On August 10, 2013, the Wall Street Journal reported that IRS is issuing 20,000 letters to businesses that accept credit cards and asking them “to explain why the portion of [their] gross receipts from non-card payments appears unusually low.” According to the Journal, the letters form part of a “broader initiative aimed at boosting federal tax receipts and insuring compliance.” Businesses with accurate sets of accounting records have nothing to fear. However, businesses with inadequate sets of accounting records are vulnerable to large and sometimes catastrophic audit adjustments. Failure-to-pay penalties, substantial understatement-of-income-tax penalties and interest on these penalties can often add another 50 percent to already significant audit adjustments.
Where S corporations and partnerships are involved, the IRS audit examination also extends to the personal income tax returns of the business owners. Moreover, IRS shares its audit adjustments with the Massachusetts Department of Revenue (“DOR”) and the departments of revenue of many other states. The Massachusetts DOR typically responds to IRS-initiated “audit changes” by initiating its own income tax and sales tax audits.
We have been involved professionally in a number of federal and state audits that involve significant audit adjustments. These adjustments are often associated with inadequate sets of accounting records. In our experience, the root cause is often incompetent bookkeeping services – and not criminal wrongdoing.
Where criminal wrongdoing is not involved, we have invariably found that the best response to an IRS or Massachusetts DOR audit is to generate accurate books and records and to correct promptly erroneous income tax and sales/meals tax returns. Sometimes our firm does this work “in-house.” Sometimes we supervise outside CPAs chosen by our client. In either case, the development of corrected accounting records must be done expertly, under the attorney-client privilege, often under severe time constraints, typically using CPAs instead of bookkeepers, and must be sufficiently detailed to withstand sustained scrutiny by IRS and state tax auditors. All of this can be expensive to accomplish.
We have nonetheless found that generating an accurate set of books and records and preparing corrected tax returns is cost-effective for the following four reasons:
- Reduced Tax Liability. A tax auditor invariably makes an estimate of the additional tax due, and he or she typically estimates “high.” Our firm, however, determines the exact tax, and that tax is usually lower than the auditor’s estimate. The auditor will, of course, agree to the actual tax due, since we have the ability to show exactly how we computed the correct tax.
- Reduced Penalties. Penalties are a percentage of the unreported or unpaid tax. Thus, reducing the tax liability (see immediately above) directly reduces the penalties. Penalty reduction is significant since, as noted above, penalties and related interest can often add 50 percent or more to the tax bill.
- Waived Penalties. IRS and state departments of revenue sometimes waive all penalties based on (1) a taxpayer’s sometimes justified reliance on inadequate bookkeeping services and (2) the taxpayer’s full cooperation, which frees up the tax auditor to conduct more audits.
- Re-Audits Avoided. As part of our rehabilitation effort, we help the business acquire the services of a licensed CPA and a competent bookkeeper. Once rehabilitated, IRS and the DOR will normally not re-audit the business since a rehabilitated taxpayer typically is not a significant source of large audit adjustments.
We have found that even the best tax audit defense is no substitute for preventing exposure to significant audit adjustments in the first place. Offers in compromise and installment payment agreements are not a “Plan B” for those who lose the “audit lottery.” Federal and state offers in compromise are invariably difficult and expensive to negotiate and typically subject businesses to unacceptable tax liens. Thus, some business owners ultimately pay over their entire “working capital” to the taxman, thereby threatening their ability to stay in business. Other business owners will preserve their “working capital” – but only at the cost of obtaining significant mortgages on their business or personal assets or by “raiding” their personal retirement accounts.
The 20,000 IRS letters reported by the Journal are therefore “fair warning” to business owners that they now have no choice but (1) to maintain accurate books and records and (2) to employ licensed CPAs and competent bookkeepers as their first line of defense against potentially catastrophic tax audits.
Attorney Morris N. Robinson, CPA, LLM is the in-coming President of the New England Chapter of the American Association of Attorney-CPAs. He is also managing Director of M. Robinson & Company, a Boston law firm that specializes in international, federal, Massachusetts and multistate taxation, including dispute resolution.