Do I Need to Set up an LLC or Incorporate?

Originally published in the Cedar Street Times

October 3, 2014

Two weeks ago I discussed some of the pitfalls of using an online service to help you set up an entity such as an LLC, C-Corporation, or S-Corporation for your business.  In a nutshell, you really need tailored advice from an accountant and an attorney to address your circumstances and you should use an attorney to properly set everything up.  I have found that people that utilize these services generally do not have a good understanding of what they did and why, and they don’t know much about their ongoing responsibilities, the importance of carrying them out, or the consequences of failing to do so.

Now I am going to turn the tables and ask you why you think you need a formal entity at all?  When I say this I am thinking about small businesses getting started.  If your accounting and legal advice is from family or friends, hopefully they actually are accountants and business attorneys and reviewing your WHOLE situation.  Or maybe you read something online – maybe even an article like this!  Be careful what you read!

My personal feeling is that there are a lot of small businesses out there that have set up entities prematurely, and have entangled themselves in a lot of extra cost, record keeping, and administrative hassle for very little benefit.

The vast majority of people setting up entities for small businesses do it because of perceived liability protection for their personal assets.  Some do it for certain circumstances that can lead to tax benefits, and others do it in rare circumstances where a major customer requires it.

It is important to understand there is no bullet proof solution when it comes to shielding yourself from liability.  There is almost always a way to spoil a good plan.  Legions of lawyers make their living at this.  Layers of protection are often implemented to mitigate the risk of chinks in your armor.  For instance have an entity and also having insurance would be a good example.

It is also important to understand that entities do not protect you from all forms of claims.  For instance, professionals cannot be shielded by an entity for acts of malpractice.  Malpractice insurance, however, could cover you.

If you do not respect the entity by following all the rules of corporations, s-corporations, or LLCs promulgated by various government authorities, then if there is a lawsuit, the courts could say, “You didn’t respect the entity, so why should we?”  They could look right through your entity and allow a creditor to go after your personal assets.

Small businesses are at a much higher risk for this since they generally don’t have a legal department trying to keep up with all the details!  I have seen small businesses that have gone through the hassle and expense of setting up corporations, filing tax returns and paying the California Franchise Tax each year and yet they have never held a corporate meeting or elected officers, never recorded any corporate minutes (and even if it is just you wearing all hats, you can’t ignore these things!), and treated the bank accounts of the company like an extension of their personal checking account.  And all the while they were thinking they had solid liability protection because they were a corporation…uhh no.  The devil is in the details as it is said!

Besides the initial cost of setting up an entity properly which could run two or three thousand dollars or more, you then have to file separate business tax returns, file an informational filing with the Secretary of State, possibly have an attorney draft a document or two each year, have better accounting for the tax returns (true double-entry accounting which includes an accurate balance sheet in addition to the profit and loss statement), and then you get the privilege of paying California at least $800 a year whether you make a dime or not.  So you have at least another couple thousand dollars each year of ongoing costs (more if you need to hire a bookkeeper when you find out that QuickBooks actually requires a fairly good amount of accounting knowledge to operate it properly.)

If the inherent risk of the business is relatively small or moderate, and especially if you are starting very small and do not even know if the business is going to be successful, then I think you need to carefully way the benefits and costs.  Could you just carry really good insurance and mitigate your risk to an acceptable level?  Do you need the additional layer of protection?  You can always incorporate or set up an LLC later.  Do you have employees, and what amount of risk do they expose you to?  Are they driving vehicles a lot for your business?  Or do you have rental property with lots of tenants?  Maybe you are a free-lance graphic artist designing business cards remotely from your home – not much risk there!  What are you trying to protect anyway – maybe the bulk of your personal assets you have would be considered exempt assets from creditors already? Although attorneys are generally risk-averse because they see all the things that can go wrong, and therefore would prefer to set up an entity, I think these types of discussions can be had with them and really question if it is right to set up an entity for your business for liability reasons.

Taxwise, there can be benefits to setting up an entity, depending on your circumstances, but it is rarely a driving force in and of itself for most small businesses.  The most common one people ask about deals with reducing self-employment taxes for the owner of an S-corporation.  There are ways this can be successful, but it is an issue that is in jeopardy of being eliminated.  It also has the drawback of possibly reducing your future Social Security benefits – although our government will probably beat you to the punch on that one anyway.

If you read this article and think, gee, I am not sure I really need the entity I have – do not just ignore the entity and pretend it doesn’t exist anymore!  Besides getting the proper tailored advice for you, you generally must properly dissolve it, or you will be plagued with continuing mandates for tax returns as well as Franchise Tax fees to California.  (There are limited circumstances where you can just walk away.)

In summary, get competent advice from an accountant and an attorney in light of YOUR facts and circumstances before jumping into an entity.  And question its necessity if you are small or if your business has low or moderate inherent risk and you have access to insurance that could protect you sufficiently.

Prior articles are republished on my website at www.tlongcpa.com/blog.

Travis H. Long, CPA is located at 706-B Forest Avenue, PG, 93950 and focuses on trust, estate, individual, and business taxation. He can be reached at 831-333-1041.

Forming a Business Entity

Originally published in the Cedar Street Times

September 19, 2014

Over the years, I have had many appointments with new and existing clients that are starting a small business for the first time.  We usually spend about an hour or so going through the basics of what to expect and be aware of: we cover things like self-employment taxes, tax estimates, business property tax statements, employees, insurance, sales tax, fictitious business name registration, business bank accounts, EINs, business licenses, etc.  One of the first things we talk about, however, is entity selection.  In other words, are you going to operate as a sole proprietorship, or will you form an LLC, S-corporation, C-corporation, partnership, etc.

Unfortunately, there are many people out there who pull the trigger early on entity selection based on something they hear from friends or find on the internet prior to getting tailored professional advice.  My feeling is that you really want to have a discussion about your particular situation with your accountant to provide input on the tax and accounting related issues and a business attorney to weigh in on liability, and other legal related issues before you get started.  The attorney should form the entity if you choose to operate other than as a sole proprietorship.

There are too many pitfalls, and I know there are many people out there that have made the wrong choice or, even worse, are operating with a presumption of liability protection when they have none because they did not properly form or respect the formalities of the entity.  Opposing counsel could have a victory on their hands if you failed to prepare annual corporate minutes, for instance. “Piercing the corporate veil” could suddenly enter your lexicon.

Online companies attempt to make it cheap and quick to form an entity for you, but I can tell you from my experience that many of the entities formed this way are later corrected or scrapped and redone by an attorney if one is hired to review it.  One of the problems, is that you have to be an attorney to render legal advice, and since it is rare for online companies to have attorneys for you to discuss your situation with, you may not choose the best entity or get all the language in your formation documents that you need.

Online companies also have difficulty conveying in an effective manner the important things to keep up with and staying in touch regarding these issues.  Many of the people who have used online services show up in my office with a fat binder that was shipped to them in the mail of which they have very little understanding; often has blanks that were never filled out; and has been collecting dust on the shelf.

I also hear from a fair number of these people that get notices from California requesting tax returns and a bunch of money for entities the taxpayer stopped operating years ago or maybe never even started aside from setting up the entity.  Unfortunately no one was there to advise them on how to properly close the entity.  The taxpayer often thinks that if they stop operating or decide not to go ahead with the business that they are done.  It doesn’t work this way.  I have even had people that formed an entity online and were shocked that they would have an $800 minimum fee to California each year.

There is a general push from many directions for people to establish entities for their small businesses these days.  In two weeks we will discuss the merits (or not) of this presumption.

Prior articles are republished on my website at www.tlongcpa.com/blog.

Travis H. Long, CPA is located at 706-B Forest Avenue, PG, 93950 and focuses on trust, estate, individual, and business taxation. He can be reached at 831-333-1041.

Confidentiality, Privilege, and Taxes

Originally published in the Cedar Street Times

August 22, 2014

Pretty much anybody that watches crime shows on television knows about attorney-client privilege.  This is how murderers can admit the details of their crimes to their attorneys and the communication is protected from discovery by the courts.

But what about tax related communications with your accountant?  Unfortunately, there are not a lot of television shows featuring taxpayers admitting the gory details to their accountants on how they swindled the IRS.  That said, prime time dramas are probably not the best place to learn about the legal and accounting world anyway!

Misinformed people will sometimes think they can sit down with their CPA and contrive ways to scheme the IRS, or that they can openly discuss all the income they took in under the table and did not report.  Communications with a CPA are confidential due to professional standards, but they usually do not qualify for evidentiary confidentiality privilege in a court of law.  This means the CPA should not disclose the information to other parties without your permission, but if questioned in a court of law, the information would have to be disclosed.  The other problem a CPA would have knowing the skeletons in your closet, is that a CPA (or any preparer) cannot knowingly file a false return.

So you may think you should hire a tax attorney to prepare your returns in order to get privilege.  That actually won’t work either.  One of the main tenets of attorney-client privilege is that if you do not treat the information as confidential and you disclose it to a third-party other than your attorney and his or her associates, then you have lost your privilege.  Since tax returns are inherently a third-party communication for disclosure to the taxing authorities, it has been ruled that tax preparation services are not afforded attorney-client privilege.  In fact, there have been interesting cases where attorneys have lost their attorney-client privilege because they included estate tax preparation as part of their engagement with the client.

Tax advice, however, is a different story.  For engagements that strictly involve tax advice, and not tax preparation, attorney-client and accountant-client privilege is extended.  Accountant-client privilege has more limitations than attorney-client privilege as defined in Internal Revenue Code section 7525.  Most notably is that accountant-client privilege does not extend to criminal matters before the IRS or Federal courts, nor does it apply to tax shelters designed for tax evasion.

As previously discussed, the disclosure of information to a third-party generally waives the attorney-client privilege.  An exception to this rule is if the attorney needs the assistance of another professional (such as an accountant) in order to render legal advice to the client.  A Kovel letter (based on the 1961 case) can be drafted and signed by the accountant and attorney which essentially extends the attorney-client privilege to the accountant.  The accountant is then, in essence, working for the attorney and not the ultimate client.  This does provide additional protections, but it still would not provide protections for tax return preparation.

Prior articles are republished on my website at www.tlongcpa.com/blog.

Travis H. Long, CPA is located at 706-B Forest Avenue, PG, 93950 and focuses on trust, estate, individual, and business taxation. He can be reached at 831-333-1041.

Do You Own Inches of Land in the Yukon?

Originally published in the Cedar Street Times

July 25, 2014

When I was growing up, I remember my Dad once telling me that he owned eight square inches of land in Canada.  He said he got the land as a promotion when buying cereal as a young boy.  At the time, I thought that was kind of cool, and just accepted it at face-value.

As I look back on that now from my perspective as an accountant, dealing with all kinds of financial related issues on a daily basis, a lot more questions come to mind.  For instance, where are the deeds to the property, and how would we find the right recorder’s office to get copies of the deeds if needed? Were the deeds ever even recorded?  Was it a fee simple interest?  Did he have mineral rights?  Eight square  inches may be just enough to drill a very small oil well!  Or maybe there is gold!

How would that impact his retirement planning? What about real estate taxes?  Typically land requires the annual or semi-annual payment of property taxes or the land is taken back or sold to settle the outstanding debt if unpaid.  Are there any laws regarding foreign ownership of land or any new requirements to look into regarding foreign asset holdings?

Could we lease the land, and what would the tax impacts be?  Should my Dad have included it in his estate planning so that loose ends would not pop up at some point which could result in title problems or perhaps probate?  Would there be any liability associated with this land, and should he have carried a general liability or perhaps an umbrella insurance policy in case his eight inches contained a stone on which someone could have tripped?!

What was his cost basis on these inches and how much profit would be recognized if we sold it?  All of these questions and more find their way to my door step for other client issues. As an accountant, we often end up as the independent advisor –  like the hub in a wheel with spokes running out to the financial planner, investment advisor, insurance agent, attorney, banker, etc.  Almost every profession leads back to taxes and tax planning in some way.

In my Dad’s case, I found we did not have any real concerns, but there is a fantastic story to go along with these inches of land which you can read all about at: http://www.yukoninfo.com/dawson-city-yukon/the-klondike-big-inch/.  The gist of the story is that this was a marketing plan in 1955 developed by Bruce Baker to get children to buy Quaker Oats Puffed Rice and Puffed Wheat cereals.

Baker decided to tie-in a popular radio and television show which Quaker Oats sponsored, “Sergeant Preston of the Ukon” by offering children the opportunity to own one square inch of land in the Yukon in Canada if they bought cereal.  The attorneys thought the idea was crazy, but Baker persisted and even flew to the Yukon and secured a 19.11 acre parcel to be divided up into 21 million one-square-inch parcels.  The company eventually agreed to the idea and thus began their most successful campaign ever.  Cereal boxes flew off the shelves as deeds were printed and inserted into each box, and every one inch parcel was given away.  They did a second campaign and Baker had four tons of Yukon riverbed sand sifted and packaged into tiny promotional pieces as well.

As the years rolled on, the inquiries about these hard-earned plots of land kept coming in by owners that wanted to know more about their plot of land, or its worth, and also by estate planning attorneys that were trying to figure out what to do with these deeds!  One child was said to have sent four toothpicks and a string and asked the Quaker Oats company to put a fence up around his property!  One person collected over 10,000 of these from people around the country and asked Quaker Oats to pick out a quiet place for him along a lake or river, if possible!

The reality of what happened is that the company that was created to handle all the deeds – The Klondike Big Inch Land Company, Inc. realized it would be way to expensive to record all the deeds in each child’s name, so with the opinion of a Canadian attorney they decided to send the deeds out and never have them officially registered.  The Klondike Big Inch Company, Inc. did not pay the $37.20 property tax bill in 1965, so the land reverted back to the Canadian government.  The company then shut its doors.

Still, to this day, however, nearly 60 years later, Canada and Quaker Oats receive hundreds of communications each year regarding the land!

Prior articles are republished on my website at www.tlongcpa.com/blog.

Travis H. Long, CPA is located at 706-B Forest Avenue, PG, 93950 and focuses on trust, estate, individual, and business taxation. He can be reached at 831-333-1041.

Claire Elise Long

Originally published in the Cedar Street Times

July 11, 2014

At 7:50 am on July 3rd, I entered into my second contract of fatherhood! Fortunately it was not during tax season like my last contract when my son was born!  No, I was all smiles when my daughter, Claire Elise Long was born in our home with the help of our wonderful midwife, Maggie Bennett, weighing in at around six pounds 14 ounces and 19 inches long.

Whereas the vast majority of children born on the Monterey Peninsula have a Monterey birth certificate due to CHOMP’s location, I think it is quite fun that my son has a Pacific Grove birth certificate and my daughter will have a Pebble Beach birth certificate.  I told my wife, Joy, that we need to move and have children in Seaside, Sand City, Del Rey Oaks, Carmel, and Marina so we can collect all of the more rare birth certificates.  She did not find that as amusing as I did.

I think Claire Elise may be a Daddy’s girl as she followed through on my in-womb negotiations with her about the timing of her birth…unlike her brother, Elijah, who came during tax season despite express language in his birth contract stating otherwise. Claire Elise upheld the terms of not exceeding seven pounds eight ounces (a point bargained for by her mother) and she was given a right to exercise her birth option from June 29th to July 31 with a birthing bonus if born on July 4th.

When negotiating pressures intensified in the early hours of July 3rd, Joy caved and was very easy to persuade and saw no further need to hold out until the 4th.  I, however, needed more convincing.  Claire Elise deftly pointed out that being born exactly on the first day of the 10th fiscal quarter after her brother was born, would simplify things for quarterly reporting purposes…she knew how to push my buttons.

After holding the beautiful bundle of love, we immediately decided to approve her initial contract for child-rearing.  When my son was born we struck a deal with him to extend his initial contract through kindergarten with two renewable six-year options.

The second renewable option would include an opt-out for us after the middle school years.  There would be some additional language which could allow for a third six-year option to get through the college phase depending on certain performance benchmarks achieved in the prior option period.

Based on our experience with our son, we decided to offer similar terms but with some additional specific language regarding liquidated damages for things like unprovoked dumping of milk and juice and other gravitational experiments with glassware and plates, storing the remote control in a cup of chocolate milk, and breaking necklaces and expensive pairs of eyeglasses.

With business out of the way, we have been having the time of our lives…again!  The precious little noises and movements, the intoxicating cuteness, and her absolute and impartial trust make life a true blessing.  As I hold her in my arms, I know there is much good to come.  I can now look forward to not only experiencing the unique joys of having a son, but also the equally unique joys of having a daughter – and for this, I am very grateful.  I love you, Claire Elise; you make Daddy very proud!

Next step…convincing Momma that baby-modeling is a good idea so Claire Elise can generate earned income and open a Roth IRA!

Prior articles are republished on my website at www.tlongcpa.com/blog.

Travis H. Long, CPA is located at 706-B Forest Avenue, PG, 93950 and focuses on trust, estate, individual, and business taxation. He can be reached at 831-333-1041.

We Buy Gold…FIFA World Cup Trophies

Originally published in the Cedar Street Times

June 27, 2014

As a young lad, I played a lot of soccer.  The first team I was on was called the “Half-Pints.”  I think I was four or five years old, but I can still remember our green and white uniforms and the coach wearing jacked-up tube socks with colored stripes along the top.  When I was six and seven I played on the “Chiefs” – I am not sure that team name and logo with the Native American headdress would be allowed today.  Around that time, I also played on the “Jedis” – probably because the original Star Wars trilogy was in its heyday.

By the time I was in middle school, my brother and I were both on traveling soccer teams often playing at opposites ends of the state on any given Saturday.  We played a fall outdoor season, a winter indoor season, a spring outdoor season, and then attended soccer camps during the summer.  In high school I played on regular club teams as well as the high school team.  One very vivid memory was winning the state championship my junior year in high school.  The opposing team had two players that went on to play in the MLS, one of which even played on two U.S. World Cup teams.  I went to college and played a few more years there until other priorities began to emerge.

Throughout my time playing soccer, there was one thing that eluded me – a real gold trophy!   Cheap plastic trophies at the end of a season, or after winning a tournament remained pretty consistent.  They seemed like treasures when I was young and most survived through the years with only minor dents and scratches.  A few unlucky ones had lost an appendage or their fake gold hair paint had rubbed off leaving the embarrassing white plastic beneath.  Eventually, they all got round-filed save one early trophy as a momento.

If I had only managed to keep playing, gain citizenship in a powerhouse soccer country, join the national team, and then win the World Cup, my dream could have been realized! With the World Cup currently in full swing, some country is only two-and-a-half weeks away from holding the world’s most valuable trophy. Not only in symbolic worth to the world, but also in perceived collectible value and sheer melt value, the FIFA World Cup Trophy is the world’s most valuable trophy.

The trophy is not gold-plated as most other major sports trophies are, but its 13.6 pounds is made almost entirely of 18k gold.  If you took the championship trophies from the NHL, NFL, NBA, and MLB and melted them all down, their combined value would be worth only about 28 percent of the melt value of the World Cup Trophy, which currently has about $200,000 of gold in it with an estimated collectible value of $10 – $20 million.

What does this have to do with taxes? – Not a whole lot, but it was a good excuse to talk about soccer. I will say this: buying and selling gold has been quite popular since the markets bottomed out in 2009.    It seems that everybody has a sign that says, “We buy gold.”  I think I even saw that written on the back of an “Anything will help” sign from a panhandler.

There are a lot of special tax and regulatory rules surrounding gold sales, so you need to make sure you get the right advice before you buy a bunch of gold or gold coins thinking you are making a solid investment to protect you from inflation.  For instance, if you owned the FIFA World Cup Trophy, you would be subject to special collectibles tax rates of 28 percent if you tried to sell it, as opposed to lower long-term gain rates even if held over a year.   People wanting to hold gold directly in their IRAs also have special rules to follow regarding the purity of the gold they purchase, in order to maintain the tax deferral.

So, scout it out before you buy gold!  Besides, it’s better to just win the gold.  Go USA!

Prior articles are republished on my website at www.tlongcpa.com/blog.

IRS Circular 230 Notice: To the extent this article concerns tax matters, it is not intended to be used and cannot be used by a taxpayer for the purpose of avoiding penalties that may be imposed by law.

Travis H. Long, CPA is located at 706-B Forest Avenue, PG, 93950 and focuses on trust, estate, individual, and business taxation. He can be reached at 831-333-1041.

What Are Your Chances of Being Audited? Part III – Red Flags

Originally published in the Cedar Street Times

June 13, 2014

Four weeks ago I discussed some of the statistics regarding your chances of being audited by the IRS, and two weeks ago I discussed audit selection methodology.  A few of the high points from the articles were: 1) on the average, audit rates for individuals are generally less than one percent each year, and increase as you make more money, 2) about 75 percent of audits are actually mail correspondence audits focused on a narrow request of information for specific items on your return rather than a full-blown in-person, field audit, 3) the IRS does not release its exact methods of selecting audits, and many people have incorrect notions about this process, 4) the IRS does tell us audit selection is aided by a computer scoring system to help find returns that will likely yield a change; it uses computer matching to ensure information reported on 1099s by third parties matches what you report; it uses publicly available information; and it uses statistical random sampling.  The rest of this article will be devoted to “red flags.”

So what are these “red flags” everyone talks about?  One fairly obvious assumption we can make from the audit statistics released by the IRS is that they follow the money!  You are three times more likely to be audited if you make over $200,000 a year and over eleven times more likely to be audited if you make over $1,000,000 a year.  C-corporations face a similar dynamic of increasing audit rates on larger corporations – for instance, one out of every three corporations with assets over $250 million are audited.

Not reporting all your income even when it is reported to the IRS should not be a surprising red flag, but it happens frequently.  I see this most commonly with stock sales reported on a 1099-B when people prepare their own returns – they either forget, or do not understand the form.  I also see this with contract work where a 1099-Misc is issued and the individual forgets to report it.

There are a number of issues related to small businesses that raise eyebrows.  Keep this in mind – anytime there is an easy path for someone to pass-off personal expenses as business expenses, you are going to have a higher level of scrutiny.  For instance – relatively high amounts of: business automobile mileage (or claiming 100% business use on your vehicle – very rare in reality), home office deductions, meals and entertainment, or travel expenses.  All of these can be easily abused, so they are highly scrutinized.  If you are beyond the norms, you are a clearer target.

Here is another golden nugget – if your job is one that millions of people do for fun as a hobby (although perhaps not nearly as well!), then you have a higher level of audit risk, particularly if you are losing money.  Think of the arts – photography, video, music, drawing, painting, performing, etc.  Also, think of horse racing and breeding for the wealthier set.

That brings us to another “red flag,” businesses that lose money every year.  The IRS is trying to determine which of these three describes your nonprofitable business situation: 1) Are you really trying to make this successful and genuinely feel it will be profitable overall?  2)  Are you trying to deduct your personal expenses, your hobby, or keep up appearances? or 3) Are you just plain nuts?  By allowing people to continue businesses circumscribed in two and three, the rest of the country is having to foot the bill for the lost tax revenues.  This is because the “losses” generated are offsetting the person’s other income that would otherwise be taxable.  With no realistic future expectation to recuperate the losses, the IRS is ready to pounce.

Claiming rental losses in California is fairly common due to the high cost of our real estate, but claiming a real estate professional designation in combination with these losses is an area of greater concern.  If your main occupation is in the real estate related field, and you work at least 750 hours in this trade, you are allowed to deduct all of your rental losses in the year they are incurred.  Everyone else get to deduct $25,000 at most, and are rapidly phased out to no deductions for the losses based on income levels.  The losses get suspended until the property is disposed of or until there is passive gain to offset.  There are a lot of challenges when it appears the person has substantial earned income from a trade or business unrelated to real estate or if there is very little income from real estate related trades.

Refundable tax credits such as the Earned Income Tax Credit, Child Tax Credit, American Opportunity Credit (for education), and Health Care Tax Credit can also be a point of concern, particularly when the total refund on your return is higher than the tax paid in to the system!  The IRS receives thousand of fraudulent returns each year that use refundable credits to steal money from the government.

Although harder to catch, unreported foreign income is an area worth mentioning due to the extremely high penalties by the Treasury Department for failure to report foreign accounts, and it has been a hot-button issue that has raised billions in revenues.

The above is not an exhaustive list, but it does describe many commonly seen areas of concern.

Prior articles are republished on my website at www.tlongcpa.com/blog.

IRS Circular 230 Notice: To the extent this article concerns tax matters, it is not intended to be used and cannot be used by a taxpayer for the purpose of avoiding penalties that may be imposed by law.

Travis H. Long, CPA is located at 706-B Forest Avenue, PG, 93950 and focuses on trust, estate, individual, and business taxation. He can be reached at 831-333-1041.

What are Your Chances of Being Audited? Part II – Audit Selection

Originally published in the Cedar Street Times

May 30, 2014

Two weeks ago I discussed some of the statistics regarding your chances of being audited by the IRS.  A few of the high points from that article were: 1) on the average, audit rates for individuals are generally less than one percent each year, although audit rates jump to over three percent on people making over $200,000 a year, 2) about 75 percent of audits are actually mail correspondence audits focused on a narrow request of information for specific items on your return rather than a full-blown in-person, field audit, 3) partnership, LLC, and s-corporations have a less than half of one percent chance of being audited, while small c-corporations with less than $10 million in assets have an audit rate just under one percent, 4) larger c-corporations have increasingly higher chances of being audited with a roughly one in three chance for corporations with over $250 million in assets.  If you would like to read the full article, you can read it on my website at http://www.tlongcpa.com/blog.  The rest of this article will be devoted to audit selection and in two weeks we will discuss “red flags.”

Regarding audit selection, let me start by saying that no matter what you read or hear, nobody knows the exact methodology the IRS uses to select returns for audit as it is not public information.  All we really know is the broad overview the IRS tells us about its methodology and the limited statistical information the IRS releases about audits; the rest is conjecture based on the type of returns that we as tax practitioners see being audited.  Of course that can be warped by our own experiences.  That said, when you have been in the field long enough and have read about or talked to others about their experiences, you do get a good idea of the common issues for the types of clients with which you work.  When a client comes in and says, “I heard that if you report over ‘x amount’ of this, it is a red flag,” or “I am not going to file until ‘this date’ because you are less likely to be audited,” I know they have latched onto some misguided information.

So what does the IRS say about their audit selection tools and methods?  First, they tell us there is a computer scoring system called “Discriminant Inventory Function System” (DIF).  This system looks at your return and compares your return to similar returns to come up with a score for your return; the higher your score, the more likely an audit will yield a tax change.

Secondly, they use computers to match information reported on your return with information reported by third parties such as on Forms W-2, 1099, 1098, and the like.  Automatic notices can be generated as a result of mismatched items.

Third, they admit to using a variety of other tactics and resources such as the internet, newspapers, and other public information, or even people who may file a complaint or “squeal” on you.  They say they will investigate these sources for reliability before using it for an examination.

They also have the right to contact third parties about you, such as neighbors, co-workers, bankers, etc. Generally they have to inform you if they contact someone else unless they feel it would jeopardize their ability to collect the tax or that you might retaliate against the individual.

Although I have not seen this written as a tactic employed, I am aware of a situation where the IRS was selecting returns because they were prepared by a particular tax professional in a particular industry (and no, it wasn’t me!).

In addition there have been various programs over the years such as the Taxpayer Compliance Measurement Program and the more current National Research Program which introduces a random statistical selection methodology.  One of the uses for the information gathered in this program is to fine-tune the DIF computer scoring system.  It also means that ANYONE can be audited.

In two weeks we will discuss “red flags.”

Prior articles are republished on my website at www.tlongcpa.com/blog.

IRS Circular 230 Notice: To the extent this article concerns tax matters, it is not intended to be used and cannot be used by a taxpayer for the purpose of avoiding penalties that may be imposed by law.

Travis H. Long, CPA is located at 706-B Forest Avenue, PG, 93950 and focuses on trust, estate, individual, and business taxation. He can be reached at 831-333-1041.

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