Financial

Avoiding Tax Audits the Right Way

By Mark E. Battersby / Published July 2023

While the IRS’s own figures reveal that, in general, only one or two percent of all taxpayers have their returns audited each year, the threat of an audit continues to strike fear into every pressure washing business owner. That fear increased dramatically with the IRS’s reported plans to hire an additional 87,000 workers.

     Agents in back offices are being replaced by computers with complex algorithms that cast a wide net, one that pulls many law-abiding people into the chaos of an audit. The result is that many businesses are being scrutinized far more often than the numbers indicate.

     The IRS takes a dim view of a failure to report income, of more concern than a minor overstatement of deductions. But, keep in mind that there are penalties and then there is the fraud penalty equal to a whopping 75 percent of the unreported tax. Fortunately, there are perfectly legal strategies that can greatly reduce that audit threat.

Triggering Mistakes and Round Numbers

     The IRS obviously checks the math on every return, and too many errors will trigger red flags. Incorrect totals for expenses, missing Form 1099s, and transposed numbers are all believed to concern the IRS even if the mistakes are not big.

     Although employment is considered a business, an employee’s business expenses are largely relegated to being itemized deductions which aren’t currently available. The Tax Cuts and Jobs Act of 2017 largely eliminated employee expense deductions until 2026. 

     The IRS is also reportedly on the lookout for numbers that are too round. After all, it is unlikely that all of the numbers shown on any return will end in fives and tens or even thousands. 

Hints From The IRS

     The IRS offers the following steps that everyone can take to reduce the risk of their pressure cleaning business becoming an audit target:  

• Don’t report a loss. Never report a net annual loss for any business.
• Be specific about expenses.
• Provide more detail when needed.
• Be on time.
• Avoid amending returns.
• Match up all your paperwork.
• Don’t use the same numbers repeatedly.
• Don’t take excessive deductions.

     Obviously, this list favors the IRS and the basic tax law. But, keep in mind that no less a body than the U.S. Supreme Court has ruled that striving for the lowest possible tax bill is perfectly legal. Thus, reducing the possibility of an audit by not reporting a loss should be taken with a grain of salt. 

Beyond The Obvious

     While many unexpected and significant swings in income can usually be easily explained, large inconsistencies in income from year to year are often an area of concern to the IRS. Changes in the amount of income reported are considered a main indicator of underreported income. 

     Large shifts in income can be indicative of someone hiding income in either the current or a past tax year. When taking a closer look at the income earned in different tax years (as well as substantiating documents), the IRS often finds discrepancies between what a pressure cleaning operation earned and what was reported. 

     Despite the postponed requirement that third-party payers report payments to recipients, cash remains a major red flag because it creates all sorts of problems for the IRS. It is almost impossible to track cash transactions, cash can be easily hidden, it is difficult for the IRS to verify, and, despite the new reporting requirements, there are few electronic records to track it.

     Cash transactions go unreported by many who believe that cash doesn’t have to be reported or, more commonly, those who figure the IRS will never know that cash was received. However, today’s IRS targets returns where pressure cleaning operations may deal in large amounts of cash and consider it an audit red flag when a return contains a high probability of unreported income.

     Using a disproportionate number of independent contractors as opposed to employees is more of an audit target today with the states also on the lookout for large numbers of independent contractors used by a business.

     A pressure washing operation uses independent contractors to avoid paying payroll taxes—federal and state—including the employer portion of Social Security and Medicare demanded by the Feds. This doesn’t mean the business shouldn’t use independent contractors; just ensure compliance with the IRS’s worker classifications and the “worker-status tests” that vary greatly from state to state. 

     Many business owners set up an S-Corp instead of an LLC to avoid the 15.3 percent self-employment tax. However, while they aren’t subject to self-employment tax on distributions, S-Corp shareholders—as well as every pressure washing business shareholder and owners working as employees—must receive “reasonable compensation.” 

     The IRS is on the lookout for S-Corps and other incorporated businesses paying shareholder-employees unreasonably low (or even no) salaries. The IRS will compare compensation to the standard for a similar position in a similar industry.

     Failure to provide shareholder/owners with reasonable compensation (as W-2 reportable wages) is an audit flag often leading to a more comprehensive audit of the entire business.

     Even before the pandemic, the home office provided a place for pressure washers to catch up on paperwork, bookkeeping, or payrolls. With many taxpayers shifting to “work from home” during the pandemic, it should come as no surprise that the home office deduction will be under extra scrutiny.

     The deduction for home offices is more complex than many pressure washing business owners realize. The calculation for the home office deduction is based on square footage but only the square footage used exclusively for business purposes.

     When it comes to a pressure washer’s personal vehicle used for business purposes, the pressure washing operation—not the pressure washer—can often deduct a portion of the vehicle expenses. If the vehicle is used exclusively for business, a deduction for depreciation is often available. Unfortunately, because 100 percent business use is unlikely in most cases, claiming full business use of a vehicle is an audit red flag. The vehicle expense deduction should be backed up with mileage logs showing the dates and purposes of every trip.

Triggered By The Tax Pro

     Far too many professionals and business owners have succumbed to the promise of big refunds when using the services of a particular tax pro. Beware, however, as tax preparers have been a high priority target of the IRS for years as have many of their clients.

     The IRS has a number of ways that it discovers crooked tax return preparers. One of their clients may be audited and the results unrealistic enough that the IRS may take a look at other returns they have prepared.

Reality Versus Triggers

     In reality, no one knows which tax returns will be singled out for audit by the IRS’s computer algorithms. Many so-called “triggers” have been developed through the experiences of many professionals. The proposed increase in IRS auditors may or may not impact the current audit rate that sees fewer than two percent of all income tax returns examined within a year. 

     The statute of limitations for an IRS examination is three years from the due date of the federal tax return or the date it was filed. This period is doubled to six years if the return reveals a substantial understatement of income, usually more than 25 percent of taxable income. There is no time limit for failure to file a return for a particular year or if fraud is suspected.

Caught, Now What?

     If a tax return is selected for an IRS audit, the pressure cleaning business (or its owner) will receive a notice in the mail. The notice is always sent to the last known address and is never by phone, email, or social media.

     If audited, it will most likely be through a correspondence audit. The letter will contain instructions about what information must be sent them. If more information is needed, the IRS will reach out again.

     Should the IRS request an in-person meeting, typically at their regional office, the notice usually contains instructions about preparing for the audit and the particular items being examined. As an alternative, Letter 2205, a shorter version of the audit notice, will request a phone call and usually prefaces a face-to-face meeting.

Avoid Not Evade

     It is impossible to fully inoculate the pressure cleaning business or its owner from being the subject of an IRS audit since a portion of all audits are truly random. There are, however, steps that can be taken to minimize the likelihood of receiving that feared notice from the IRS.

     Obviously, everyone should claim deductions they or their business are legitimately entitled to. Of course, there is a need for vigilance and detailed recordkeeping to defend those deductions in an audit.

     Honesty and clarity go a long way toward preventing, dealing with, and surviving an IRS audit. Naturally, every business owner and manager should have a strategy for avoiding audits as well as for dealing with an IRS auditor. A fallback position should those strategies fail should also be in place.