Laura Saunders wrote a wonderful article published in The Wall Street Journal titled “Are You Ready to Be Audited?” The article provides great insight into factors that influence why the IRS selects certain taxpayers to be audited based on income and errors reported on a return.
This blog dissects the audit issue a bit further to provide business owners with some insight into why they may be selected for an audit and the pitfalls if they are audited.
The key to the IRS’ decision to audit is based in part on the IRS’ Discriminant Function (DIF) score and in part on the type of return filed. In 2007, the Government Accountability Office (“GAO”) prepared a report for Congress to identify taxpayers who largely contributed to the tax gap. The tax gap is essentially the amount the U.S. Government estimates to be unreported and owed for taxes. In its report, GAO states: ” [M]ost sole proprietors, at least an estimated 61 percent, underreported net business income, but a small proportion of them accounted for the bulk of understated taxes.”
The reason small business owners attempt (and do) underreport income is because some income small business owners receive cannot be documented – not all businesses receive 1099s (i.e. those that sell products versus services or corporations are not all required to be issued a 1099). Congress recognized this gap in reporting and has already begun closing the avenues of unreported income. For example, merchant processors are now required to issue a 1099-K to all businesses who receive credit card proceeds. The 1099-K even breaks out gross proceeds by month to provide a statistical average or trend for the IRS to examine.
Furthermore, if the IRS flags a return for an audit of a business, the business owner(s) are usually audited as well, especially for S-corps, partnership, LLCs, etc, where the income flows through to the shareholders’ or partners’ returns. Once an audit is commenced for a company, payroll records are frequently reviewed and 1099s are examined as well as 941s and 940s (payroll returns). One common issue is misclassification of employees as independent contractors. If the business has underreported its payroll taxes, officers, directors, and shareholders working in the business entity can be personally liable for a portion of the unreported payroll taxes, also known as a “Trust Fund Recovery Penalty” (“TFRP”). The TFRP is not a penalty but a legal method for the IRS to make parties who are responsible for paying payroll taxes, and do not turn over these funds, personally liable.
Our law firm defends officers (CFOs, CEOs) against the IRS to minimize a TFRP assessment. These cases require a clear understanding of the taxpayer’s business (i.e. manufacturing business versus a retail establishment) and the legal issues that define when a person is responsible for the TFRP. The IRS routinely holds officers liable because they have a “duty” to oversee the payment of taxes. This is not conclusively. There have been cases of a single shareholder and CEO of a corporation that did not pay payroll taxes or file payroll reports who was found not to be liable for the TFRP. However, there was, and must be, a person who is responsible.
If you are a CEO or CFO and the company you work for owes payroll taxes, contact our office to speak with an experienced tax attorney to determine your legal rights before the IRS begins their investigation.
Learn more about the IRS and tax law from our San Diego tax lawyer.