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You've heard about the kinder, gentler Internal Revenue Service? It's true to some extent. The agency has been so lax audit and collection activities have fallen off a cliff in recent years. But try telling that to John Jones (not his real name), who in March 2000 received one of those dreaded tax notices that begins: "We have selected your federal income tax return for the year shown below..."
Nearly a year after first laying eyes on those menacing words, Jones, a restaurateur in New York City, still has lawyers and other advisers on his personal payroll, and no resolution in sight. He and the IRS are at odds over whether he owes taxes stemming from a soured real-estate investment. Jones insists he's entitled to a deduction for his loss. The IRS says no; the loss represents income because the mortgage holder wrote off the loan as uncollectible, in essence forgiving the debt. It's a thorny issue, one that Jones says has him "so upset that I've hardly been sleeping."
His case should put taxpayers every-where on notice: The IRS may be re-discovering some of the teeth that once made it the most feared federal bureaucracy. It will increase staff by about 2,000 this year-the first increase in six years-and as many as 1,000 of those slots will be for examiners. These grand plans have tax experts bracing for a surge in audits and collection efforts beginning later this year and continuing into 2002. "There was a real crash in this kind of activity," says David Burnham, co-director of the Trading Records Access Clearinghouse (TRAC) at Syracuse University, which keeps an IRS database. "Now we expect the level of enforcement to pick up."
The IRS surely won't return to the abusive practices that landed it in hot water a few years ago-routinely padlocking offices, placing liens on property, and generally terrorizing taxpayers into paying whether they had a legitimate case or not. Such arrogance came under scrutiny in 1997-98 congressional hearings and shamed the IRS into a full-scale reorganization. During that upheaval audits fell nearly 50%, and IRS staff dropped nearly 20%.
"The last few years have probably been the best time in history to cheat on your taxes...based on the low level of enforcement," quips San Francisco attorney Frederick Daily, author of Stand Up to the IRS (Nolo.com, $24.95). Instead of focusing on specific functions such as collection, examination, and audit, the agency will target four types of taxpayer: tax-exempt entities; investment and wage earners; middle- and large-sized companies; and self-employed people and small business. That doesn't mean everyone will be created equal: The IRS has said corporate tax cheats are high on its list. But tax pros expect renewed enforcement to target small-business owners too.
"That's where the money is; where there is the most potential for cheating," notes Jim Southward, an IRS-sanctioned taxpayer adviser, known as an enrolled agent, in San Francisco. The IRS makes no bones about needing to do more audits. "Clearly the declines we've seen in the past few years need to stop," an IRS spokesman says. "We believe we will show improvement in the audit area this year."
If you get flagged as the IRS ramps up activity, remember that it's best not to go to your audit alone. You are entitled to representation by a CPA, tax attorney, or enrolled agent. They speak the auditor's language, will keep emotions out of the process, and won't hand over to an agent a shred more than is required. During an audit, the biggest mistake a taxpayer can make is to turn over too much information in a show of confidence. That only gives an auditor more to question. To locate a pro in your area, call the National Association of Enrolled Agents (800-424-4339) or the American Institute of Certified Public Accountants (202-737-6600).
Don't be afraid to fight the IRS. In the case of a simple notice of additional taxes due, a prompt letter with documentation stating your position will often fix things. Send it by registered mail. You can also challenge a claim on one of the agency's IRS Problem Solving Days, when taxpayers can get help by appointment, by phone, or by walking in. Dates and locations are on the agency's Website, www.irs.gov. Or try the IRS's National Taxpayer Advocate (877-777-4778). If you get audited and want to dispute the findings, you can request a review by the auditor's supervisor. That rarely wins a reversal, but you can then seek review by a full board of IRS auditors, which has the authority to change the findings. If you get no satisfaction there, you can file a petition in U.S. Tax Court or U.S. District Court.
But the best defense, as they say, is a good offense. Avoid getting flagged in the first place. Income seems to have little to do with being singled out for an audit. In 1999, the IRS audited more individuals with income under $25,000 than it did those with income of more than $100,000. The same was true for businesses. Schedule C returns with less than $25,000 in gross receipts had a higher audit rate than those with more than $100,000, TRAC reports.
But other things matter a lot-and many tax pros expect high earners to get more attention going forward. Here are some tips for owners of small businesses on how to fly below an IRS auditor's radar.
Independent contractors. If you use them excessively you are an audit waiting to happen. The IRS estimates that half of the eight million independent contractors in the U.S. are misclassified, costing the government $20 billion a year in tax revenue. The number of independent contractors is growing five times faster than the general work force, says Andrew Schultz, president of the tax-consulting firm Pro Unlimited in Boca Raton, Fla. So the IRS wants to crack down fast. He advises you to check any independent contractor to whom you pay more than $10,000 a year. He might be an employee subject to withholding. A true independent contractor should have multiple clients and be paid per project, not per hour.
Recidivist auditee. It's a fact: If you've been audited in the past and were found to owe additional tax, you're more likely to get audited again.
Rounding. Don't broadly round numbers on your tax return or any of the accompanying schedules. That's a signal you're not keeping good records, and the IRS can have a field day with small-business owners who don't abide by this rule.
Cash is king. High on the hit list are cash businesses such as laundromats or pizza parlors, which can easily underreport income. The IRS has worked hard to better understand them and learn how an owner might hide income. The agency has developed audit guides for 62 types of businesses, including bed-and-breakfasts, architecture firms, and gas retailers, most of which do cash transactions. "Now, in the case of a pizza shop, the agents know more than the owner," says Sharon Flynn, president of the National Association of Enrolled Agents. "They can tell from how much pizza sauce you ordered how many pizzas you made, and from that what your gross sales were in a year."
Neatness counts. A third of all tax returns are incomplete. The IRS can stay plenty busy just making sure those returns get fixed. Why file one of those? Make sure every appropriate line is filled in and easy to read, and don't forget to include all applicable schedules.
Deduct this. Large and unusual business expenses are hard to miss. A plumber with extravagant entertainment and travel deductions is begging for an audit.
Ownership. Sole proprietorships get tabbed for audit more often than partnerships or S or C corporations because the IRS tends to believe such owners are more likely to underreport income and stretch the truth about what is a business expense versus a personal expense. Talk to an attorney or CPA about changing.
Pay for play. An inflated compensation package for a key employee such as the CEO or CFO-even if he is the owner-looks bad. The IRS worries owners may be trying to mask profits as tax-deductible salaries. Even if you raise no red flags, you could be picked. But if you've been honest and have good records, these days an audit isn't so bad.
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