James L. Beddow, PC

The IRS audits about 1% of the Schedule C’s filed each year. That’s the tax form sole proprietors complete to calculate their taxes from self employment. 25% of these returns report losses and 95% or so of the losses are deducted against other income. The GAO estimates that 70% of of those returns understated income or overstated expenses and the resulting unreported income is estimated at $40 billion. In 2008, the IRS devoted about 25% of total revenue agent time to auditing sole proprietors. This is a very inefficient use of agent time because these audits individually yield small amounts of money. The Treasury Department is giving some consideration to recommending limits on these deductions because they are so difficult to audit.

The U.S. General Accounting Office has issued a report containing 19 specific recommendations for closing the tax gap by auditing employers with a high likelihood of using misclassified workers. The 19 recommendations include:

• Clarify the distinction under federal law
• Allow workers to challenge the classification determination in Tax Court.
• Define misclassification as a violation under the Fair Labor Standards Act.
• Narrow the definition of “a long standing recognized practice of a significant segment of the industry”, which would eliminate one avenue of penalty relief.
• Lift the ban on IRS/Treasury issuing regs or revenue rulings clarifying employment status of individuals for purposes of employment taxes.

In short, GAO recommends cracking down in this area. The IRS is about the initiate a National Research Program that will involve “randomly” selecting employers to audit, for the purpose of developing statistical data for guilding audit selection.

Also, be aware that the IRS and 34 states share employment tax misclassification information and the IRS shares some information with all 50 states. If a company has workers re-classified as employees, the past due state unemployment taxes trigger increased federal employment tax rates by a factor of 775%, from .8% to 6.2% of the first $7,000 paid an employee. Reclassification promises to be an expensive proposition if it’s done by the IRS.

The IRS has issued temporary regs which hold that an understatement of gross income in a partnership resulting from an overstatement of basis in a partnership extends the statute of limitations on the return from 3 years to 6 years if it’s a 25% understatement of gross income.  The IRS has lost several court cases on this issue and now believes they have the power to issue regs based on the wording in a Supreme Court case.  This is a very complex issue and taxpayers should consult their tax advisor if they’re involved in a partnership. There are two important points here. First, the IRS will continue to litigate this issue, so if you’ve got grief in this area, more is coming. Second, taxpayers should have an accurate basis calculaton for partnership and S corporation interests so they’re not caught in this trap.

The Treasury Inspector General for Tax Administration (TIGTA) issued a report on August 5, 2009 entitled “Potential Opportunities Exist to Enhance the Favorable Productivity Trends for Audits Initiated by the Updated Return Selection Formulas”. (With a title like that, who needs the report?) The reports says that fewer returns flagged by the formulas are being closed with no changes. These formulas are used by the IRS Small Business/Self Employed Division to identify incorrect returns and bring them in for audit. The good news is that if your return is right, the IRS is trying not to hassle you. You are not their target since they won’t get more money from you. Testing continues in an effort to make audits more efficient and to more tightly target bad raturns.

During the 2008 filing season, the Treasury Inspector General for Tax Administration at the Department of the Treasury found that a majority of tax returns prepared by a sample of unlicensed, unenrolled preparers contained substantial errors, according to TIGTA assistant inspector general for audit Michael McKenney. The auditors posed as taxpayers and paid to have 28 tax returns prepared at 12 commercial chains and 16 small, independently owned tax preparation offices.

“TIGTA found that these preparers made substantial errors when completing tax returns and correctly prepared only 39 percent of the returns,” he said. “Of the 61 percent of the returns that were prepared incorrectly, 65 percent contained mistakes and omissions that were considered to have been caused by human error or misinterpretation of the tax laws. The remaining 35 percent contained misstatements and omissions that were considered to have been caused by willful or reckless conduct.”

That means that 1/3 of the incorrectly prepared tax returns contained acts of willful or reckless misconduct. When the IRS uncovers these errors, it’s the taxpayer that’s still responsible for the late tax payments, penalties and additional preparation charges for amended state income tax returns.

He added that none of the preparers in the sample exercised due diligence in determining whether the undercover investigators were eligible to receive the Earned Income Tax Credit. TIGTA is calling for a unique identifying number for each preparer to keep better track of errant tax preparers.

The Earned Income Credit has been previously identified as a common tax fraud vehicle and is under close scrutiny by the Internal Revenue Service.
(Some of this information came from WebCPA)

A new Treasury Inspector General for Tax Administration recommend that the IRS use mortgage interest reporting to identify people who have mortgage interest but fail to report enough income to cover mortgage debt. In one statistical study with 95% confidence, the TIGTA found 219,593 individuals without a corresponding tax return, based on 2005 data. TIGTA choose 100 of these randomly and found 21 that appeared to have a filing requirement, but had not been contacted by the IRS. Only an IRS examination could confirm whether or not there are uncollected taxes, but it appears to be an avenue to help close the tax gap.