This article originally appeared in the December 2023 issue of THE SHOP magazine.
By Mark E. Battersby
Even though the IRS’s own figures reveal that, in general, only 1%-2% of all taxpayers actually have their returns audited each year, the threat of an audit continues to strike fear in small business owners. And, that fear increased dramatically late last year with the IRS’s reported plans to hire an additional 87,000 workers.
Once a large and inefficient federal bureaucracy, the IRS is changing to become more streamlined and, most importantly, catch more tax offenders. Agents in back offices are being replaced by computers with complex algorithms that cast a wide net—one that pulls many law-abiding people into the chaos of an audit.
Today, the IRS enforces the tax law in a number of ways including the increasingly more common correspondence (examination by mail) audits and the dreaded field (face-to-face audit) examinations. The result is that many businesses are being scrutinized far more often than the numbers indicate.
Although the IRS takes a dim view of overstated deductions, something such as a failure to report income can result in penalties. Then there is the fraud penalty—equal to a whopping 75% of the unreported tax.
Fortunately, there are perfectly legal strategies that can greatly reduce that audit threat.
MISTAKES & ROUND NUMBERS
The IRS obviously checks the math on every return, and too many errors will trigger red flags. Incorrect totals for expenses, missing Form 1099s and transposed numbers are all believed to concern the IRS—even if the mistakes are small.
The Tax Cuts and Jobs Act of 2017 largely eliminated employee expense deductions as a personal itemized expense until 2026.
The IRS is also reportedly on the lookout for numbers that are “too round.” After all, it is unlikely that all of the numbers shown on any return will end in fives and tens or even thousands.
HINTS FROM THE IRS
The IRS offers a few steps that everyone can take to reduce the risk of their automotive aftermarket shop becoming an audit target. These include:
- Be specific about expenses
- Provide more detail when needed
- Be on time
- Avoid amending returns
- Match up all your paperwork
- Don’t use the same numbers repeatedly
- Don’t take excessive deductions
- Don’t report a loss. Never report a net annual loss for any business
Obviously, this list favors the IRS and the basic tax law. But keep in mind that no less a body than the U.S. Supreme Court has ruled that striving for the lowest possible tax bill is perfectly legal. Thus, the last suggestion of reducing the possibility of an audit by not reporting a loss should be taken with a grain of salt.
BEYOND THE OBVIOUS
While many unexpected and significant swings in income can usually be easily explained, large inconsistencies in income from year to year are often another area of concern to the IRS. Major changes in the amount of income reported are considered a main indicator of underreported earnings.
Large shifts in income can be indicative of someone hiding income in either the current or past tax years. When taking a closer look at the income earned in different tax years (as well as substantiating documents) the IRS often finds discrepancies between what a shop earned and what was reported. Areas to watch include:
Despite the postponed requirement that third-party payers report payments to recipients, cash remains a major red flag because it creates all sorts of problems for the IRS. It is almost impossible to track cash transactions, cash can be easily hidden, it is difficult for the IRS to verify, and, despite new reporting requirements, there are few electronic records to keep track of it.
Cash transactions go unreported by many who still believe that cash doesn’t have to be reported or, more commonly, those who figure the IRS will never know that cash was received. However, today’s IRS targets returns where shops may deal in large amounts of cash and consider it an audit red flag when a return contains a high probability of unreported income.
Hiring a disproportionate number of independent contractors as opposed to employees is more of an audit target today, with states also on the lookout for large numbers of independent contractors used by a business.
An automotive aftermarket shop may use independent contractors to avoid paying payroll taxes—federal and state—including the employer portion of Social Security and Medicare demanded by the Feds.
This doesn’t mean the shop shouldn’t use independent contractors—just ensure compliance with the IRS’s worker classifications and the “worker status tests” that vary greatly from state to state.
Low Salaries for S Corp Shareholders
Many automotive aftermarket professionals set up an S corporation instead of an LLC to avoid the 15.3% self-employment tax. However, while they aren’t subject to self-employment tax on distributions, S corp shareholders working as employees must receive “reasonable compensation.”
The IRS is on the lookout for S corps paying shareholder employees unreasonably low (or even no) salaries. The IRS will compare compensation to the standard for a similar position in a similar industry.
Failure to provide shareholders/owners with reasonable compensation (as W-2 reportable wages) is an audit flag, often leading to a more comprehensive audit of the entire business.
The Home Office
With many taxpayers shifting to “work from home” during the pandemic, it should come as no surprise that the home office deduction will be under extra scrutiny.
Calculations for home office deductions are based on square footage—but only the square footage used exclusively for business purposes.
Travel & Meal Expenses
Travel (not commuting) and meal costs are legitimate business expenses, particularly if they involve meeting customers or prospects. However, higher-than-average spending in these areas can draw the attention of the IRS.
When writing off travel and meal expenses, proving they are for business purposes is essential. Everything should be documented, and receipts retained so, if necessary, a meeting’s connection with the business can be proven.
Triggered by the Tax Pro
Far too many professionals and business owners have succumbed to the promise of big refunds when using the services of a particular tax pro. But beware—tax preparers have been a high-priority target of the IRS for years, as have many of their clients.
REALITY VS. TRIGGERS
In reality, no one knows which tax returns will be singled out for audit by the IRS’s computer algorithms. Many so-called “triggers” have been identified through the experiences of many professionals.
The proposed increase in IRS auditors may or may not impact the current audit rate that sees fewer than 2% of all income tax returns examined within a year.
The statute of limitations for an IRS examination is three years from the due date of the federal tax return or the date it was filed. This period is doubled to six years if the return reveals a substantial understatement of income—usually more than 25% of taxable income.
For failure to file a return for a particular year, or if fraud is suspected, there is no time limit.
CAUGHT! NOW WHAT?
If audited, it will most likely be through a correspondence audit. The letter will contain instructions regarding what information must be sent to the auditors.
Should the IRS request an in-person meeting, typically at a regional office, the notice usually contains instructions about preparing for the audit and the particular items being examined. As an alternative, Letter 2205—a shorter version of the audit notice—will request a phone call and usually prefaces a face-to-face meeting.
The Taxpayers Bill of Rights, part of the IRS Restructuring and Reform Act of 1998, requires the IRS to provide a written statement detailing the taxpayer’s rights and the IRS’s obligations during the audit, appeals, refund and collection processes.
Among the most important rights of every taxpayer whose return is targeted for an audit is whether to be represented by a tax professional or whether to attempt to answer the IRS’s questions alone. Another important consideration for business owners and managers being audited is where to hold that meeting.
NOT A LOST CAUSE
While it is impossible to fully inoculate a business or its owner, since a portion of all audits are truly random, there are steps that can be taken to minimize the likelihood of receiving that feared notice from the IRS.
Yes, every automotive aftermarket business should claim deductions they or their shop are legitimately entitled to, but there is a need for vigilance and detailed recordkeeping to defend those deductions in case of an audit.
Honesty and clarity go a long way toward preventing or dealing with and surviving an IRS audit.
Naturally, every specialty automotive aftermarket professional should have a strategy for avoiding audits as well as for dealing with an IRS auditor. A fallback position should also be in place, should those strategies fail.
Mark E. Battersby writes on financial and tax-related topics. Learn more at thetaxscribe.com.