The Right Way to Avoid Tax Audits

While the IRS’s own figures reveal that, in general, it only audits 1% or 2% of all taxpayers each year, the threat of an audit continues to strike fear into every construction business owner. The Inflation Reduction Act of 2022 directed $80 billion in new funding to the IRS over the next decade so it could hire 87,000 new workers. Whether the increases will materialize or whether audit rates will increase, targeting more small business owners remains questionable. 

In reality, the IRS, which was once a large and inefficient federal bureaucracy, is becoming more streamlined and, most importantly, expanding its ability to catch more tax offenders. The IRS is replacing agents in back offices with computers with complex algorithms that cast wide nets that can pull many law-abiding people into audits. 

Penalties Abound

It is no secret that the IRS takes a dim view of a failure to report income — more than a minor overstatement of deductions. The IRS looks for incorrect expense totals, missing Form 1099s and transposed numbers, even if the mistakes are not big.

There is a penalty, and then there is the fraud penalty: equal to a whopping 75% of the unreported tax. While most penalties are based on the amount of the underpayments, the so-called “frivolous return” penalty is a flat $5,000 that can be imposed even if there is no underpayment. Fortunately, there are legal strategies that can greatly reduce that audit threat.

Tips From the IRS

The IRS offers a few steps that everyone can take to reduce the risk of becoming an audit target. For example: 

• Be specific about expenses.
• Provide more detail when needed.
• Be on time.
• Avoid amending returns.
• Match up all your paperwork.
• Don’t use the same numbers repeatedly.
• Don’t take excessive deductions.

Obviously, this list favors the IRS and the basic tax law. But keep in mind that striving for the lowest possible tax bill is perfectly legal. 

Beyond the Obvious

While businesses can explain many unexpected and significant swings in income, large inconsistencies in income from year to year are often areas of concern to the IRS. Large shifts in income can be indicative of someone hiding income in either the current year or in a past tax year. Other possible red flags include such things as: 

• Cash — Despite the postponed requirement that third-party payers report payments to recipients, cash remains a major red flag because it creates all sorts of problems for the IRS. Many businesses don’t report cash transactions because they believe they don’t have to or that the IRS will never know they received cash. However, today’s IRS targets returns where contractors may deal in large amounts of cash and considers it an audit red flag when a return contains a high probability of unreported income.
• Independent contractors — A disproportionate number of independent contractors as opposed to employees is more of an audit target today, with the states also on the lookout for general contractors or construction businesses using large numbers of independent contractors. Some businesses use independent contractors in order to avoid paying payroll taxes — federal and state — including the federally mandated employer portion of Social Security and Medicare. This doesn’t mean the business shouldn’t use independent contractors; it should just ensure compliance with the IRS’s worker classifications and the “worker status tests” that vary from state to state.
• Low salaries for S-corporation shareholders — Many business owners set up an S corporation instead of an LLC to avoid the 15.3% self-employment tax. However, while they aren’t subject to self-employment tax on distributions, S-corporation shareholders working as employees must receive “reasonable compensation.” The IRS is on the lookout for S corporations paying shareholder-employees unreasonably low (or even no) salaries. The IRS will compare compensation to the standard for a similar position in a similar industry. Regardless of the business entity, failure to provide shareholders/owners with reasonable compensation (as W-2 reportable wages) is an audit flag often leading to a more comprehensive audit of the entire construction business.
• The home office — Even prior to the pandemic, the home office provided a place for construction business owners to catch up on paperwork, bookkeeping or payrolls. With many taxpayers shifting to work from home during the pandemic, it should come as no surprise that the home office deduction faces extra scrutiny. The deduction for home offices is more complex than many construction business owners realize. The calculation for the home office deduction is based on square footage — but only the square footage used exclusively for business purposes.
• Vehicle deductions — If a contractor uses a personal vehicle for business purposes, he or she can usually deduct a portion of the vehicle expenses. If the contractor uses the vehicle exclusively for business, a deduction for depreciation is often available. Unfortunately, because 100% business use is unlikely in most cases, claiming full business use of a vehicle is an audit red flag. 

Reality vs. Triggers

In reality, no one knows which tax returns the IRS’s computer algorithms will single out. Tax professionals have used their experiences to develop the many so-called “triggers.” While the proposed increase in IRS staff may or may not impact the current audit rate that examines fewer than 2% of all income tax returns in a year, the penalties remain.

The statute of limitations for an IRS examination is three years from the due date of the federal tax return or the file date. This period doubles to six years if the return reveals a substantial understatement of income, which is usually more than 25% of taxable income. There is no time limit on failure to file a return for a particular year, or if the IRS suspects fraud.

Caught — Now What?

If the IRS selects a tax return for an audit, the business (or its owner) will receive a notice in the mail. The notice
is always sent to the last known address and is never sent by phone, email or social media.

If the IRS audits your business, it will most likely be through a correspondence audit. The letter will contain instructions about what information you must provide. If the IRS needs more information, its representatives will reach out again.

Should the IRS request an in-person meeting (typically at its regional office), the notice usually contains instructions about preparing for the audit and which particular items the IRS is examining. As an alternative, Letter 2205, a shorter version of the audit notice, will request a phone call and usually prefaces a face-to-face meeting.

Mixed Results

Remember, the IRS isn’t hiring 87,000 people to fill auditor-specific roles, and the chances of a construction business — or its owner — getting a visit from the IRS will continue to be remote. Although compliance with the IRS’s rules for many small businesses is fairly easy, especially with the help of a tax professional, keep in mind that an audit may not resolve all issues.

If the IRS audits a construction business — or its owner — it doesn’t mean all is not OK. IRS auditors rarely look at everything on a return. But if the IRS doesn’t challenge a deduction or accounting method, it doesn’t mean the operation is off the hook. A change in facts or a change in the law may mean the deduction or method is no longer valid. 

While it is impossible to fully inoculate the business or its owner since a portion of all audits are truly random, you can take steps to minimize the likelihood of receiving that feared notice from the IRS.

Honesty and clarity go a long way toward preventing, handling and surviving an IRS audit. Naturally, every construction business owner should have a strategy for avoiding audits and dealing with an IRS auditor.