Whether you are the owner of an IT consulting firm that employs a few hundred people or a boutique owner that personalizes holiday gifts, the chance of being audited by the Internal Revenue Service (IRS) is increasing. Managing your company through these economic times is difficult, but an IRS audit has the potential to take stress to the next level. Of the $450 billion tax gap, the IRS believes under reporting by small businesses is responsible for 84 percent of it. This past summer, the IRS announced significant areas they will prioritize for the 2012 tax return year. Several of these areas may specifically affect your small business. Is your company an easy target?
- Fringe benefits – The IRS’ emphasis is on personal use of company cars. Any personal use of company owned vehicles should be reported as additional wages. A possible red flag is company vehicles with 100 percent business usage, but the IRS may also scrutinize luxury autos. Keep a mileage logbook to prove business usage.
- Proper worker classification – The IRS is looking to see if you are properly classifying workers. Whether a worker is classified as an employee or as an independent contractor makes a big difference for federal income and employment tax purposes. The IRS realizes companies have an economic incentive to treat a worker as an independent contractor instead of an employee. With added payroll taxes and benefits, the misclassification can save businesses up to 30 percent in labor costs. Because the stakes are high, this issue is often hotly contested between the businesses and the IRS. Periodic review of these workers’ classification is critical.
- S corporation losses – The IRS is scrutinizing whether you have adequate basis to take losses. If you think just because you have not made any profit that you are safe from an IRS audit, think again. The IRS is looking at S corporations that have losses that flow through to their owners. Then they are looking at the owner’s returns to see if they have enough basis to take the losses. Be sure to update your basis schedules annually; losses will carry forward until you have basis to utilize them.
- S corporation officer’s compensation – This hot issue has increasingly been a focus of IRS exams. In an effort to get around paying payroll taxes, owners may be taking distributions that are nontaxable as long as you have basis, instead of paying a reasonable salary or sometimes no salary at all. The IRS is focusing on companies that have taxable income and distributions but have little to no salary paid to its officers. Some courts have allowed the IRS to reclassify as salary substantial amounts of distribution payments, thus resulting in the company owing additional employment taxes. The lack of a clear legal standard and the need to consider the relevant facts and circumstances have made it difficult to develop guidance on what constitutes an adequate salary. The IRS’ list of factors includes time and effort devoted to the business, distribution/dividend history, and what comparable businesses pay for similar services. What is clear, though, is that not paying a salary when taking distributions is a red flag.
- High income/high wealth taxpayers – If a taxpayer has total positive income of more than $200,000, the IRS audit risk increases. The IRS defines total positive income as all gross receipts and sources of income before expenses and deductions. Taxpayers who file a Schedule C business return with total positive income of more than $1 million will be an area of focus for the IRS through 2013. In this group of $1 million earners, 12.5 percent of them were audited by the IRS in 2011. By comparison, only 8.4 percent of this taxpayer group was audited in 2010. Clearly, the IRS is focusing on this group of high income taxpayers.
- Credit for small business employee health insurance – This federal income tax credit was added with the signing of the Patient Protection and Affordable Care Act on March 23, 2010. This credit is for eligible small employers that make non-elective contributions toward their employees’ health insurance premiums. A small employer is defined as having 25 or fewer full-time equivalent employees, paying average annual wages of less than $50,000 and paying at least 50 percent of the premium. The credit is up to 35 percent of the non-elective contributions paid by the eligible small business. Because this credit first became available on 2010 returns, the IRS will be targeting those claiming this credit to verify eligibility compliance.
- Abusive transactions, especially international transactions – Widely publicized, the IRS stepped up its focus on the international tax gap. The IRS is aggressively pursuing taxpayers who use overseas accounts to hide assets. The IRS is currently on its third voluntary initiative for foreign bank account reporting. Small and large businesses should be aware that the IRS is concentrating on offshore transactions as well as offshore accounts.
- Partnership returns – The new audit area of emphasis is this flow-through return. The IRS is looking for unreported income and abusive transactions. They may also look at large loss partnerships.
- Form 1099-K matching – Effective for sales made on or after January 1, 2011, reportable payment transactions are required to be reported on Form 1099-K. A reportable payment transaction is a transaction when a payment card (credit card or gift card) or third-party payment network (PayPal) is used. These payment processors report the gross amount paid to the merchant on this annual form submitted to both the merchant and the IRS. Processors will only be required to report merchants who have at least 200 transactions and at least total payments of $20,000 for the year. The IRS plans to begin Form 1099-K matching in late 2013. The IRS anticipates this initiative will increase compliance of previously unreported sales by small businesses.
No longer are big businesses being targeted; audits of small businesses are on the rise. Think about these areas of focus for the IRS. Which ones might land your business in the cross hairs? As a best practice, proactively examine these audit areas with your management team and trusted business advisor.