Small corporate clients may be subject to more exacting audits from the IRS in the near future. The Treasury Inspector General for Tax Administration (TIGTA) recently issued a report containing recommendations for improving the IRS's performance in audits of corporations falling within the purview of the IRS Small Business/Self-Employed Division (SB/SE).
SB/SE currently serves more than 57 million taxpayers, among them 9 million small businesses with assets of less than $10 million.
Background
For Fiscal Years (FY) 2006 through 2011, SB/SE reported an average of 32 percent of its audited corporate returns as "no-change," meaning examiners made no recommendations for additional taxes for those audited returns.
The "no-change" rate has been shrinking and agent productivity has been rising in recent years, even as the IRS is called to do more. For FY 2011, the additional taxes recommended per IRS agent's hour was $843, a marked improvement from $384 in FY 2006. For fiscal years 2006 through 2011, the no-change rate was, respectively, 37 percent, 38 percent, 28 percent, 32 percent, 28 percent, and 27 percent.
Although IRS management is prohibited by Congress from evaluating agents individually on dollar productivity for their audits, records are kept for other purposes.
The high corporate return "no-change" rate, according to TIGTA, suggests that the IRS is wasting its resources on unproductive and needlessly burdensome audits targeting the wrong small corporations. On the other hand, the report speculated that the high rate may stem from inadequate audits that, among other things, ignored major discrepancies between the labor costs deducted on the return and the amounts reflected on employment tax returns filed with the IRS.
Increased Small Business Audits
The TIGTA report represents a development in a larger push by the IRS to improve tax compliance among small businesses, an area considered ripe with compliance issues. A 2007 Government Accountability Office report on the tax gap estimated that sole proprietors in particular had underreported their net 2001 income by 57 percent. The report found that 39 percent of all sole proprietors had erred in reporting their gross income on Schedule C and 11 million had overstated their expenses by $40 billion. Of the $345 billion tax gap from 2001, sole proprietors accounted for $68 billion, or 20 percent.
Small corporate taxpayers may be able to predict what is in store for them by comparing the IRS response to previous TIGTA reports on small business audits. In September 2010, for example, TIGTA issued a report on IRS audit performance with respect to sole proprietorships, viewing the area as one still rife with compliance problems, both intentional and unintentional. TIGTA found, however, that IRS audits covered only a small portion of sole proprietors each year. The IRS's Data Book for FY 2008 showed more than 4.9 million sole proprietors, but just 72,801 field audits and $1.1 billion in recommended additional taxes.
IRS and Unincorporated Businesses
SB/SE audits consist of several preliminary tests for unreported income, or "minimum income probes," which begin with the Financial Status Analysis, or Cash-T analysis. Using the Cash-T probe, IRS examiners compare the balance sheet and income statements from the year under audit with prior/subsequent year data. TIGTA reported in September 2010 that for FY 2008 it had sampled 227 sole proprietor audits and found the Cash-T stage of the income testing to be lacking. Notably, in several cases, examiners did not consider the taxpayer's personal living expense (PLE) data or determine whether the reported income was sufficient to pay both for the business expenses deducted on the tax return as well as the taxpayer's basic rent, food, clothing, and other living expenses not included on the tax return.
In a 2010 report, TIGTA recommended the IRS should increase examiner accountability for their audits by instructing group managers to provide written feedback to their examiners on their application of the minimum income probes. They should also incorporate that feedback into the examiners' progress reports and annual appraisals. Finally, TIGTA recommended that IRS examiners consider PLE data in their Cash-T analyses.
In another 2010 report, TIGTA report estimated that the tax gap for unreported income earned by unincorporated businesses and unpaid self-employment tax was still $148 billion. While this represents a marked improvement over the figure from 2001 contained in the GAO report, TIGTA would still like the IRS to improve small business audit performance. TIGTA plans to release reports on S corporation and passthrough entity audits with similar findings later in the fiscal year.
IRS and Small Corporations
The latest TIGTA report targets IRS audits of small, closely-held corporations. The opening lines of the report state that close corporation transactions are often structured to avoid tax compliance. The report states:
"Shareholders typically have a significant amount of control over managing and directing the day-to-day operations of the corporation. This, in turn, provides opportunities to improperly structure transactions so they reduce the income taxes owed by the corporation or the shareholders. Corporations and shareholders that take advantage of such opportunities to understate their tax liabilities can create unfair burden on honest taxpayers and diminish the public's respect for the tax system".
TIGTA found that audits of close corporations increased the recommended additional taxes, but TIGTA still had quality concerns. Among these concerns, the report stated, IRS examiners ignored or overlooked many discrepancies between the corporate return and other returns that were filed or should have been filed, such as information returns, employment tax returns, and shareholders' individual tax returns.
National Quality Review System statistics cited in the report stated that examiners had failed to complete these required filing checks in an average of 24 percent of field examinations. Additionally, for the reporting periods between 2006 and 2010, the percentage of examiners that had not completed the filing checks had never been lower than 22 percent.
TIGTA made several recommendations:
• Examiners should take advantage of the IRS's automated information systems to complete their checks for filed returns;
• First-line managers should continue to monitor audit performance and provide written feedback on points where examiners could improve their filing checks, while also citing specific examples of accomplishments and achievements in their reviews.
IRS Return Selection Methods
In light of TIGTA's report and recommendations, the IRS is updating the Discriminate Index Function (DIF), used to score corporate tax returns for their audit potential. The DIF assigns a higher score to corporate returns containing red flags such as larger-than-usual deductions, losses, and expenses, blank sections, and too many round numbers. The higher the score, the more likely a corporate return will trigger an audit.
The high "no-change" rate may be due in part to outdated DIF formulas, last updated in 1988. The report stated the following:
"Consequently, it is no surprise that the passage of time has made using the DIF less useful for identifying and searching returns for audit, given the tax law and economic changes that have occurred."
In light of the age of the DIF formulas, the current policy is for the IRS to use non-DIF sources to select appropriate corporate returns for audit. This is one factor that TIGTA attributes to the increasing amount of recommended additional taxes. For FY 2010, 45 percent of the corporate audits involved returns selected by non-DIF sources.
The IRS plans to conduct a National Research Program study of tax compliance by small corporations and small corporate shareholders. The study could lead to an updated DIF that the IRS would use to generate a new workload identification formula for taxpayers with similar situations as those selected for the study. Officials anticipate that the study will involve the selection of 2,500 returns from the 2010 tax year filed by corporations with assets of less than $250,000.
SB/SE Measures to Improve IRS Performance
In light of the likely increase in number or intensiveness of IRS small corporate audits, TIGTA recommended that practitioners should alert their corporate clients to several IRS programs and initiatives designed to improve small business tax compliance. ).
Voluntary Classification Settlement Program (VCSP). Under the VCSP, qualifying employers can reclassify their workers as employees rather than improperly classified independent contractors, for whom they pay no employment taxes. In exchange for their voluntary compliance with the tax laws, they will pay an amount of just over one percent of the wages paid to the reclassified workers for the past year, but without interest or penalties. Additionally, the employers will not be audited on the reclassified workers' payroll taxes for prior years.
To qualify, employers must have consistently treated the workers to be reclassified as nonemployees and filed all required returns, such as Form 1099, for at least the three prior calendar years. In addition, employers may not currently be under audit for worker classification issues by the IRS, U.S. Department of Labor, or any state government agency.
IRS outreach efforts. Acknowledging that SB/SE compliance issues arise out of taxpayer ignorance of the ever-changing Tax Code, the IRS has focused on increasing its customer service, website navigation, and available educational materials.
Because the majority of SB/SE division tax returns are prepared by practitioners, much of the outreach effort is intended for practitioners. But telephone assistance is available for businesses during the work week, from Monday through Friday, 7:00 am to 10:00 pm EST. There is a 24-hour recorded assistance line as well.
The IRS.gov website also offers a Virtual Small Business Tax Workshop to educate small business owners about their Federal tax obligations. Common business issues covered on the website include how to apply for an Employer ID Number (EIN), regularly used small business forms and publications, which factors generally determine a worker's status, and more.
"Shareholders typically have a significant amount of control over managing and directing the day-to-day operations of the corporation. This, in turn, provides opportunities to improperly structure transactions so they reduce the income taxes owed by the corporation or the shareholders."
No comments:
Post a Comment