation. Yours does not have to be pretty to be adequate.

Bonus Tip: Keep this documentation updated annually and include it with your corporate records to show consistency.

For S Corporation owners, balancing compensation can be a tightrope walk. Unlike other business structures, S Corporations offer a unique tax advantage: distributions to shareholders are not subject to payroll taxes. But here’s the catch—if you’re actively working in your S Corporation, the IRS requires you to pay yourself a reasonable salary before taking those tax-free distributions. Mess this up, and you could be inviting an audit. Let’s dive into the most common red flags for S Corporations regarding compensation.

The IRS’s Biggest Target: Paying Zero Salary

If you’re a shareholder-employee of an S Corporation and pay yourself no salary, you’re putting a giant bullseye on your back. The IRS has made it clear that zero salary is not acceptable for any owner who actively works in their business. Why? Because wages are subject to payroll taxes (Social Security and Medicare), while distributions are not. By avoiding salary, you’re dodging these taxes, which will almost certainly trigger an IRS audit.

Other Common Triggers That Could Lead to an Audit

Beyond paying zero salary, here are other red flags the IRS watches for in S Corporations:

1. Unreasonably Low Salaries

Another major red flag is paying yourself a salary but setting it way below what someone in your role would typically earn. For instance, if you’re running a thriving business but only paying yourself $15,000 a year while taking $200,000 in distributions, the IRS might see this as an attempt to avoid payroll taxes. They’ll likely reclassify part of your distributions as wages, slapping you with back payroll taxes, penalties, and interest.

2. Disproportionate Salary to Distributions Ratio

The IRS often looks at the ratio of your salary to distributions. If you’re taking minimal salary and large distributions, it could signal an attempt to skirt payroll taxes. While there’s no hard-and-fast rule, a significant imbalance will catch the IRS’s attention.

3. Industry-Out-of-Whack Compensation

The IRS compares your salary to industry standards for similar roles. If your salary falls well below what others in your industry typically earn for the same job, it raises a red flag. For example, the IRS will likely question your compensation if you’re a tech consultant but only paying yourself $30,000 a year while the industry average is $100,000.

How the IRS Determines Reasonable Salary

The IRS uses several factors to determine what constitutes a reasonable salary for S Corporation owners, including:

• Your role and responsibilities. Are you the CEO? A manager? Or someone performing administrative tasks?
• Time spent working. The more hours you work, the higher your salary should be.
• Industry standards. Salaries for comparable positions in similar businesses are a key benchmark.
• Company size and profitability. A highly profitable business typically warrants a higher salary for its owner.

The Cost of Non-Compliance

If the IRS decides your salary is unreasonable, they can reclassify your distributions as wages. This means:

• You’ll owe back payroll taxes (Social Security and Medicare) on those reclassified amounts.
• You could face penalties for underpayment of employment taxes.
• The IRS may tack on interest for the time those taxes went unpaid.

How to Stay Compliant

To avoid trouble, follow these best practices:

• Set a reasonable salary. Use industry benchmarks, your role, and your business’s profitability as a guide.
• Document everything. Keep records of your duties, hours worked, and how your salary was determined.
• Consult a tax professional. A CPA or tax advisor can help you structure your compensation correctly while minimizing your tax burden.

Final Thoughts

For S Corporations, paying a reasonable salary is more than just good practice—it’s a requirement. The IRS focuses on shareholder-employee compensation, and paying zero or unreasonably low salaries is the quickest way to get audited. By ensuring your salary aligns with your role and industry norms, you can enjoy the benefits of S Corporation tax savings without the risk of penalties. Play by the rules and keep your business and the IRS happy.

There’s good news if you’ve ever been stressed about not having every receipt for your tax deductions. Almost 100 years ago, a principle was established that still benefits taxpayers today—it’s called the “Cohen Rule.” Born out of the 1930 Cohen v. Commissioner case, this rule remains a powerful tool, saving taxpayers from being unfairly penalized when documentation is missing or incomplete. And believe me, it’s still relevant—even though some may have thought it had faded into obscurity.

My Experience as an IRS Agent: Is the Cohen Rule Dead?

When I was an IRS Agent decades ago, my Group Manager often claimed the Cohen Rule was dead. I heard it all the time. But even then, I knew better. In practice, the Cohen Rule was still quietly applied in cases where taxpayers couldn’t produce every receipt but had reasonable, credible deductible estimates. And today, it’s still doing exactly that—protecting taxpayers who may not have a perfect paper trail.

The Origins of the Cohen Rule

The rule originated when George M. Cohen, a famous Broadway producer and performer, faced a challenge we all can relate to: he claimed deductions for business expenses. Still, he didn’t have every receipt on hand. The IRS disallowed those deductions, but Cohen argued that the expenses were reasonable and ordinary for his line of work. The court ruled that if a taxpayer could provide reasonable estimates for legitimate expenses, the deductions could still be allowed, even without perfect documentation.

How the Cohen Rule Helps Taxpayers Today

Fast forward nearly 100 years, and the Cohen Rule remains vital, especially for non-filers trying to get back on track. When you’ve fallen behind on filing taxes, tracking down every bit of paperwork can feel impossible. The IRS typically requires documentation for expenses, but if you don’t have all your records, the Cohen Rule can help. It allows taxpayers to estimate certain expenses as long as they’re reasonable and supported by other evidence, like bank statements or testimony.

Impact on Non-Filers

This flexibility is crucial for non-filers. Imagine trying to catch up on several years of taxes but missing essential receipts for legitimate expenses. Without the Cohen Rule, you could face hefty penalties, interest, and additional taxes just for not having every document. But the rule provides some much-needed breathing room, recognizing that life isn’t always perfect, and neither is paperwork.

Conclusion: The Cohen Rule Still Offers Relief

In a world where tax compliance can feel overwhelming, the Cohen Rule is still quietly offering taxpayers a fair chance—even decades after my manager claimed it was dead. For those behind on their taxes or who don’t have every receipt in hand, it’s a reminder that reasonable, honest efforts to comply are still respected.

When a taxpayer fails to file a return or keeps inadequate records, the IRS doesn’t just shrug and give up on assessing tax. Instead, it has a range of tools at its disposal to estimate a person’s taxable income through what’s known as “indirect methods.” These techniques help the IRS reconstruct income when accurate records are unavailable, ensuring that non-filers are held accountable.

What Are Indirect Methods?

Indirect methods refer to various approaches the IRS can use to estimate an individual’s or business’s income when direct evidence, like bank statements or tax returns, is incomplete or missing. These methods rely on external sources of information and lifestyle indicators to paint a picture of the taxpayer’s financial situation.

Some of the most commonly used indirect methods include:

1. Bank Deposits Method: This involves analyzing taxpayers’ bank accounts to identify deposits. The IRS assumes that most bank deposits reflect income unless proven otherwise, such as loan repayments or gifts. The IRS adjusts for known non-taxable deposits, but unexplained amounts are generally considered taxable.
2. Net Worth Method: The IRS assesses changes in a taxpayer’s net worth over time by examining assets, liabilities, and expenditures. If a taxpayer’s wealth significantly increases without a corresponding explanation (like inheritance or gifts), the IRS may attribute that growth to unreported income.
3. Expenditures Method: This method assumes that a person’s income must cover expenses. The IRS can estimate income levels by evaluating a taxpayer’s spending patterns. For example, if someone is living a high-cost lifestyle but there’s no evidence of reported income, the IRS may assume that unreported income is financing those expenses.
4. Markup Method: Typically used for businesses, this method calculates income based on the cost of goods sold and expected profit margins. Suppose a business doesn’t have records or reports less income than seems plausible. In that case, the IRS uses industry standards to estimate the revenue based on purchases and standard markup rates.
5. Cash-T Analysis: This approach looks at taxpayers’ cash on hand and spending. If someone spends more money than they could reasonably withdraw or earn based on their reported income, the IRS may infer additional unreported cash income.

Are Indirect Methods Likely to Overstate Income?

Indirect methods rely heavily on assumptions, which means the IRS could overestimate taxable income. For instance, if the IRS mistakenly classifies a non-taxable deposit as income or overlooks legitimate expenses, the taxpayer’s income could be overstated. However, taxpayers can challenge these estimates by providing evidence to the contrary. Proper documentation is crucial to avoid this scenario.

The Takeaway

Indirect methods are essential tools in the IRS’s arsenal, allowing them to estimate taxable income even when non-filers try to evade detection. Anyone in this situation should understand that the IRS can and will find ways to calculate your income. If you’re concerned about unfiled returns or incomplete records, it’s always better to voluntarily file and communicate with the IRS before they contact you with these indirect techniques.

One of S corporation owners’ most crucial tax considerations is determining “reasonable compensation.” The IRS scrutinizes S corporation shareholders’ compensation because it impacts how income is taxed. While S corporation shareholders can take salary and distributions, only the salary is subject to payroll taxes. Distributions are not, making it tempting to underpay salaries. However, doing so can lead to IRS penalties if the salary is deemed unreasonably low.

What is Reasonable Compensation?

Reasonable compensation is the salary an S corporation owner must pay themselves for the services they provide to the business. The IRS expects this salary to reflect what someone in a similar role with similar experience would earn in the market.

The IRS looks at factors such as:

• The shareholder’s duties and skills
• Time and effort spent on the business
• Comparable salaries in the industry
• The company’s gross revenue and profits

How to Calculate Reasonable Compensation

1. Research Comparable Salaries
Use resources like the Bureau of Labor Statistics (BLS) or salary surveys to find salary data in your industry and region. For example, if the owner is both a CEO and performs technical work, combine salaries for those roles.

2. Consider Hours Worked
Estimate the time spent on each role and calculate compensation based on that split.

3. Factor in Company Financials
Your compensation should also reflect the financial health of your business. Higher profits may justify a higher salary while struggling businesses might opt for more modest compensation.

The Importance of Documentation

Maintaining documentation or a study to support your salary calculation is crucial. Without this, you leave the determination of what is “reasonable” to an IRS auditor if you’re ever examined. This could result in the auditor setting a higher salary than you paid yourself, leading to back payroll taxes, penalties, and interest.

If the IRS determines underreported wages, they will likely apply the adjustment to all three open tax years, increasing your liabilities.

Conclusion

Determining reasonable compensation for S corporation owners is critical to avoiding payroll taxes and penalties. To protect yourself in the event of an audit, be sure to document your approach based on industry standards, duties, and financial performance.