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The release of preliminary findings of a study of small business tax compliance by the National Taxpayer Advocate Service (TAS) may confirm the IRS targets small business owners for audits.
TAS is an organization within the IRS that operates
independently to help taxpayers resolve problems with tax issues and the IRS. Now preliminary findings of a TAS study on taxpayer compliance seems to confirm what many small business owners suspect; small business owners, especially sole proprietors, are under more scrutiny and are more likely to be audited.
The TAS study is trying to determine taxpayer compliance for specific small business “communities” with similar operations and offerings. TAS seeks to confirm what affects compliance and whether tax cheating is driven more by IRS rules or individual will.
Its findings are relying on secret IRS DIF data, so many tax experts conclude the study confirms the IRS is targeting small businesses and reveals which small businesses are more likely to be audited.
Small business tax returns are subjected to a computer program to mathematically quantify the higher chances of cheating or misrepresentation. Each return is assigned a score, with the higher scores more likely to be audited. The score is called the Discriminant Inventory Function or DIF, but the math formula used to figure this score remains a secret.
Though it cannot be confirmed, tax preparation experts know that there are red flags that increase the odds that a small business will be audited:
- Operating as a sole proprietorship
- Claiming expenses that are unusually high based on business income averages
- Claiming charitable deductions as a large percent of income
- Failure to report all income that has been independently reported to the IRS
The study is expected to take another two years to complete, but early findings claim small businesses with low compliance levels are typically clustered in geographic communities and may be more likely to associate with each other through local organizations. They typically believe tax laws and the IRS are unfair.
TAS’s preliminary analysis shows “smaller businesses with local customers and those in professional or technical businesses were more often in the high-compliance group…Taxpayers in construction-related and real estate-related industries appeared to be less compliant.”
The IRS may be using that information to determine which tax returns it will select for audit. The report suggests tax returns filed by sole proprietors that are paid cash rather than wages are targeted more often for IRS questions or audits seeking to collect more money.
The study says most compliant business owners used a professional tax preparation service, which may indicate self-prepared tax returns for small business owners are more likely to be audited.
The results also state that the low-compliance groups are more likely to say government is too big and wastes tax dollars.
TAS says its goal is to improve voluntary tax compliance. The findings of its study are being released at the same time the IRS is stepping up its effort to increase collections.
For more information you may wish to read the most recent TAS Annual Report to Congress detailing what it calls the “most serious problems” encountered by taxpayers.
Should you be audited or have a question, contact us at McRuer CPAs. When dealing with the IRS, it’s better to be safe, than sorry.
