The second biggest mistake is nearly as important as the first, and that’s fearing, rather than respecting, the IRS.
Many business owners are simply afraid to take deductions they’re entitled to, for fear of raising the proverbial “red flag.”But what does the kind of tax planning we’re talking about really do to your odds of being audited? The truth is, most experts say it pays to be aggressive. That’s because overall audit odds are so low, that most legitimate deductions simply aren’t likely to wave “red flags.”
Audit rates peaked in 1972 at one in every 44 returns. But lately they’ve dropped to historic lows. For 2014, the overall audit rate was just one in every 100 returns.
Roughly half of those centered on a single issue, the Earned Income Tax Credit for low-income working families. The rest focused mainly on small businesses, especially sole proprietorships – and industries like pizza parlors and coin-op laundromats, where there are significant opportunities to hide income and skim profits. In fact, the IRS publishes a whole series of audit guides you can download from their web site that tell you exactly what they’re looking for when they audit you!
So, if you do get audited, what then? Well, if you’ve properly documented your legitimate deductions, there’s little to fear. In fact, about 15% of audits actually result in refunds. (Another 20% result in no change either way.)
And if you lose? You’ll get what the IRS calls a “deficiency notice,’ which is simply a bill for more tax. If you still think you’re right, you can appeal it to the IRS. If you don’t like the result you get there, you can appeal to the U.S. Tax Court. There’s even a “small claims” division for disputes under $50,000.
Just how aggressive can you get before risking actual penalties (as opposed to merely paying more tax)? You can avoid accuracy-related penalties if you have a “reasonable” basis for taking a position on your return. Generally, this means your position has more than one chance in three of being accepted by the IRS. You can file Form 8275 or 8275-R to disclose positions you believe to be contrary to law or regulations. But some advisors recommend not filing them. Why volunteer information that can attract unwanted attention? (Think of this as the tax equivalent of calling in an airstrike on your own position.)
Are you worried about getting in real trouble, as in criminal prosecution? Don’t. Seriously. For fiscal year 2012, the Service initiated just 5,125 criminal investigations (up from 4,720 in 2011). That’s an almost unimaginably tiny fraction of the 240 million returns they collect in a year. Out of those 5,125 investigations, they recommended 3,710 prosecutions (IRS investigators don’t actually prosecute offenders themselves; they turn that job over to the Department of Justice.) There were 3,390 indictments and 2,634 convictions — the Feds don’t take you to court if they’re not already pretty sure they can win. In the end, just 2,466 lucky winners drew all-expense-paid trips to “Club Fed.”
In the end, the average American really has nothing to fear from the IRS Criminal Investigations unit. As far as most of us are concerned, the IRS is just the federal government’s collection agency, nothing scarier. You’ve got to do something really outrageous to draw one of those 5,000 investigations.
Sometimes, just changing how you report an item can dramatically change your odds of getting audited. Take a look at the chart at the beginning of this chapter. You’ll see that for 2014, the IRS audited 2.16% of Schedule C businesses reporting gross income over $100,000. Yet for that same year, they audited under one half of one percent of partnerships and S corporations, regardless of how much they made. That suggests you can cut your odds of being audited by over 86% just by reorganizing your business.
Here’s the bottom line. You should never be afraid to take a legitimate deduction. And if your tax professional does recommend you shy away from taking advantage of a strategy you think you deserve, ask them to explain exactly why they say so. And don’t be satisfied with a vague reply that it will “raise a red flag.” Remember, it’s your money on the table, not theirs.
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