While IRS audit rates are down considerably and the chances that you’ll be examined are small, recognize that there are still thousands of small business owners audited each year. Even though tax season is now over, here are three IRS hot button issues for the coming year, why you should avoid them, and what happens if you don’t and the IRS audits you.
3 IRS Hot Button Issues To Avoid
Never Omit Business Income
The government knows what your income is in many cases. Income is reported to the IRS on Form 1099-MISC  if you’re an independent contractor or if you receive royalties. It also knows your income from partnerships and S corporations through Schedule K-1 filed by the entities. And banks, PayPal, and other processors of credit cards and electronic transfers report these transactions on Form 1099-K.
However, many small businesses are cash intensive. They don’t use credit or debit cards or receive payments by check; business is done largely or partially in cash. Such businesses include beauty shops, bail bonds, car washes, coin operated amusements, convenience stores and mini-marts, laundromats, scrap metal, and taxi cabs.
Why you should report all income. Besides the fact that it’s required by law so it’s the right thing to do, also consider that the IRS is on the hunt for businesses that don’t report income. It suspects that a significant portion of the $385 billion “tax gap,” which is the spread between what the government actually collects and what it believes it should collect, is because Schedule C filers under-report their income. The IRS has an audit technique guide  for its agents to use in examining cash intensive businesses.
An underpayment of tax can be subject to civil penalties and interest. Use care because even inadvertent omissions can be penalized. I once received Form 1099-MISC with two entries. I only noticed one when I completed my tax return, and had to pay up when the IRS computers detected the omission.
If there’s fraud involved in your omissions, this can lead the IRS to pursue criminal penalties. It’s a lot less costly to report income and pay the resulting tax than to pay penalties or have to fight criminal charges.
Never Mis-classify Workers
From a company perspective, it is much less costly to use independent contractors than employees. The added costs for employees include FICA (Social Security and Medicare taxes), federal and state unemployment taxes, workers’ compensation, and other benefits, some of which are mandated (e.g., health coverage for a business with 50 or more full-time/full-time equivalent employees). However, you cannot simply label a worker as an independent contractor to duck employer responsibilities. The worker must truly be an independent contractor for you to treat him or her as such. It comes down to control. Essentially, if you can say when, where, and how the work gets done, likely the worker is your employee.
Why you should properly classify workers. The IRS, as well as the Department of Labor, and state revenue departments are all looking to make sure that you’re treating workers correctly. When the IRS examines a business return, it almost always checks on worker classification. There are big bucks at stake. The U.S. Department of Labor recouped  more than $83 million in back wages for about 108,000 misclassified workers in 2013. New York, for example, last year found  (PDF) 26,000 cases of misclassification that resulted in assessments of $8.8 million in state unemployment taxes.
If you misclassify workers and the IRS correctly treats them as employees, you can face severe penalties and interest for back employment taxes. Just to give you some idea:
- $50 per unfiled Form W-2
- Penalty for failure to withhold income taxes and the employees’ share of FICA
- Penalty for failure to pay the employer share of FICA. The failure to pay taxes is 0.5% of the unpaid tax liability for each month or part thereof, up to 25% of total liability.
If there’s fraud or intentional misconduct, there are penalties of 20% of wages, 100% of FICA taxes (both the employees’ and employer share). And there can be criminal penalties in extreme situations.
Altogether, penalties can be so severe that they wipe out the business. Moreover, an employer then owes back benefits to the newly-classified employees (e.g., vacation pay, sick leave, retirement plan contributions, medical coverage). And the IRS shares information with the states, so back state unemployment taxes and workers’ compensation will be due.
Never Falsify Documents
For tax purposes, businesses are required to keep books and records, and to have certain documentation to support positions claimed on tax returns. For example, if you drive your personal vehicle for business, you need a written record of mileage and other information to back up a deduction for the business driving. Unfortunately, many business owners are lax when it comes to recordkeeping. Some try to re-create documents after the fact, such as when they receive an audit notice.
Why you should never falsify documents. The government isn’t as dumb as some taxpayers believe. The IRS has been able to show in some cases that documents are phony. In one case (PDF), a taxpayer in the floral design business created fake receipts for her purchases in order to fabricate deductions. The court concluded that she never made any such purchases and imposed a fraud penalty on top of back taxes, interest, and penalties for the underpayment of tax.
As is obvious, falsified documents usually amount to fraud. There’s a myriad array of civil and criminal penalties for fraud, as listed in the IRS chart.
Do things right and avoid IRS hot button issues! You will not have penalties and hassles with the government if you do and it lets you do what you do best: run your business.
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