July

Accurate bookkeeping is an essential ingredient for successfully defending oneself in an audit. Whether it is full disallowance of a deduction or refusal to release a frozen refund, without accurate bookkeeping, every meal offered at Café IRS will taste terrible. To avoid that, taxpayers should keep supporting documents for the duration of a potential audit. Generally, the IRS has three years to audit a return. However, there are situations such as substantial omission where the examination/audit period is six years or, if the taxpayer committed fraud or is a nonfiler, forever.

Worker classification

A business must accurately report the status of its workers as employees or independent contractors to avoid back taxes, penalties and interest. Generally speaking, independent contractors have more autonomy in setting their work schedules, while employees work under employers who determine the work schedules and procedures. Employers are responsible for withholding taxes from employees’ paychecks and contributing to programs like Social Security and Medicare. Independent contractors are responsible for their own tax withholdings. Businesses sometimes misclassify workers as independent contractors to avoid paying payroll taxes, but the IRS has clear guidelines on who can be classified as an independent contractor versus an employee.

Business versus hobby losses

Fortunately, the likelihood of an audit is lower during a business’ initial years because losses are more commonplace for a startup. However, businesses are expected to eventually become profitable; therefore, the longer they operate unprofitably, the greater the burden of convincing the IRS that the business owner is engaging in a business activity and not a hobby. To demonstrate this point, the IRS has a safe-harbor rule to qualify as a legitimate business if the business can demonstrate profitability in three of the past five tax years. Generating profits on a regular basis can pose a significant challenge for many businesses. However, businesses that show consistent losses where deductions exceed income can draw the attention of the IRS. This scrutiny arises because the IRS presumes that a taxpayer who generates consistent losses is not necessarily engaging in a bona fide business activity for profit but rather a hobby for which losses are nondeductible. This does not necessarily mean that the IRS is correct, but it does increase the taxpayer’s risk of an audit and the likelihood that the IRS will hold it to a higher standard of proving that it really is operating the business with the intent to make a profit.

Fraud

Being found liable for the tax fraud penalty can be costly. Tax fraud is an intentional wrongdoing with the specific purpose of evading a tax known or believed to be owed. The tax code imposes a 75 percent civil penalty on the portion of tax underpayment attributable to fraud. Common evasion schemes include intentional understatement or omission of income; claiming fictitious or improper deductions; false allocation of income; improper claims, credits or exemptions; and/or concealment of assets. In all criminal and civil tax fraud cases, the burden of proof is on the government.

How to Handle an IRS Audit There are three outcomes of an audit:

No change – an audit in which you have substantiated all of the items being reviewed and results in no changes being made from your tax return. Agreed – an audit where the IRS proposed changes and you understand and agree with those changes. Disagreed – an audit where the IRS has proposed changes, and you understand but disagree with the changes.

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