Surviving a Business Audit

Introduction

RS sends an audit notice demanding an extensive list of records, none of which you have.

Terror strikes and you think to yourself: Am I going to jail? Will I be wiped out financially? Did they find out about those under-the-table payments? If I had known how frightening this is, I would have kept better records

So now’s your chance.

Audit Prevention

Here are several basic steps to protect yourself when the tax man comes knocking:

1. Use a separate credit card and bank account for your business. Do not co-mingle (mix together) your personal and business income and expenses. Always deposit your business income into your business account, never into your personal bank account. Transfer funds from your business to your personal account when you need money.

2. For each tax year, purchase an accordion file with monthly slots and place invoices, receipts and bank statements in the appropriate slot. Label the file with the year.

3. If you deduct automobile expenses, notate either a paper or electronic calendar each time you travel on business. Record the client, location and purpose of the travel. Deduct only the portion of the expenses actually used for business.

4. If you claim entertainment expenses, pay by business credit card and jot down on the receipt: the client, his or her company and the purpose of the meeting. Note this information in your calendar as well. When you receive the monthly credit card statement, staple the notated receipts to the statement, or record the information from your calendar or receipts on the statement.

5. When determining your gross business income, make sure your business account deposits correspond to your paid billing invoices and account for any cash received, checks deposited into your personal account or checks cashed by a third party.

During an audit, IRS may compare these amounts and if unreported income is discovered, expect a penalty in addition to the taxes and interest owed. If the discrepancy is large, consult with a tax attorney immediately, as this might lead to civil fraud or even criminal charges, depending on the circumstances.

6. If you are paying workers as independent contractors, make sure you know the rules and comply with them. You should have a written contract. Obtain a Form W-9 from the worker, pay by check (note the project in the memo section) and issue an Form 1099. However, if an individual is really an employee, do not try to classify the person as an independent contractor, otherwise, you are inviting big trouble.

7. To minimize the tax consequences of an adverse audit, timely and fully pay your quarterly estimated taxes, or overpay and apply any refund to next year’s estimated taxes. Be sure to file your Form 1040 on time, or request an extension.

Remember, the failure to file penalty is generally 10 times higher than the failure to pay penalty – so file timely, even if you cannot fully pay your taxes.

Conclusion

Take these common-sense steps now to prevent a potential tax disaster. Record your business income and expenses using accounting software, such as Quickbooks, and work with a bookkeeper to set up your account systems correctly from the start.

If this sounds like too much trouble, imagine when the IRS comes knocking at your door and your reaction of sheer panic.

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Amusing Tax Tidbits

Introduction

Oops. I forgot to publish a newsletter for March. So here it is, over a month late.

I decided to write about several recent tax news items.

Pole Dancing

In the nice try department: An enterprising taxpayer tried to dodge New York sales tax by claiming his strip club’s pole dancers were “artists,” thus exempt under a “dramatic arts exception” to sales taxes.

Taxpayer’s expert witness testified that pole dancing was a choreographed dance performance within the meaning of art. The court, however, did not buy it, concluding that pole dancing was learned from other dancers, or on YouTube, and did not fall within the art of dance.

Adding insult to the dancers, the court analogized pole dancing to “peep show” performances, rather than ballet or opera, holding that payment of cover charges and fees for private dances were no different than the entertainment sought at peep shows, which, according to a another court ruling, were subject to New York’s sales tax.

IRS v Palin

Okay, tea baggers, who wins a popularity contest commissioned by Fox News during tax time – the Tea Party, Sarah Palin or IRS? Surprise! IRS smoked them both, receiving a favorable rating of 49% compared to the Tea Party’s 36%, with Mrs. Palin trailing the pack at less than 25%. In fact, IRS was tied in popularity with President Obama.

However, not all the news is bad for the tax baggers: Their nemesis Speaker Nancy Pelosi received 29%, Senate Majority Leader Harry Reid was less popular than Palin with 16%, however, House Minority Leader John A. Boehner, a Tea Party supporter, checked in at just 12%.

After its victory, rumor has it that IRS hired a personal trainer to tone up for the swimsuit contest. Competitors are diving for cover.

Court Rejects Geithner Defense

Taxpayers using Turbo-tax cannot blame the program to avoid negligence penalties, according to a recent court decision. The court rejected the so-called “Geithner defense”, named after Treasury Secretary Timothy Geithner, who, during his Senate confirmation, blamed Turbo-tax for errors on his tax return.

The court noted that the taxpayers did not consult professionals, visit the IRS website or read the relevant instructions to make sure they were filing their tax returns correctly. The court then stated that it did not accept taxpayers’ misuse of TurboTax, even if unintentional or accidental, as a defense.

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PILOT CRASHES INTO IRS BUILDING: IS SECTION 1706 TO BLAME?

Introduction

On February 18th, a deranged taxpayer smashed his airplane into an IRS office in Austin, Texas, killing himself and a long-time IRS employee.

While this terrorist ranted against several institutions of authority, including the Catholic Church, his suicide note blamed an obscure tax provision, IRC Sec. 1706, for ruining his life.

How could this be?

High-Tech Workers

Section 1706 of the Tax Reform Act of 1986 (P.L. 99-514), enacted in 1987, caused a schism between high-tech companies and their self-employed consultants.
Prior to IRC Sec.1706, professionals who formed single-owner consulting businesses considered themselves independent contractors, but Congress then singled out high-tech programmers, engineers and analysts and, in essence, reclassified them as employees of the companies receiving their services.

Note: Section 1706 is not part of the Internal Revenue Code. It is subsection (d) to Section 530 of the Revenue Act of 1978.

Upshot

After enactment of IRC Sec.1706, large and mid-sized high-tech firms stopped hiring professionals operating as independent companies and forced them to join the payroll as employees

Thus, Congress targeted this particular class of entrepreneurs and crushed their American dream of owning and growing their independent consulting businesses.

IRS Rationale

Section 1706 was supposed to recover revenue allegedly lost through tax cheating by consultants who owned their businesses.

However, later studies concluded that IRC Sec.1706 did not raised revenues and may have cost the government money. In response to these studies, Congress tried, but failed, to repeal the law.

Conclusion

Sometimes, enacting a tax provision produces unintended results.

Section 1706 harmed the budding industry of professional consultants owning their companies, including — according to his suicide note — the crazed pilot who crashed into the IRS building in Texas. This discriminatory law should be repealed.

Ironically, IRS has recently stepped up audits against high-tech consultants in the search for additional revenue and, once again, has been aggressively reclassifying them as employees. Will Congress finally intervene?

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