Tuesday, September 1, 2009


A tax audit is indeed an inconvenience, and has a great potential for agita and aggravation, but it is not something “evil” that must be avoided at all costs. As I have blogged in the past, if your deductions are legitimate and properly documented you should have nothing to worry about.

While my office audit experience over the past 38 tax seasons has been minimal, considering the volume of returns I have prepared during the 38 seasons, I have found the IRS auditors with whom I have had dealings, while of varying degrees of competence and tax knowledge, to be, for the most part, pleasant and cooperative. I have, thank my lucky stars, never had to deal with a real male sex organ.

My audits have usually ended in “no change” or a minimal mutually agreed on small balance due. I do recall that on one occasion it was determined that the IRS owed my client about $20.00 – but we said we would rather have a “no change” determination than get a check for such a small amount.

In my “wanderings” on the internet I have come across a tax professional who, a while back, appeared, or so it seemed to me, to be advising clients and readers alike not to claim legitimate deductions on a 1040 simply because they fall into an assumed or proven IRS “red flag” category and might increase the chances of an audit.

According to this tax pro it is more important to avoid an audit than to file a correct and accurate return, and it is more important to avoid an audit than to pay the absolute least amount of income tax possible.

I firmly believe in this quote from former IRS Commissioner Donald Alexander (as usual, the highlight is mine)–

"As a citizen, you have an obligation to the country's tax system, but you also have an obligation to yourself to know your rights under the law and possible tax deductions -- and to claim every one of them."

If you actually spent the money for the item and the item is a legitimate tax deduction, and you can prove with physical documentation that you actually spent the money and that it is a legitimate tax deduction, claim it!

If you do not claim the deduction you are automatically auditing your own return and voluntarily overpaying the IRS, and probably also your state tax authority as well.

The same tax professional recently reported, and rightfully so, that IRS statistics indicate that Schedule C businesses are audited much more frequently than corporations. The professional went on to advise clients and readers, “This reason alone is sufficient to justify the additional costs and paperwork associated with forming a separate legal entity and filing its annual report and tax return”.

Again the tax pro says avoiding an audit is the most important factor to be considered.

I do agree that a business enterprise filing as a Schedule C “sole proprietor”, whether registered as an LLC or not, is more likely to be audited than one filing as a corporation. In my recent 2-part post on the advantages and disadvantages of incorporating I explained that –

The reason for this is a corporation with gross receipts that if reported on a Schedule C may be considered to be 'large' in relation to other Schedule C businesses will be relatively 'small' when compared to the total population of corporations. And it appears that the IRS will be specifically targeting certain Schedule C businesses for audit in the near future as part of its war on the Tax Gap.”

But the only taxpayer for whom this benefit should be the only reason for incorporating is the crook who wants to commit tax fraud, either on his/her own or with the assistance of an unethical tax preparer, by not reporting all income and/or overstating deductions and claiming personal items as business expenses.

The honest taxpayer/businessperson who will be properly reporting all income and claiming only legitimate deductions, and who keeps good receipts and records, should consider this tax advantage of incorporating as “icing on the cake” if, and only if, an extensive cost benefit analysis indicates that incorporating is justified. Or perhaps the deciding factor if it is a very close call.

Other tax bloggers have given more appropriate advice about incorporating in their postings -

• As I quoted in the above referenced 2-part post, TAX GIRL Kelly Phillips Erb, a tax attorney, has said, “In most cases, a C corporation is ‘overkill’ for a freelancer with no immediate plans for expansion, hiring of employees, etc.”

• Joe Kristan, in his post “Corporations: Yea or Nay?” at the ROTH AND COMPANY TAX UPDATE BLOG, says, “Which entity is best? That's a discussion to have with your tax advisor. If you don't know what to do, start with the partnership or proprietor formats; if nothing else, they are the easiest formats to change. C corporations are the only ones that can cause your income to be taxed twice -- when earned and when distributed -- so make sure you really know what you're doing before you go that way.” Joe’s post also includes a quote from another party that best describes the situation – “Decisions to embrace the corporate form of organization should be carefully considered, since a corporation is like a lobster pot: easy to enter, difficult to live in, and painful to get out of."

• John Sheeley, an Enrolled Agent and business advisor, writes a blog at www.johnsheeley.com that I recently discovered when he chose to “follow” me on Twitter. In his post “Choosing the Correct Business Entity Type” from earlier in the year he advises – “Always meet with your accountant or attorney BEFORE committing to the formation of a company. Make sure you form the right type of entity, in the correct jurisdiction. One size (or entity type) does not fit all.”

In my aforementioned 2-parter I revise John’s advice to say – “the first person you consult about such a decision is a tax professional, and not an attorney”.

The bottom line - You shouldn’t be so afraid of an audit of your return by the IRS that it causes you to pay extra income taxes by not claiming legitimate documented deductions, or causes you make a foolish move (incorporating) that will end up costing you a lot more money in the long run and result in unnecessary additional paperwork, filings, and agita, if you are an honest and ethical taxpayer.

Now if you are a crook that is another matter.


No comments: