Caught, audited, and home free...MAYBE

June 1, 2007
Audit is a four-letter word to the American public. Here’s how you can avoid one.

Audit is a four-letter word to the American public. Here’s how you can avoid one.

For many years, the children’s chant of “Who’s afraid of the big, bad wolf?” was more of a threat to many dental businesses than the Internal Revenue Service. Today, under pressure from lawmakers to cut the tax gap, the difference between the amount owed by taxpayers and the amount actually paid, it appears that the risk of an IRS audit is noticeably increasing.

In fact, the IRS’s tax cheat dragnet brought in a record $47 billion during the 2006 fiscal year. Audits of individuals rose by 7 percent last year, while small business audits have more than doubled since 2000. The complexity of our tax laws and the confusion most dental businesses face trying to keep abreast of those ever-changing rules have all contributed to the increased success of the IRS’s auditors.

Avoiding audits

Who wouldn’t like to ensure their tax returns - or those of their dental business - escape examination by the IRS? A few dealers have discovered a surefire method to ensure their return is selected - take big-time losses, operate as a cash business, and keep sloppy records. Fortunately, avoiding audits is both legal and easily accomplished.

There is no justification for sacrificing valid deductions, even if large or unusual. Obviously, all income and deductions should be reported truthfully. If that means a higher chance of audit, so be it. But remember that, in this electronic age, most transactions are reflected on the tax returns of your customers and suppliers.

An excellent strategy for avoiding an audit involves pointing out “oddball” items on the tax return. Give the IRS the answer before they ask the question. Attach a note, a brief statement, documents, and explanations for all unusual transactions.

For large transactions that may fall into one of the innumerable “gray areas” of our tax laws, there is yet another tax form. Form 8275, “Disclosure Statement,” may help avoid penalties by disclosing questionable deductions, positions, or investments. Few experts believe using this form will increase the chance of an audit.

When offense is not enough

What happens if, despite your best efforts, the IRS requests your presence to review your tax returns? It goes without saying the worst thing that any business owner can do if he or she receives an audit notice is to ignore it. The best bet is a quick response. It also helps if the business owner works with the IRS to resolve the matter.

If a small business has kept organized records - including bills, receipts, and canceled checks - and has in place the proper internal controls, there is little need to worry. The IRS may interpret the operation’s situation differently, but there is no crime in having differences of opinion.

Thanks to the IRS Restructuring and Reform Act of 1998, small businesses now have many new protections in the audit process. First, the IRS’s ability to conduct so-called “lifestyle” or “economic reality” audits has diminished.

Today, the IRS is generally prohibited from asking for extensive information about a taxpayer’s financial status, standard of living, and other information to determine the existence of unreported income. The IRS can only ask for that information if it has a reasonable indication that there is a likelihood of unreported income based on the tax return and information reports from third parties.

What the IRS is looking for

Many experts agree that an improperly prepared tax return is a good way to ensure an IRS audit. Sloppy returns are also hazardous.

Those dental business owners who fail to report all income send up an instant red flag in our computerized business world. Information mismatches produced by erroneous Form 1099s often create disparities in reported income. If the amount reported on the Form 1099 is wrong, the individual or firm that sent the form should correct it and file an amended Form 1099. Intentionally mismatching the information of the tax return can only draw attention.

The biggest problem for most dental businesses - as well as their owners - is a lack of good expense records. The use of an automobile for business purposes is a classic example. Although the vehicle may have been used 75 percent of the time to call on customers, many dealers fail to keep a detailed record and, thus, are unable to state that clearly on a tax return. Records can be easily kept in the form of a log.

Those dealers, suppliers, and manufacturers who use an office in the home to conduct business, keep records, or perform management chores may discover that the risk of an audit is not worth the small tax deduction. The home-office tax form (Form 8829, Expenses for the Business Use of Your Home) has, for some time, been a definite audit flag.

If the owner of a business has only a minimal amount of deductible home-office expenses and poor records, the risk of an audit may not be worthwhile.

Also, keep in mind that the use of an office in the home can substantially reduce or even eliminate the unique home-office exclusion. That exclusion allows up to $250,000 ($500,000 on a jointly-filed return) of gain from the sale of a residence to be excluded or ignored. A business owner cannot claim the exclusion for gains that result on any portion of that residence that is not used as a “personal residence.”

Taxpayer rights

The Taxpayers Bill of Rights, part of the IRS Restructuring and Reform Act of 1998, requires the IRS to explain a taxpayer’s rights and the IRS’s obligations during the audit, appeals, refund, and collection processes. A taxpayer is also guaranteed the right to be represented by any individual currently permitted to practice before the IRS. What’s more, any interview must be suspended when the taxpayer clearly requests the right to consult with a representative.

Among the more important rights given anyone whose returns are targeted for further examination is whether to be represented by a tax professional or to attempt to answer the IRS’s questions alone. However, unless it issues an administrative summons, the IRS cannot actually require the taxpayer to accompany the representative to the interview.

Another important consideration for every dealer being audited is where to hold that meeting. Should the meeting be in the accountant’s office where all of the working documents are easily accessible? Should it be at the place of business, the place where all the records are kept, in order to demonstrate to the IRS auditor that there is nothing to hide and that the operation is a legitimate one? Or should the dealer and/or his or her representative 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.

Ignoring the IRS does not work. The IRS may issue summonses to third-party record keepers (attorneys, enrolled agents, banks, brokers, accountants, etc.) for the production of records concerning the business transactions or affairs of a business - and its owner. Of course, the taxpayer must be notified of the summons and has the right to intervene. The taxpayer can, in fact, begin a proceeding to quash the third-party summons.

Appeal after appeal

The occasional error, misinterpretations, or honest disagreements of “gray areas” may result in additional tax assessments. However, from the initial screening for accuracy that each return receives until the final appeal is exhausted, mistakes in the favor of the taxpayer have been discovered in about 25 percent of all cases.

The IRS is usually quite sympathetic to honest mistakes and more than willing to discuss underpayments of taxes that may result from the many so-called “gray areas” of our tax rules. On occasion, they will negotiate the amount of tax due - but they do not like fraud.

Deal with it

Changes to our tax laws in recent years have resulted in tax professionals generally taking a more conservative approach to the tax advice they render and the tax returns they prepare. After all, if the IRS discovers a transaction has been mislabeled, or incorrectly structured, and if the tax laws were ignored, the professional as well as the taxpayer face penalties.

Despite the ultraconservative position now taken by many tax professionals, no business - or business owner - should forego or ignore valid tax deductions. Often, disclosing those transactions or deductions on the tax return will be enough to pass the scrutiny of the IRS, eliminating a full-blown audit. At worst, disclosure may help avoid the levy of numerous penalties for taking a “frivolous position,” or claiming deductions that result in “accuracy-related” penalties.

Honesty and clarity can go a long way toward preventing and dealing with an IRS audit. Obviously, every dental business owner and manager needs an audit strategy as well as a fallback position should those strategies fail.