The IRS doesn’t really care whether our tax policy is right or wrong, it just “enforces” the policy. It has indicated that most “cheating” is done by small business and as a result it watches small business owners more closely than wage earners.
This is partially evidenced by the number of IRS employees (more than 45,000) dedicated solely to squeezing the small businessperson where it hurts the most
As a result, small businesses are at great risk for an audit. We know though what the IRS is typically looking for when they conduct a small business audit, and the most common items are:
Personal living expenses written off as business expenses
Auto expenses written off for travel that was not business related
Large business entertainment expense
Failure to report all business related income
Whether workers are being classified as independent contractors when they should be classified as employees
Whether the business is making all of it’s payroll tax deposits.
I always make four suggestions to small business owners as a result:
1. Use a reputable payroll company – this helps prevent the use of payroll withholding to keep the business afloat during down times. The most dangerous problem is when the small business owes a lot of payroll tax. It won’t go away. It will stay with the business until it dies and a large portion of it will stay with the responsible owner etc. until it’s paid.
2. Use someone else to do the tax return – i.e. don’t do it yourself – a third party cpa or tax lawyer can look at the big picture and make sure the return makes sense, spot missed deductions, and apply tax law to the facts of your situation. This reduces the chances that income is missed and increases the odds that all legal deductions are taken. It is worth the dough in the end.
3. Plan ahead – talk to a cpa or tax attorney about what you can do in coming year(s) to take advantage of the tax code. Talk to them especially when you plan on taking on employees and paying them as independent contractors, or leasing a private jet.
4. Treat the business as a separate entity – set the business up properly, keep a separate set of books, use separate checking accounts, don’t use business accounts to pay for movie tickets and trips to the zoo.
IRS Penalties are a fact of life unfortunately. They are a revenue “stream” for the IRS and not one that it will give up easily.
When the IRS sends you a bill from the negative results of an audit, it will add a penalty or two to the bill. Interest is also conveniently attached to the underlying new debt and the penalty as well.
These penalties were originally designed to be a punishment. A punishment meant to deter bad conduct. They are now a dependable source of income for our ever expanding government. Many tax experts consider the billions a year assessed as penalties to just be a tax and not a real deterrent.
Let’s look at some of these penalties just to give you an idea what you are facing.
The IRS gets to tack on ¼% to 1% each month of the amount you didn’t pay on time, ½% to start and drops to ¼% once you arrange a payment plan. If you fail to pay and a notice of intent to levy is issued – the penalty can be raised to 1%. It is imposed monthly.
Failure to File Timely Penalty
If you filed the return late – the penalty is 5% per month on the balance due up to 25% of the total debt. This penalty tops out if 5 months and 1 day after the return was originally due you still have filed the tax return. If you file but no debt is owed – there is no penalty. Some non income tax/personal returns have other rates.
The IRS gets to stick an additional 20% penalty to the tax bill if the IRS auditor decides that you understated your tax liability. This is very common.
If the requested return(s) isn’t filed, the IRS has the authority to file/audit the tax return all in your name. The IRS employee tasked with this job is directed by the Internal Revenue manual to calculate a “reasonable and substantially correct” return.
The auditor who is creating this return can rely on the income information reported like w-2 and 1099 income, but he can also rely on other sources to estimate your income and expenses.
This is common when the income reported doesn’t seem to match your living arrangement.
Think…gated community and large home with only $20,000.00 of reported income.
For businesses with unfiled returns, the auditor uses sources that provide him “industry standards”. He can actually estimate what he thinks your business may have earned and spent on overhead by comparing your business to other business’ similar in age, purpose and size.
After the auditor is all done estimating your income and budget items, he will forward a copy to your last known address and give you the opportunity to dispute with figures of your own or provide your own correct return or he may simply issue a notice of deficiency and provide you 90 days to contest the report in Tax Court.
Once the dates are missed and the auditor created return is “assessed”, the new “substitute” return can be used by the IRS collection department as a basis to levy a paycheck or bank account.
This process is the most common problem my clients face; i.e. a number of years of unfiled tax returns, a few of which have been done by the IRS as substitute returns, and subsequent collection activity.
If you have been putting off the creation of unfiled returns and you earned money during the years in question, it will be cheaper and probably much easier to beat the IRS to the punch before you are…audited.
1. Mail them. Late tax returns can’t be filed electronically. They must be mailed in and to a specific address. Visit the IRS. Gov website to find the address that most accurately fits your description.
2. Hand deliver the returns. If time is of the essence and you need proof that you filed a particular return by a certain date,make a photocopy of the return and take the original and the copy to the IRS office locally.The stamped photo copy proves where and when.
3. Send certified. Certified mail provides proof that each return was received by the IRS. Do it. Don’t take chances. If you don’t send by certified mail, than follow up with the IRS to make sure they recieved the return by asking for an “account transcipt” that will show a return was filed by you and when.
4. Mail in separate envelopes. If sending certified, mailing separately will ensure each return has it’s own date stamp and certified mail receipt. This could come in handy later when the IRS says they didn’t recieve it on time or at all. This may also prevent the IRS from missing a return altogether that has been lumped together with others.
5. Speak to counsel. If you have a number of unfiled returns, it may be wise to speak with a tax attorney as you begin the process.
1. IRS filed returns can be changed. The IRS constantly files returns for non filers based on income information it has recieved. The returns are almost always incorrect and overstate the taxpayer’s liability. The IRS uses these returns to get the taxpayer’s attention. The good news is that the correct return filed correctly will almost always eliminate the IRS filed return. So don’t panic if you are getting bills for years you haven’t filed, just create the correct return.
a. The first rule is that the refund for a tax return is lost forever if the return is filed more than three years after it was due. This rule affects many more taxpayers than you would think. The IRS makes a large profit each year on the number of returns left unfiled with refunds due.
b. The second is the statute of limitations related to collecting tax debt. The Service has 10 years to collect a debt from the date it was assessed. They tend to apply this rule to returns they have completed and assessed. If the substitute return was assessed 8 years ago for example and shows $100,000.00 in debt, it may not make sense to file the correct return even if it reduced the debt to $10,000.00 depending on your current financial situation. It may make more sense to let the clock kill the debt and avoid the hassle of completing the returns.
The reason is obvious. There can be significant benefits to filing bankruptcy.
6 of the most important potential benefits are as follows:
1. The Automatic Stay
“Automatic Stay” is the common term used to describe that section of the bankruptcy code that governs what creditors must do or stop doing, once a bankruptcy is filed. It applies in every bankruptcy case. This law requires that almost every creditor in almost every situation, stop collection activity once the case is filed. This includes the IRS.
If the IRS has proper notice of the bankruptcy, the filer can actually sue the IRS for violation of the Automatic Stay Provision and recover actual damages including court costs and attorney fees, if the automatic stay provision is violated.
2. Elimination of Tax Debt after Discharge
The most obvious reason to file the bankruptcy, is the ability to get rid of the debt. As I often say, “believe it or not” certain income tax debts can be wiped away in bankruptcy along with accumulated penalty and interest. Determining “dischargeability” can be more complicated than it seems. Use of experienced legal counsel is a must.
Thousands of Americans have serious tax debt. They are often taken in by the promise of an easy solution via the IRS offer in compromise (OIC) program. The problem is that most people aren’t good candidates for the OIC program.
In an OIC the IRS is empowered to accept less than what they are owed if:
1. The debt amount is incorrect
2. The debt isn’t reasonably collectible
3. The debt is collectible but there is some other reason that would make it unfair for the IRS to collect the debt.
Most OIC cases are those that are based on #2 – the debt isn’t reasonably collectible. Most people don’t try an OIC and of those that try, most fail.
Reason 1 – The debt is collectible
The IRS is allowed to use a “formula” to determine whether a debt is collectible before the 10 year statute of limitations (SOL) on collection runs out. The formula is theoretically simple.
Average Income – “necessary” Budget = Excess Income
Excess income multiplied by time left in SOL + asset value = amount collectible over remaining time in SOL
If amount collectible over remaining SOL is less than the debt:
Cash Offer – Excess income x 12 plus asset value = OIC amount
Payment Offer – Excess income x 24 plus asset value = OIC Amount
The formula is simple on it’s face and for those that make little money and have few assets the formula often works well. The problem and the reason why so many OIC’s fail, is found in the details of the formula.
How does the IRS calculate income? If you have had a down year income wise, will the IRS limit it’s calculation of your income average to that year?
How does the IRS calculate your budget? It uses a standard budget with variations. Not your budget. If your house payment is $2500 per month and the standard for your household size is $1500 per month, it will usually use the lower number creating a larger excess income amount and phantom income.
The formula usually results in a failed OIC based on one of two things:
The IRS sees the ability to pay the entire debt before the statute of limitations runs out
The formula works but the taxpayer can’t afford to pay the settlement amount
Reason 2 – The process can be difficult
The IRS purposefully makes the process difficult. It initially rejects many cases and many do not have the funds or desire to continue the fight.
Reason 3 – Large amount paid upfront
The taxpayer must typically pay 20% of the debt with the offer (in a cash offer) or start making monthly payments equal to the offered monthly payment amount and loses those funds if the offer is unsuccessful.
Reason 4 – Full compliance is often a problem after acceptance
IF the offer is successful, the taxpayer must file tax returns and pay tax obligations for 5 years, if not, the offer is over, the money paid is lost, and the total original debt with it’s accrued interest, continues to be owed, minus what has been paid.
Reason 5 – Offer in Compromise is not a complete solution
Often, the taxpayer proposing the OIC has medical bills, credit card debt, personal loans, state tax debt etc. all of which must still be dealt with outside of the offer in compromise. The payments on these debts aren’t always allowed as part of the budget in calculating the reasonable collection potential of the taxpayer, making it difficult to comply with the requirements of the OIC.
OIC’s have other problems as well
1. When an OIC is rejected, the taxpayer still owes the entire debt with interest, while the statute of limitations period on the collection of the debt has been stopped. The taxpayer is right back where he or she began.
2. The taxpayer who has been rejected, has provided every detail about his or her financial life to the IRS making it easy for it to collect the debt. They’ve provided a detailed roadmap.
3. The OIC stops certain time-period(s) from running for purposes of bankruptcy requiring a payment plan to be negotiated post rejection in order to run out the time.
BANKRUPTCY – is it really an alternative?
Believe it or not many people with tax debt use bankruptcy to reduce, eliminate or control tax debt.
A quick review of bankruptcy in relation to tax debt will help to explain why:
There are two types of bankruptcy that pertain primarily to consumers. Chapter 7 and chapter 13.
A chapter 7 bankruptcy is the more commonly filed, and is a liquidation case. In a chapter 7 bankruptcy, the debtor loses all assets not protected by statute and is forgiven his or her dischargeable debt.
Chapter 13 bankruptcy is a “reorganization” bankruptcy. The debtor attempts to keep his or her assets and pay some or all of the debt depending on income and budget amounts. The plan length varies between 3 and 5 years depending on a number of factors.
Tax debts as alluded to above, are classified in either a chapter 7 or chapter 13 as either dischargeable or non dischargeable on the date the bankruptcy petition is filed.
Non-dischargeable tax debts include:
1. collected and unpaid sales tax (of the trust fund nature)
2. trust fund recovery penalty (employment tax unpaid by a business assessed against a “responsible party”).
3. Trust fund tax
4. Income tax related to a return that was not filed or filed but within 2 years of filing the bankruptcy.
5. Income tax related to a return that was due including extensions within the last three years
6. Income tax related to a return for which fraud was involved
7. Income tax for a tax liability that was assessed by the taxing authority within 240 days prior to the date of the bankruptcy filing.
Dischargeable tax debt includes:
1. Those income and certain other non “trust-fund” taxes that meet the following criteria:
A “return” was filed
It was filed more than two years ago
It was due more than three years ago including extensions
The tax was assessed more than 240 days ago
There was no civil or criminal fraud nor did the taxpayer willfully evade or defeat the payment of the tax debt.
In essence, a tax motivated bankruptcy is a bankruptcy case that takes into account filing issues, timing and taxpayer history in a way to take maximum advantage of bankruptcy law in relation to the tax debt.
Or in other words, what may be a non-dischargeable tax debt today may become a dischargeable tax debt tomorrow.
The other benefits in comparison to an offer in compromise are as follows:
1. OIC’s factor in the taxpayer’s income while chapter 7 bankruptcies usually don’t. In a chapter 7 if the majority of the taxpayer’s debt is tax debt, then the income is irrelevant as to whether the taxpayer qualifies to file a chapter 7. The bankruptcy means testing shouldn’t apply.
2. OIC’s factor in future income potential while most bankruptcies don’t. It may not matter in bankruptcy that the taxpayer may be making more next year. Many offers are rejected on that basis alone.
3. OICs factor in asset equity. Bankruptcies do not. Equity in bankruptcy has little to do with ability to file or the dischargeability of the debt itself. Certain assets may be liquidated in a chapter 7, most consumer assets are safe.
4. The largest benefit of bankruptcy over the Offer in Compromise is that a bankruptcy can be crafted to deal with all of the other taxpayers debts at once. State tax, credit card, medical bill, personal loans and other consumer debt.
An “offer in compromise” is simply an offer to settle tax debt made by the taxpayer to the IRS that may result in a settlement agreement between the two.
The driving force behind the process is that…like most creditors, the IRS is smart enough to know when a “bird in the hand” is worth more than “two in the bush”, i.e. if it really believes that it will get less in the end, it will agree to take what it can now, and call it a day.
The initial standard used to determine the “bird in the hand” value is whether the amount being offered by the taxpayer to settle the debt once and for all, is greater than or equal to the “reasonable collection potential” of that taxpayer. (RCP)
How Does The IRS Determine One’s “RCP”? The most common way stated generally is as follows:
The equity value of taxpayer assets PLUS The difference between the taxpayer’s income and budget when multiplied by 12.
An example: Fanny Fictitious
Fanny has the following:
$30,000.00 Equity in home (“Market value” of home – loan amount)
$5000.00 Equity in car (“Market value” of car – loan amount)
$10,000.00 “Value” of Retirement Fund
$45,000.00 Total Equity
$5,500.00 (gross monthly income)
$5,300.00 (gross monthly living expenses including proper tax withholding)
$200.00 (Remainder) X 12
$2400.00 Ability to pay from income
$45,000.00 PLUS $2400.00 = $42600.00
$42,600.00 = Reasonable Collection Potential
Fanny’s RCP would be $42,600.00.
If she owes more than $42,600.00, than in theory, it’s a good settlement, i.e. the IRS is getting…the bird… and Fanny is paying less than she owes.
Great right? Now the catch.
The payment would have to be made by sending 20% of it as a lump sum with the filing of the offer proposal and the remainder within a very short period of time following the agreement. (by the way if the offer doesn’t pan out, the IRS keeps the 20%)
Yes, this type of offer in compromise requires the amount to be paid in full, very quickly following acceptance.
So what if Fanny doesn’t have access to such a large sum of money?
She could convince the IRS to try and calculate the RCP another way. She would multiply the remainder number by 24 instead of 12 thereby increasing the RCP but also thereby creating a payment plan of sorts. A payment plan that requires the RCP be paid over what is typically a two year period.
There are exceptions, but you are getting the idea.
This RCP thing seems simple enough…
So, Why Do So Many Offers In Compromise Fail?
How many? Nationwide you can count on about a 65% to 80% failure rate each year.
A few reasons:
1. The Relationship Between 12 and Fannie’s Lifestyle
It’s a bad one. The IRS is able to “impose” a budget on Fanny, at least to start. That budget is usually not the same as Fannie’s actual budget. It is lower. Every dollar that the IRS can remove from the budget is 12 dollars added to the cash offer and at least 24 to a “payment plan” offer.
Many people that file offers in compromise don’t fully understand this relationship and the IRS’ ability to use budget numbers different than their own.
Of course, this basic budget can be challenged in different ways, and an experienced practitioner will understand some of the ins and outs related to convincing the IRS to agree to a more reasonable number.
2. Inability to Pay Offer Amount
Assume that Fanny owes the IRS 1 million dollars. The above RCP is only $42,600.00. A savings of…alot.
Holy smokes. That is really a fantastic settlement. Amazing.
Fanny doesn’t have $42,600.00 though. She can’t borrow it because no one she knows has that kind of dough.
She switches to the payment plan but the monthly amount needed to pay the settlement over a limited period of time leaves her too little income to pay her actual bills.
3. Unclear Standards
The law surrounding what constitutes an acceptable offer in compromise is a bit..fickle. You know, uncertain, flighty, gray etc.
Ms. Bennett owed some money to the IRS. She calculated her RCP and submitted the offer.
Although the IRS admitted that the offer amount she submitted was more than “ten times” the RCP based on it’s own calculations, it rejected the offer.
Some of the reasoning:
Internal Revenue Manual (IRM) Part 126.96.36.199(5)(Sept. 1, 2005), says that a rejection can be based on a determination that an acceptance of the offer is simply not in the government’s best interests.
In other parts of the IRM the IRS is allowed to reject the offer if the taxpayer had a bad history of filing returns on time and there was some belief that she would continue in that manner.
The doubt as to collectability i.e. the RCP amount above only determines whether the offer should be “considered for acceptance”.
Quoting from the case.
“This language…doesn’t require that the Commissioner accept an offer in compromise whenever the amount exceeds the collection potential. Rather, it only establishes grounds for winning consideration”.
What this case really stands for is that RCP is really just the beginning of the process.You don’t have the right to appeal the denial of the offer and win just because the numbers make sense. The IRS can deny the offer for a whole host of reasons including quite possibly…just because.
You don’t have the right to appeal the denial of the offer and win just because the numbers make sense. The IRS can deny the offer for a whole host of reasons including quite possibly…just because.
4. I Just Can’t Hack It
It takes an organized and dedicated individual to put together the information necessary to submit with a compromise offer.
In the more complicated case, the amount of paperwork kills a few trees.
Not only that but in order to make the RCP work, to the taxpayer’s advantage, some planning i.e. changes must often be made.
Many people bail out during this process. It is just too much work, and the inability to keep up dooms the case from the start.
The IRS audit or the creation of tax returns by the IRS are uncomfortable propositions no matter your circumstance. The Cohan Rule may help.
Why so scary? An audit is just an attempt by the government to grade your homework right? A simple review of the documents you used to create your income and deduction disclosures. No big deal.
For many, the above is true. Of course, they are the ones that sat in the front of the class.
For most of us, a review of documents used to create income and deduction disclosures is scary. Why? Bad recordkeeping.
Now, I am just trying to be funny by over-generalizing. In reality, many of those who sat in the back of the class , are good record-keepers and vice versa. No matter our personalities, we should all be aware of the following:
The IRS can ask for documents and other proof to substantiate income and deductions claims on the tax return.
The IRS can review bank statements and lifestyle clues for signs of unreported income.
The IRS can expand an audit from one year to multiple years
The lack of substantiation can turn a civil audit into a criminal referral.
An attorney is needed to deal with the sensitive areas of the audit to try and prevent audit expansion and criminal referral.
The Good News:
Despite the above, “holes” in your record keeping i.e. missing receipts, checks etc. can be filled in legally.
Thanks to an old case called Cohan v. Commissioner, 39 F 2nd 540 (2nd Cir. 1930), the IRS will allow proof of expenses, even if receipts and checks are missing.
The catch is that the taxpayer must have a “reasonable basis” for the claim made on the return.
What is “reasonable basis” then? An example.
Imagine a realtor that drove many miles over hill and dale, night and day in her attempt to sell homes. She maintained a calendar of her workday all year, but didn’t keep a mileage log.
When audited she reconstructs the mileage log using the calendar. She submits the new mileage log along with an affidavit in which she swears that she drove that many miles.
What if the audit has already completed and the realtor did not recreate her mileage log. She knows the new bill is too high but doesn’t know what to do.
If the audit has been completed and the bill is too high, the audit may be reopened and the IRS can review the created mileage log. This process is called “”audit reconsideration“.
The Cohan rule still stands for the proposition that direct records aren’t necessary to verify an IRS expense deduction if a “reasonable basis” estimate can be reconstructed. If you have unfiled returns or are being audited and are concerned about missing documents, you are welcome to call me to discuss.
In a tax situation, a taxpayer may be able to learn how and when the IRS problem began, the amount of the tax, and the penalties being assessed and any interest and payments made. Additionally, notes, opinions and calculations made by IRS agents and officers may be obtained. This can be crucial information in a tax case and an FOIA request is possibly the only way much of this information can be located.
FOIA requests must be in writing and include your name, address and a copy of your driver’s license. The request must be for specific records and must include a statement that the request is being made under the FOIA. You must also state that you will pay any fees associated with retrieving documents.
Documents obtained under a correctly done FOIA request can take 30 days or longer to arrive. Therefore, it is important to properly prepare the request and send it in quickly if it is considered that the information will be necessary to the defense of the tax collection matter.
Again, if you are facing an audit or have serious tax debt, a FOIA can be a useful tool.
You are welcome to call and discuss your situation in order to determine whether such a request should be made.