How to Avoid an IRS Audit

Published on April 27, 2024

While the IRS’s own figures reveal that, in general, only one or two percent of all taxpayers actually have their returns audited each year, the threat of an audit continues to strike fear into every pond professional. That fear has increased dramatically with the IRS’s reported plans to hire additional workers..

The Inflation Reduction Act of 2022 directed $80 billion in new funding to the IRS over the next decade so it could hire 87,000 new workers — purportedly to better target millionaires and millionaire scofflaws. Whether or not the hiring spree materializes and audit rates increase (with more small businesses targeted) remains questionable.

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In reality, what was once a large and inefficient federal bureaucracy, the IRS is changing to become more streamlined and, most importantly, equipped to 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 with increasingly more common correspondence (examination by mail) audits and the dreaded field (face-to-face) examinations. The result is that the mere threat of an audit continues to strike fear into every pond and water-feature business owner.

Targeted!

It is no secret that the IRS takes a dim view of a failure to report income (much more than a minor overstatement of deductions). In fact, the IRS will assume bank deposits are income unless the pond professional can show otherwise. 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 not big.

While most penalties are based on the amount of the underpayments, the so-called “frivolous return” penalty is a flat $5,000 that can be imposed even if there is no underpayment. Keep in mind that there are penalties, and 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.

Hints from the IRS

The IRS itself offers a few steps that every professional can take to reduce the risk of their pond or water feature business becoming an audit target. For example, it recommends that you be specific about expenses and provide more detail when needed. Be on time with your filing.

Match up all your paperwork so that you can avoid amending your returns. Don’t use the same numbers repeatedly or take excessive deductions. Finally, never report a net annual loss for any business.

Obviously, not reporting a loss should be taken with a grain of salt. While the list of “don’ts” favors the IRS and basic tax law, no less a body than the U.S. Supreme Court has ruled that striving for the lowest possible tax bill is perfectly legal!

Every pond professional should claim deductions they or their business are legitimately entitled to. However, while honesty and clarity go a long way toward preventing, dealing with and surviving an IRS audit, every pond and water feature business owner should have a strategy for avoiding audits as well as for dealing with audits.

Beyond the obvious

While many unexpected and significant swings in income can usually be explained easily, large inconsistencies in income from year to year are often an area of concern to the IRS. Changes in the amount of income reported is considered a main indicator of underreported income. Large shifts in income from year to year can be indicative of a business hiding income in either the current or a past year.

A disproportionate number of independent contractors as opposed to employees is also more of an audit target today, with the states also on the lookout for large numbers of independent contractors used by a business. Many pond and water features business 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 business 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.

Many pond professionals operate as 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 Corporation shareholders working as employees must receive “reasonable compensation.” The IRS is on the lookout for S Corporations 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 shareholder/owners with reasonable compensation (as W-2 reportable wages) is an audit flag often leading to a more comprehensive audit of the entire business.

Even before the Pandemic, the home office provided a place for pond professionals to catch up on paperwork, bookkeeping or payrolls. With many taxpayers shifting to work from home or remotely during the Covid-19 pandemic, the home office deduction continues to face extra scrutiny. The deduction for home offices is more complex than many pond professionals realize. The calculation for the home office deduction is based on square footage — but only the square footage used exclusively for business purposes.

When a pond professional uses a personal vehicle for business purposes, the business can often deduct a portion of the vehicle expenses. If the vehicle is used exclusively for business, a deduction for depreciation is often available. Unfortunately, because 100% business use is unlikely in most cases, claiming full business use of a vehicle is an audit red flag.

Other business expenses, even the expenses of the operation’s owner, are largely relegated to being itemized deductions, which aren’t currently available. The Tax Cuts and Jobs Act of 2017 largely eliminated employee expense deductions until 2026. Fortunately, there is always the business’s deduction for those whose expenses that qualify.

Remember, avoid unscrupulous tax-return preparers! Far too many taxpayers, including many business owners, have succumbed to the promise of big refunds when using the services of a tax pro. The IRS has a number of ways that it discovers crooked tax-return preparers. One of their clients may be audited, with the results unrealistic enough that the IRS may take a look at other returns these “professionals” have prepared.

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 developed through the experiences of many professionals. The proposed increase in IRS auditors may or may not impact the current audit rate, which sees few income tax returns actually examined every 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. Failure to file a return for a particular year, or if fraud is suspected, means there is no time limit.

Caught! Now, what?

If a tax return is selected for an IRS audit, the pond and water feature business (or its owner) will receive a notice in the mail most likely calling for a correspondence audit. The letter will contain instructions what information must be sent to them.

Should the IRS request an in-person meeting, typically at their 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.

It should be kept in mind that the IRS isn’t hiring 87,000 auditors. The chances of a pond or water feature business or its owner getting a visit from the IRS will continue to be remote. However, while compliance with the IRS’s rules is pretty straightforward, the same can’t be said for complying with the state, county or town tax rules, with many of these jurisdictions exchanging audit results on both the local and federal level.

Today, complying with the IRS’s rules is fairly straightforward, especially with professional help, despite the complexity. However, it should be kept in mind that an audit may not involve all issues. That’s right — just because the IRS doesn’t challenge an issue on a tax return doesn’t mean that it is approving it.

It is impossible to fully inoculate the business or its owner because a portion of all audits is truly random. However, the help of good records and a tax professional can minimize the likelihood of receiving that feared notice from the IRS. a 

About the Author
With over 25 years of professional experience in the fields of taxes and finance enable Mark Battersby to write on unique and topical subjects. Although no reputable professional should ever render specific advice at arm’s length, he does craft unbiased, interesting, informative, and accurate articles. Mr. Battersby currently writes for publications in a variety of fields. His topical columns are syndicated in many publications each week. He also writes columns for trade magazines and has authored four books.

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