Defending Your Business Against Tax Audits
Everyone has at least one pet peeve. The IRS has many. Here are some items that the tax agency may target on a manufacturer’s 2014 tax return — and ways to help safeguard against an IRS audit.
1. Owners Compensation
A privately held C corporation may try to overpay its owners in lieu of paying dividends to avoid double taxation. Conversely, an S corporation that’s not subject to corporate-level taxes might try to underpay its owners to minimize payroll taxes and, instead, make higher distributions. The IRS is on the lookout for whichever ploy applies to your company and may compare your owners’ compensation to that of other manufacturers or distributors in your area.
How much should an owner get paid? There’s no right answer for every company. It depends on what unrelated third parties with the same responsibilities, schooling and experience receive for performing the same functions. Outside sources, such as headhunters and various compensation surveys, can be used to substantiate your owners’ compensation expenses.
2. Personal Use of Company Vehicles
Private business owners sometimes push the envelope when it comes to purchasing vehicles through the company that are often used for personal purposes. But the IRS has strict rules on what qualifies as business use and what personal use is treated as income to the owner or employees.
When employers make company vehicles available to owners and employees for both business and personal use it is important to track mileage between these two categories. It is also important to remember that commuting miles are generally considered personal use. The personal use portion is a taxable fringe benefit to the employee that must be included in their W-2 wages.
There are a few methods available to calculate the compensation related to personal use of company vehicles. The cents per mile method is available when vehicles are below a certain cost threshold ($16,000 for 2014). For other vehicles, the annual lease value is used to determine the taxable fringe benefit. This income inclusion applies to employee shareholders as well. Additionally, gas or other vehicle costs paid for by the company are also included in compensation to the extent they are unreimbursed and relate to personal use mileage.
3. Meals and Entertainment
Likewise, excessive meals and entertainment expenditures are likely to catch the IRS’s attention. You generally can deduct up to 50% of business-related meals and entertainment expenses incurred for the purpose of entertaining a client, customer or employee. Maintaining detailed records is the key to protecting your meals and entertainment deductions. Your company’s expense reimbursement forms should require the following information:
- Amount of the expense
- Time and place
- Business purpose
- Name and business relationship of any person entertained
Hold onto records supporting the items claimed until the statute of limitations runs out. (The statute of limitations usually runs out three years from the due date or the filing date, whichever is later.) However, the IRS can go back more than three years if it suspects a substantial omission of income or tax fraud.
4. Net Operating Losses
When expenses exceed revenues, a business may incur a net operating loss (NOL). Businesses may elect to carry back (or forward) NOLs to offset income in other years. The IRS may ask your company to substantiate the loss, not only in the year it’s incurred, but also when a refund is claimed for an earlier (or later) year. So, proper record retention is essential with NOLs. IRS instructions recommend saving records until NOLs no longer have an effect, plus seven years.
Tax Pros Lower Audit Risks
A small percentage of tax returns are audited by the IRS. Sometimes a business is randomly selected. But in many cases, high-risk or excessive deductions trigger an audit. The IRS keeps “norms” on how much manufacturers under each industrial classification code typically deduct for each line item — but, unfortunately, it doesn’t publish industry norms to the general public.
IRS auditors often have a field day with do-it-yourself returns. An advisor who specializes in the manufacturing niche can evaluate your deductions line-by-line and help minimize your audit risks.
Managing IRS Inquiries
The IRS wants to make up for a tax gap that’s estimated at more than $300 billion. So, it’s become more efficient and targeted in its audit efforts.
If you receive a notice from the IRS in the mail, contact your tax professional immediately. He or she can help you respond to the notice or question, which is often all the IRS needs to satisfy its inquiry. A tax professional can manage your ongoing correspondence with the tax agency. When an outside tax professional gets involved, it can limit your direct interaction with IRS agents.
Consider having your tax advisor onsite throughout the audit fieldwork. You can direct IRS questions through your tax advisor who can help steer to resolution and avoid wrong turns.
Also, beware that the IRS never initiates contact with taxpayers via telephone, social media or e-mail. If you receive an e-mail, text or phone call from the IRS, it may be fraudulent. Contact the IRS or Federal Trade Commission immediately.