The head of the small business/self-employed division of the Internal Revenue Service (IRS) has promised more audit activity in 2009.
Faris Fink, who runs the division focusing on the nation’s small businesses and the millions of self-employed persons, outlined a broad approach to increasing audit coverage of a wide range of business forms, saying, “That is where we are seeing the most abuse.”
The IRS intends to look closely at flow-through entities that issue K-1s but report no wages paid. Such entities file an information return, but the profit or loss flows through to the owners, who report the income or loss on their own tax returns. These include subchapter S corporations and partnerships.
Questions Over Wages
In each case, the entity’s tax return carries no tax liability; it simply reports income and expenses. The IRS intends to ferret out ignorance and abuse on the part of tax professionals and taxpayers alike over whether and to what extent self-employed owners of these businesses must pay themselves a salary.
The issue is important to the IRS because profits taken as distributions other than salary are not subject to Social Security taxes. By minimizing salary, a taxpayer can reduce his or her payroll tax hit.
But the IRS, tax code, and courts declare such entities must pay their employees a salary commensurate with the fair market value of the services they render. That means self-employed owners must draw a salary and cannot take all their compensation in the form of distributions not taxable for Social Security.
The ignorance comes in when small business owners do not understand they must pay themselves a salary subject to Social Security taxes. The abuse comes in when they know it but simply do not obey. The IRS’s audit program will focus on this issue.
Expanding Audit Areas
Several other areas will attract IRS attention next year.
The IRS will increase the number of correspondence audits. The agency can audit many more people through the correspondence process than it can in a face-to-face environment. Hence it will focus resources on the correspondence process for the vast majority of low- and middle-income citizens.
Even in the current National Research Program audit cycle, which is targeting 13,000 tax returns for audit, 5,000 of those will be done in whole or in part through the correspondence process.
The IRS will continue its use of “fraud specialists.” For some time the IRS has been working to increase the number of tax fraud prosecutions by (a) incorporating more-sophisticated fraud detection training for tax examiners and (b) planting “fraud technical advisors” directly into existing examination teams. The new head of the IRS’s Criminal Investigation (CI) function, Eileen Mayer, says the IRS will continue using these fraud specialists as consultants in ongoing examinations.
These advisors are senior examination agents or revenue officers specially trained and experienced in detecting tax fraud. They guide auditors in spotting potential fraud.
CI will continue to target “legal source income cases,” ones involving legitimate businesses, not drug dealers, organized crime figures, etc. The IRS will focus heavily on employment tax cases, including failure to pay employment taxes, failure to file employment tax returns, conspiracy to evade employment taxes, and filing false employment tax returns. IRS officials declare this area of criminal law enforcement is “not dormant anymore.”
Increasing Audit Activity
The IRS will also target more medium-sized corporations. Corporations with income up to $10 million will see more audit activity in the coming year. Though this is not said to be a major focus of IRS’s increased audit activity, the agency will strive to increase audits of these corporations.
Another new “major focus” will be on worker classification cases. These center on whether a worker is properly classified as an independent contractor or an employee. Many companies seek to save money by classifying workers as independent contractors, as it cuts employment taxes and compliance burdens. But when those workers are misclassified, the IRS imposes substantial taxes and penalties.
John Tuzynski, the IRS’s chief of employment tax issues, promises “a nice increase” in the number of employment tax cases over the next year. This will be a major focus for the IRS, and the agency has entered into data-sharing agreements with a number of state tax departments.
The agency will provide employment tax training manuals to the states, train state tax examiners in these issues, and provide leads to states on noncompliant businesses and information on cash payments made by employers to their workers. Tuzynski promises the IRS is “extending this [agreement] out to all 50 states.”
Going After Preparers
The IRS will also put the crosshairs on tax return preparers. For years the IRS has been squeezing tax preparers and their representatives. I have stated many times that the combination of preparer penalties and intimidation by the IRS against representatives show the agency wants to make the tax professional community into nothing more than tax collectors paid by the private sector.
The IRS promises it will “aggressively pursue preparers” who “push the envelope” with their clients by systematically employing improper strategies for them. It is currently pursuing about 108 preparer examination cases, where the IRS selects for audit dozens of tax returns prepared by a given tax professional.
Preparer examination cases can lead to (a) preparer penalties, including the section 6701 penalty for advocating abusive tax schemes, (b) civil lawsuits by the Justice Department for injunctions, and (c) criminal prosecution in the most egregious cases.
Dan Pilla ([email protected]) is a tax litigation consultant and author of numerous books on IRS abuse prevention and cure and problem-resolution issues. His newest book is IRS, Taxes and the Beast. He also publishes the Pilla Talks Taxes newsletter. An earlier version of this article appeared in the June/July 2008 issue of Pilla Talks Taxes. Used with permission.