Category: IRS Audits

How to avoid being audited, and how to respond if you’ve received an IRS Audit letter.

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:

  1. 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.
  2. 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.
  3. 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.
  4. 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:

  1. 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.
  2. 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.
  3. 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.
  4. 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.
  5. 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.

Understanding Common IRS Problems and How a Representative Can Help

Navigating the complexities of IRS issues can be daunting for individuals and businesses. The challenges are numerous, from receiving unexpected notices to dealing with hefty tax bills. Fortunately, IRS representatives can provide valuable assistance in resolving these issues. Here, we’ll explore some of the most common IRS problems and how a representative can help alleviate them.

1. Unfiled Tax Returns

Unfiled tax returns are a significant problem that can lead to severe penalties, interest charges, and even criminal prosecution in extreme cases. Many individuals and businesses fall behind on their tax filings due to various reasons such as personal emergencies, financial difficulties, or simple oversight. An IRS representative can help by:

  • Analyzing your tax situation to determine which returns are missing.
  • Gathering necessary documentation and information to prepare the delinquent returns.
  • Communicating with the IRS to negotiate a manageable resolution plan.
2. Large Tax Bills

Owing money to the IRS is a common issue that can result in wage garnishments, bank levies, and tax liens. Taxpayers often struggle to pay off their tax debt due to financial constraints. A representative can assist by:

  • Assessing your financial situation to determine the best course of action.
  • Helping you apply for an Installment Agreement to pay off your debt in manageable monthly payments.
  • Exploring eligibility for an Offer in Compromise, which allows you to settle your tax debt for less than the full amount owed if you meet certain criteria.
3. Audits and Examinations

Receiving an audit notice from the IRS can be intimidating. Audits can be triggered by various factors, including discrepancies in reported income, unusually high deductions, or random selection. An IRS representative can:

  • Provide guidance on what documentation and information you need to prepare.
  • Represent you during the audit, communicating with the IRS on your behalf.
  • Help you understand and respond to IRS findings, ensuring your rights are protected.
4. Penalties and Interest

The IRS imposes penalties and interest for various reasons, including late filings, late payments, and underreporting of income. These additional charges can quickly add up, making an already challenging situation worse. A representative can:

  • Review the reasons for the penalties and determine if any can be abated or reduced.
  • Help you file a reasonable cause request to have penalties removed if you have a valid reason for not complying with tax obligations.
  • Assist in negotiating payment plans that include provisions for reducing interest accruals.
5. Innocent Spouse Relief

Spouses who file joint returns are jointly and severally liable for any tax debt. However, if one spouse is unaware of errors or omissions made by the other, they may qualify for Innocent Spouse Relief. An IRS representative can:

  • Evaluate your situation to determine if you qualify for Innocent Spouse Relief.
  • Help you gather and present evidence to support your claim.
  • Guide you through the application process, ensuring all necessary documentation is submitted.
Conclusion

Dealing with IRS problems can be stressful and complicated, but you don’t have to face them alone. IRS representatives have the expertise to navigate the intricate tax laws and procedures, helping you find the best possible resolution for your situation. Whether it’s filing overdue returns, negotiating tax debt settlements, or representing you in an audit, a representative can provide the support and guidance you need to resolve your IRS issues efficiently and effectively.

When Will the IRS Army of Auditors Hit the Warpath?

The IRS received a significant funding increase through the Inflation Reduction Act of 2022. This led to speculation about a sudden surge in audit activities. Many wondered, “When will the IRS army of auditors hit the warpath?” However, the actual plan for deploying these resources suggests a more measured approach by the IRS.

The Funding Context

The IRS’s additional $80 billion plans extend beyond just increasing enforcement. This funding is also earmarked for upgrading technology and improving taxpayer services. The aim is to make the IRS more efficient and responsive rather than merely more aggressive.

Recruitment and Training

Integrating new auditors into the IRS is a structured process. It begins with the challenge of recruitment. Finding the right candidates is not quick or easy. Once hired, these new auditors go through extensive training. They must master the complexities of tax law, ethical auditing practices, and the use of sophisticated technological tools.

Phased Deployment

Auditors are not deployed abruptly. Recruits start their careers by handling simpler cases under the supervision of seasoned auditors. This integration ensures they are fully prepared before they tackle more complex audits.

Projected Timeline for Deployment

  • Year 1-2 (2022-2023): The focus is on recruitment and training.
  • Year 3 (2024): New auditors start with simpler audit cases.
  • Year 4-5 (2025-2026): They begin to handle more complex audits as their experience increases.
  • Year 6 and beyond (2027 onwards): Auditors are fully integrated and handle various audits.

Implications for Taxpayers

The gradual deployment of new auditors means there will be no immediate spike in audit activities. The IRS aims to improve the accuracy and efficiency of audits. Taxpayers can probably find better things to worry about rather than an oppressive audit increase.

Conclusion

The immediate “army of auditors” concept does not accurately reflect the IRS’s strategy or ability.  Improving audit processes takes time.  Personally, I would be happy if the IRS would just answer their phones

Are you Out-of-Luck when the IRS cannot be convinced that its Assessment is Incorrect?

It happens. The IRS audits you and makes an assessment that you know is wrong. Maybe you missed the audit appointment, and the auditor disallowed all your deductions. Or maybe the IRS has a 1099 or W-2 showing that you have unreported income and you have never heard of the issuer. If you just can’t get the IRS to listen to reason, one of your options is an Offer-in-Compromise based on Doubt-as-to-Liability.

What is an Offer-in-Compromise?

An Offer-in-Compromise is an agreement with the IRS to pay less than the full amount of the assessment. Usually, the basis for this offer is based on the inability to pay the amount before the Statute of Limitations runs. The IRS accepts these offers after doing a financial analysis and concluding that it’s their best option to collect.

The Offer-in-Compromise due to a doubt-as-to-liability is the less well-known sibling to the offer based on lack of potential to pay. Rather than submit financial information, you submit your evidence one last time as to why the assessment is in error. It gives the IRS the option of settling the issue without going through the expense of going to court and possibly losing.

What’s Different about DATL Offers?

There are two major differences. First, the offer can be very low. Second, you are not submitting information about your personal or business financial condition which is full of potential problems if there is an error on the form.

How Much Should You Offer?

This all comes down to how strong is your case. The more likely the IRS is to lose in court, the smaller your offer should be. The minimum I would suggest is $150 so that they can feel like the offer at least covers their processing costs. If it’s a 50-50 likely win for both parties, I would be inclined to make an initial offer between 30 and 50 percent. There will be an opportunity to negotiate the final amount.

Conclusion

All is not lost when it comes to assessments that you believe are in error. Try to use the regular appeals processes first. But if that does not work, then an Offer based on doubt-as-to-liability is well worth trying.

Avoiding the IRS Accuracy Penalty

The IRS accuracy penalty is a charge that the IRS imposes on taxpayers who file inaccurate tax returns. The penalty is equal to 20% of the amount of taxes that are owed as a result of the inaccuracies. This can be a hefty amount so it’s worth considering what you can do to minimize their potential.

What is the biggest cause of the IRS Accuracy Penalty?

The biggest cause of the accuracy penalty is underreported income. Computer software matches all the 1099s and W-2s reported by 3rd parties to the tax returns and automatically generates a CP2000 Notices proposing changes for anything not on the return.

How can you avoid the IRS Accuracy Penalty?

 The easiest and surest way to avoid matching problems is to file an extension and check your IRS transcripts when the income and wages are posted in early June.

If you need to file before June, it’s still a good practice to check the income and wage transcripts. Should you find a difference, immediately amend the original return with a 1040X. A timely correction makes it very hard for the IRS to claim you were negligent.

What about Information Return Errors?

The IRS process millions of information returns and a fair number of them are in error. In theory, it’s up to you to contact the 3rd party issuer and ask them to correct their filing.  Lots of luck with that approach. The fallback is to make sure that your return reflects the total income reported. Then deduct the error with a note on the return explaining the error.

Conclusion

The accuracy penalty can be big bucks. Avoiding the penalty is far easier than dealing with them after the IRS finds unreported income and automatically assesses the penalty.

Common mistakes that will earn you an IRS Audit

The IRS tries to keep its processes for selecting returns for audit a secret. However, we do know some of the general steps. The majority are selected by computer-generated scores that are based on how different an individual return is from an average return. The higher the score, the more likely the return will be sent to an audit group for audit consideration. Stacks of these returns are assigned to individual auditors. These auditors will look over the returns and decide which they find to be audit worthy.

Here are some common mistakes that will make it more likely to pique that auditor’s interest:

  1. Lots of rounded numbers. This is saying to the auditor that my bookkeeping is lacking and there are probably tax dollars to be found here.
  2. Non-cash charitable contributions. The IRS knows that most people fail to get receipts, overvalue the junk they donate, and will not spend the money on a professional valuation when required.
  3. Large amounts of business travel or auto expenses. This is almost an automatic adjustment in an audit. Most business owners will not keep the logs required to document the business purpose, dates, and amounts. Every new IRS auditor learns this within the first 10 audits they perform.
  4. Hobby losses. How earners with losses from a farm, horse ranch, race car, etc. are likely to get an IRS call to schedule the audit date. Auditors know that the burden of proof to prove there is a real business purpose for these losses has shifted from the IRS to the taxpayer.
  5. Unreported 1099s or W-2s. Not having enough compensation or gross receipts at least equal to the totals that 3rd parties have sent to the IRS is an almost guarantee that you will be spending some time with the audit division.

Most of these mistakes can be avoided. Simply don’t use rounded numbers or report a lot of non-cash charitable contributions without getting proper documentation. Keep the auto logs or be prepared to see at least 50% thrown out in an audit. If you are not sure what 1099s have been reported to the IRS, file an extension and check your IRS transcripts when the wage and income transcripts are usually updated in July of each year.

Burden of Proof

January is the month to receive IRS information forms such as W-2s and 1099s. Inevitably, some of these forms are going to wrong. Who has the burden of proof to correct these errors? The answer is that it’s you, the taxpayer. IRC 7491 does shift the burden to the IRS, but only if you are in court and have introduced “credible evidence” with respect to the issue. Bottom line, you can save yourself a lot of time and headaches by fixing the problem yourself before the IRS computer systems issue a letter.

This is a two-step process:

  1. Contact the issuer and ask them to correct or amend the form. If the issuer will not fix their error or cannot be contacted, move on to step 2.
  2. Gross up the income on your return to cover the error and take a deduction to offset it. Here is the critical part of this step – include a statement explaining the problem and deduction. Failure to explain and document this error could get you off on a very bad footing in an audit.

You could, of course, call the IRS and ask for their assistance with this problem.  Lots of luck even getting them on the phone.