The prospect of an audit can be terrifying; however, the good news you can share with your clients is that the odds of being audited are very low. Here are several ways to reduce those odds. Tax professionals can refresh themselves on these practices and share these tips with clients.
Disguising Personal Expenses as Business Expenses
The Internal Revenue Code and IRS allow individuals to deduct “ordinary and necessary” business expenses from their income taxes: “An ordinary expense is one that is common and accepted in your trade or business. A necessary expense is one that is helpful and appropriate for your trade or business. An expense does not have to be indispensable to be considered necessary.”
It’s up to the taxpayer to determine and report these expenses on the return. Since the IRS does not usually verify each and every business expense listed, it can be tempting to report personal expenses, or even fabricate expenses, to inflate deductions and decrease the tax bill. Remember, your clients will be completely defenseless if they get audited, and will need to prove the deductions they claimed were ordinary and necessary.
Backdating Checks for Write-off Purposes
Business owners often find themselves short of cash at the end of the year, just as a huge tax bill is about to come due. Some of them react by backdating checks to suppliers or business partners in order to pad deductible expenses for the previous tax year. For example, a company that pays for consulting might write out $5,000 worth of checks today, but use a date from last December. This way, the check appears to be an expense from the previous tax year and can be deducted currently.
Although there’s no guarantee the IRS will catch this, tell your clients this practice is illegal and they will need to substantiate their expenses if audited.
Understating Taxable Income
The IRS has teams of analysts who study tax fraud to uncover patterns and common avoidance schemes. Ironically, most tax fraud does not stem from people who don’t file tax returns and should; instead, it comes from those who file a return and understate their income.
Although submitting a tax return makes the taxpayer look more compliant, the IRS is aware of understating taxable income and will investigate a suspicious return. Understating income can be a dangerous practice, and the IRS uses source documents, such as W-2s and 1099s, to track income that should be reported.
Overstating Business Losses or Claiming Unqualified Credits
Just like it’s not advisable to understate taxable income, your clients will not want to overstate business losses or claim tax credits they are not entitled to receive. Knowingly not properly reporting income, expenses and credits is a form of tax fraud and can lead to late payment interest and penalties. Even though it might go unaddressed for a few years, or even forever, the threat of an audit is always ever present.
Not Filing a Return
Burying your head in the sand is not a good tax planning maneuver because it will eventually catch up with you. Because the IRS is perpetually backlogged, it might take the IRS computers a little while to identify taxpayers who do not file returns. This is especially the case if the taxpayer has a return involving a source document, such as a W-2 or 1099, because the provider files a copy with the government and the IRS matches the document with the return. By the time the IRS eventually contacts the taxpayer, he or she will also owe interest and late payment fees. These add-ons can accumulate quickly!
Three Ways to Pay a Tax Bill
The IRS offers a variety of payment options for taxpayers to pay immediately, or arrange to pay in installments. Those who receive a bill from the IRS should not ignore it. A delay may cost more in the end when interest and penalties continue to accumulate.
Here are three ways to make payments using IRS electronic payment options:
- Direct Pay: Bills can be paid directly from a checking or savings account, free with IRS Direct Pay. Taxpayers can schedule payments up to 30 days in advance.
- Credit or Debit Cards: Taxpayers can also pay their taxes by debit or credit card online, by phone or with a mobile device. The IRS does not charge a fee, but convenience fees apply and vary by processor.
- Installment Agreement: Taxpayers who are unable to pay their tax debt immediately may be able to make monthly payments. Apply for an installment agreement with the Online Payment Agreement tool. Eligibility for a monthly installment agreement include the following:
- Individuals who owe $50,000 or less in combined tax, penalties and interest, and have filed all required returns.
- Businesses that owe $25,000 or less in combined tax, penalties and interest for the current year or last year’s liabilities, and have filed all required returns.
As a tax professional, it’s incumbent on your practice and reputation to guide your clients toward making ethical and legal decisions. Good luck!
Editor’s note: For more information, check out other articles in Mike D’Avolio’s series on audits.