In the 2021 fiscal year, the Internal Revenue Service (IRS) engaged in more than 15 million compliance activities. The IRS consistently demonstrates a response to certain actions on federal tax returns that significantly increase the risk of an audit, including any errors of commission and omission. Additionally, the Inflation Reduction Act in August 2022 allocated $79.6 billion in special funding for the IRS, with $45.6 billion alone for tax enforcement activities, hiring examination agents, legal support and investment into investigative technology. This means the IRS will continue to improve how it evaluates and investigates certain actions related to federal tax returns – now more than ever, businesses should be aware of common IRS audit triggers and how to avoid them.
The following capture the top issues discussed by Tomika regarding the risk of an audit trigger:
- S-Corporations – Shareholder and Partner BasisLoans to shareholders/partners could be a disguise for potential unreported income to the owner.
- Distributions could be a red flag if they are more than individual basis or if there is an unreported gain on distributed appreciated property.
- Any losses deducted more than stock/debt basis for shareholders could raise a warning to the IRS. Remember, shareholder loan guaranty does not establish a debt basis without the economic outlay.
- S-Corporations – Officer Compensation
- An owner who works in an S-Corporation should be deemed an employee. Compensation for services must be via W-2 wages before non-wage distributions via Form 1099 or 1099-NEC.
- Reasonable compensation factors include duties and responsibilities, time and effort, payments to non-shareholder employees, and industry standards.
- Unreported Income
- Make sure that any third-party information is reported from the Form 1099-misc or 1099-K (PayPal, Square or Stripe).
- Document Matching (Non-Income Related).
- For example, you cannot have the following: Report salaries and wages without a filed W-2
- Significant contract labor without a filed Form 1099-Misc
- Schedule K-1 activity with unreported pass-through activity
- Other considerations include:
- Bad debt expenses for a cash basis business
- Lumping all expenses in “Other Deductions.”
- Significant fluctuations
- Passive activity and at-risk limitations for loss deduction
- NAICS expense inconsistencies
- High income high, wealth (HIHW) taxpayers
- Cryptocurrency
- For example, you cannot have the following: Report salaries and wages without a filed W-2
COVID-19 Related Topics
The Employee Retention Credit (ERC) filing deadline is April 2024 for the 2020 tax year and April 2025 for the 2021 tax year. With the extension on the period for assessment, the IRS has until April 2026 and April 2027, respectively, to audit these returns for any ERC issues (this was previously a three-year statute of limitations).
Exam Resolution Options
Exam resolution options when facing an audit include:
- The settlement with Exam (e.g., Manager’s Conference)
- Fast-Track mediation (only a limited number of issues)
- IRS Appeals
- Post-Appeals Mediation (PAM)
- Litigation
Be Proactive
Taxpayers can anticipate and plan for an IRS audit by ensuring thorough documentation to support the tax return. Remember to preserve any documentation that supports transactions, such as appraisals, tax opinions, detailed calculations, etc., and interview key employees who are retiring or leaving. You can also prepare detailed responses in the year of occurrence – i.e., don’t wait for the audit notice to begin preparation. If legal consultation is needed, protect attorney-client privilege materials, and maintain all documentation until the statute of limitations expires. Individual taxpayers should also obtain IRS online transcripts before filing.
For more information, contact Tomika Bullet at [email protected].
