Of all the audits your practice can be subjected to a tax audit is the most fearsome—despite the fact that fewer than 5 percent of businesses, practices, or professionals are targeted each year.
While it’s too early to predict what effect any tax legislation in 2017 will have on the tax picture of your practice—or its principals—one thing is certain: There is a greater likelihood that those already-filed tax returns will face more scrutiny.
Fortunately, there is some maneuvering room that may help reduce the odds of your practice being targeted for an audit. And even though the odds of being selected for a tax audit may be slim, you should be aware of the red flags that trigger those audits, as well your right to disagree with an auditor’s findings.
Winning and losing the audit lottery
Tax returns are not always selected for audit because of errors. Returns can be selected for a variety of reasons, including:
Random selection and computer screening: Sometimes returns are selected based solely on a statistical basis.
Document matching: When payer records, such as Forms W-2 or 1099, don’t match the information reported.
Related examinations: Returns may be selected for audit when they involve issues or transactions with other taxpayers, such as partners or investors, whose returns were selected for audit.
Regardless of the type of audit, the IRS should always specify what records are needed for review. And do keep in mind that audits tend to result in no changes as about as often as they cause them. Naturally, any changes proposed by the IRS will be explained along with your rights as a taxpayer.
Knowing your rights
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.
These rights include:
- A right to professional and courteous treatment by IRS employees.
- A right to privacy and confidentiality about tax matters.
- A right to know why the IRS is asking for information, how the IRS will use it, and what will happen if the requested information is not provided.
- A right to representation, by oneself or an authorized representative.
- A right to appeal disagreements, both within the IRS and before the courts.
Among the most important rights held by any taxpayer 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 if your practice is being audited is where to hold that meeting.
Should the meeting be in your accountant’s office where all of the working documents are easily accessible? Should it be at your practice, the place where all the records are kept, to demonstrate to the IRS auditor that there is nothing to hide and the practice is legitimate? Or, should you and your practice manager (and any other representatives) trudge down to the IRS office armed only with the specific documents and information requested by the IRS auditor? There is no one right answer.
In a hurry?
The IRS’s “Fast Track Settlement” (FTS) program offers small chiropractic practices and self-employed professionals an opportunity to resolve tax disputes early in the examination process— often within 60 days after acceptance into the program.
With FTS, a trained IRS appeals mediator is assigned to reach an agreement on the disputed issue(s). The taxpayer being audited retains full control over every decision made during the FTS process. The appeals mediator may offer settlement proposals and use their unique authority, if needed, to resolve the dispute. Either party may agree to or reject the appeals mediator’s settlement proposal.
Keep in mind that all IRS departments communicate with one another. Thus, a chiropractor’s failure to report income from a partnership or S corporation will be revealed by the K1 distribution statements the partnership or S corpo- ration is required to file along with its tax returns. Among the claimed tax deductions that may lead to an IRS audit are the following:
- Partners and shareholders in S corporations can only deduct losses up to their “basis” in the entity. Basis includes the amount of equity investment (adjusted for profits and losses) and any direct loans made to the practice.
- Did you claim auto expenses for your only car? Personal use of a practice- deducted vehicle is so common that auditors expect to find it. If the car is operated for both business and pleasure and a high percentage of that use is claimed for business use, good records (preferably a mileage log) are a necessity.
- Deducting auto leases: If you or your practice are deducting lease payments as a business expense, keep several potential pitfalls in mind: First, any upfront, lump-sum payments aren’t currently deductible. That amount must be spread over the life of the lease. Second, if the vehicle is valued at more than about $19,000 (for cars) or $19,500 (for trucks), the full amount of the lease payment cannot be deducted. The deduction must be adjusted using an “inclusion amount.” The dollar threshold depends on the year the lease began. Third, if the vehicle is used partly for business and partly for personal purposes, only the amount allocable to business use is deductible.
- Travel and entertainment expenses are another area where the IRS knows it can strike gold. All travel and entertainment deductions should be documented. Taking friends to the ballgame and calling it a business- related expense won’t fly unless the business relationship can be explained in a credible fashion.
- Are payroll tax returns being filed and tax payments made for the practice’s employees? Employment taxes are a routine part of every audit of small enterprises.
- Also, if the practice uses independent contractors, should they really be labeled as employees?
Both the IRS and the Department of Labor routinely look for taxpayers using independent contractors to reap the maximum tax savings possible when calling workers “independent contractors” rather than the employees they actually are.
Poor documentation is a death sentence
Many chiropractors, even those with no intent to commit fraud, often fall short when it comes to documentation and paperwork. The IRS appears increasingly determined to find and audit these practices.
Once sent only to those suspected of failing to comply with tax laws, information document requests (IDRs), are being sent out in record numbers as a screening tool. Even if the practice pays its taxes dutifully, it may be penalized for lacking documentation.
After all, the law requires every taxpayer to retain the records used when preparing tax returns. Those records must generally be kept for at least three years from the date the return was filed.
If records are kept electronically, the IRS may request those in lieu of or in addition to other types of records. But they will usually provide a written request for the specific records needed.
Surviving the new IRS era
Computers are less forgiving than humans. Any chiropractor who hopes to survive and thrive under the new algorithm-based IRS should follow these guidelines:
- Always be prepared for scrutiny. Understanding the rules and potential red flags is essential to knowing what information should be saved and for how long.
- Be prepared to move quickly. IDRs and audits now move on a shockingly fast timeline, so have a plan of action. Build a relationship with an accountant who can step in quickly if or when the dreaded IRS audit notice is received.
- Consistency is key. Inconsistencies in paperwork happen even to honest people when accounting is not handled professionally. The IRS, however, is increasingly viewing discrepancies as fraud until proven otherwise.
- Expect firmness. IRS agents will rarely allow wiggle room or mercy. As a result, this attitude sets the tone in their dealings.
Appeal after appeal
Until an agreement is reached with the IRS, the appeals process remains open. Most importantly, from the initial screening for accuracy that each return receives up to the final appeal has been exhausted, mistakes in favor of the taxpayer are discovered in about 25 percent of all cases.
The IRS is usually sympathetic to honest mistakes and more than willing to discuss underpayments of taxes that may have resulted from the many gray areas of the tax code. They’ll frequently negotiate the amount of tax due on occasion—but they don’t like fraud.
Honesty and clarity go a long way toward preventing, dealing with, and surviving an IRS audit. Naturally, every practice should have a strategy for avoiding audits as well as for dealing with an IRS auditor. And have a fallback position in place, should those strategies fail.
Mark E. Battersby is a tax and financial adviser, freelance writer, lecturer, and author located in Philadelphia. he can be reached at 610-789-2480.