Who is afraid of an IRS audit?
Honesty and clarity go a long way toward preventing, dealing with and surviving an IRS audit.
While the IRS’s own figures reveal that, in general, only 1% or 2% of all taxpayers actually have their returns audited each year, one of the more nerve-wracking aspects of taxes for many optometrists and practice managers continues to be the possibility of being audited.
In reality, however, what was once a large and inefficient federal bureaucracy, the IRS is becoming more streamlined and, most importantly, catching more tax offenders. Today, the IRS enforces the tax law in a number of ways, including the increasingly more common correspondence (examination by mail) audits and the dreaded field (face-to-face audit) examinations.
Agents in back offices are being replaced by computers with complex algorithms that cast a wide net, one that pulls many law-abiding people into the chaos of an audit. The result is that many optometry practices — and their principals — are being scrutinized far more often than the numbers indicate.
According to the latest figures, the IRS audited almost 1.1 million tax returns, approximately 0.5% of all returns filed in 2016. Of the audits conducted during 2017, 70.8%, were via correspondence. The remaining 29.2% were field audits. Of the more than 1.1 million audits, almost 34,000 resulted in additional refunds totaling more than $6.6 billion.
A smaller target
- Computers are less forgiving than humans. Any optometric professional who hopes to survive and thrive under the new algorithm-based IRS should follow a few guidelines:
- Always be prepared for scrutiny. Understanding the tax rules and potential red flags is essential to knowing what information should be saved and for how long.
- Be prepared to move quickly. Information Document Requests (IDRs) and face-to-face audits now move on a shockingly fast timeline, so have a plan of action. Build a relationship with an accountant who can step in quickly when you get the dreaded IRS audit notice.
- Consistency is key. Inconsistencies in paperwork happen even to honest people when the accounting is not handled professionally. The IRS, however, is increasingly seeing discrepancies as fraud until proven otherwise.
- Expect no mercy. IRS agents are being allowed no wiggle room and no grace. This attitude is being passed on to the optometry practices, professionals and businesses they deal with.
Employment tax ‘bug-a-boos’
According to the latest available figures, as of December 2016, 1.4 million employers owed approximately $45.6 billion in unpaid employment taxes, interest and penalties. Lawmakers, as well as the IRS, are aware that noncompliance with employment taxes, such as withheld income taxes, Social Security and Medicare taxes, is a growing problem.
Employment taxes, including withheld income, Social Security and Medicare taxes, account for nearly 70% of taxes collected by the IRS. The so-called Trust Fund Recovery Penalty is a weapon that allows the IRS to assess a civil penalty against any “responsible person” who willfully fails to pay over a practice’s withheld employment taxes. A responsible person can be the optometry practice’s manager or bookkeeper, its principal(s), its payroll service, its accountant — or all of them. In addition, the rules also make it a crime to willfully fail to collect or pay over these taxes.
In addition to employment taxes being a large target for IRS auditors, taxable wages for worker classification and fringe benefits were among the most frequently misreported, leading to the highest wage adjustment amounts on average. Worker classification issues arise when employers misclassify employees as independent contractors or other nonemployees and fail to withhold and pay employment taxes.
The IRS’s 2016 Data Book indicates a greater than 40% increase in all employment tax civil penalties assessed in 2016 from those in 2015. This appears to signal a greater focus on employment tax enforcement is underway and likely to continue.
Partnerships vs. partners
The Bipartisan Budget Act of 2015 replaced the rules governing partnership audits with a new centralized program that, in general, assesses and collects tax at the partnership level. Under the new rules that kicked in beginning with the 2018 tax year, any income tax resulting from an adjustment is assessed and collected at the partnership level — not from the partners. It is a similar story with any penalty, addition to tax or additional amount related to an adjustment that is determined at the partnership level.
The new rules outline the procedure an optometry partnership can use to elect out of the centralized partnership audit program. Only an eligible partnership, one that has 100 or fewer “eligible” partners, may elect out of the centralized partnership audit regime.
An eligible partner is any person who is an individual, regular C corporation, eligible foreign entity, S corporation or the estate of a deceased partner. Unlike other sections of the tax law, a husband and wife are not treated as a single partner for these purposes.
Poor documentation is a death sentence
Many optometrists, even those with no intent to commit fraud, all-too-often fall short when it comes to documentation and paperwork. The IRS appears increasingly determined to find and audit these professionals and their practices. Once sent by the IRS only to those suspected of failing to comply with the tax laws, IDRs are being sent out in record numbers as a screening tool. Even if an optometrist, or his or her optometry practice, pays taxes dutifully, he or she may be penalized for lacking documentation. After all, the law requires every taxpayer to retain the records used when preparing the tax returns. Those records generally should be kept for 3 years from the date the return is filed.
The IRS will usually provide a written request for the specific records needed. If records are kept electronically, the IRS may request those in lieu of or in addition to other types of records.
The Taxpayers Bill of Rights, part of the IRS Restructuring and Reform Act of 1998, requires the IRS to provide a written statement detailing the taxpayer’s rights and the IRS’s obligations during the audit, appeals, refund and collection processes.
These rights include:
- A right to professional and courteous treatment by IRS employees;
- A right to privacy and confidentiality about tax matters;
- A right to know why the IRS is asking for information, how the IRS will use it and what will happen if the requested information is not provided; and
- A right to appeal disagreements, both within the IRS and before the courts.
Among the most important of the rights given every taxpayer whose returns are targeted for an audit is whether to be represented by a tax professional or whether to attempt to answer the IRS's questions alone. Another important consideration for everyone and every optometrist or practice being audited is where to hold that meeting.
Should the meeting be in the accountant's office where all the working documents are easily accessible? Should it be at the location where the optometrist practices, the place where all the records are kept, to demonstrate to the IRS auditor that there is nothing to hide and that the optometry operation is a legitimate one? Or, should the optometrist, the optometry practice’s manager and/or its representative trudge down to the IRS office armed only with the specific documents and information requested by the IRS auditor? Not too surprisingly, there is no one right answer.
Building a strategy
The increased emphasis on small professional practice and business tax audits comes hot on the heels of an IRS announcement that it hopes to speed up the audit process with something called the Fast Track Settlement (FTS) program.
The IRS’s Small Business/Self-Employed FTS program (SB/SE FTS) was created to provide an expedited process for resolving disputes with small businesses and professional practices. SB/SE taxpayers who currently have unagreed factual or legal issues in at least 1 open year under examination can work together with SB/SE and the Office of Appeals to resolve outstanding disputed issues while the case is still in SB/SE jurisdiction. Once an application is accepted, the IRS’s goal is resolution within 60 days.
Until an optometrist or practice principal agrees with the IRS, the appeals process remains open. Most importantly, from the initial screening for accuracy that each return receives up to the final appeal has been exhausted, mistakes in the favor of the taxpayer are discovered in about 25% of all cases.
In the past, the IRS was often quite sympathetic to honest mistakes and more than willing to discuss underpayments of taxes that might have resulted from the many so-called “gray” areas of our tax rules. On occasion, they might even negotiate the amount of tax due on occasion. While they have never liked fraud, IRS auditors now find their actions limited.
Honesty and clarity go a long way toward preventing, dealing with and surviving an IRS audit. Naturally, every optometrist should have a strategy for avoiding audits as well as for dealing with an IRS auditor. A fallback position if those strategies fail should also be in place.
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Mark E. Battersby has been reporting on news and developments in the tax and financial arenas for more than 25 years. He can be reached at MEBatt12@Earthlink.net.
Disclosure: Battersby has no relevant financial disclosures.