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New SBA Study says IRS Small Biz Audit Crackdown is Bogus

Ten years ago, a landmark IRS report claimed that small business owners under-report income by $80-100 billion yearly and account for over half of the U.S. “tax gap” of owed by uncollected taxes.   As a result, small business owners have been subjected to increased audits and reporting requirements, including the controversial new 1099 rule.

But now for the truth:  A new study just released by the U.S. Small Business Administration (SBA) Office of Advocacy says the IRS crackdown on the backs of small biz has been bogus all along.  And that comes from independent research commissioned by the Feds themselves – not some anti-tax business group.

After reviewing 10-years’ worth of IRS small business audits related to the innocuously-named “National Research Program” (NRP), outside researchers found that a mere 1% of all issues examined resulted from intentional failures to report income properly. Yes you read that right – one percent. In other words, 99% of income underreporting is unintentional, and undoubtedly the result of a vast and utterly confusing array of tax rules and regulations.

And here’s the real gut punch for biz owners:  While small business was tagged as the tax cheating culprit, the new study says that large corporation tax gaps are scarcely being measured at all, and that the IRS has been using estimates dating back to the 1970s and 80s to calculate corporate noncompliance.  What’s more, says the new report released by SBA:  “The IRS focused its tax-gap study on individual tax returns, and on returns not subject to withholding or third party reporting, which skewed the study unfairly toward small business.”

Over the last five years, audits of returns typically filed by biz owners have soared, while those for corporations with $10 million or more in assets have actually dropped 13%.  These are figures reported by the SBA itself.

But which type of audit pays off the most for taxpayers – small biz or big corporation?  No contest.  According to the new whistle blowing report, the IRS collects an average of $9,350 per auditor hour spend examining big biz returns, but only $1,034 per auditor hour spend auditing small business.

The new study concludes with this:  Unlike large corporations, small businesses lack the resources and expertise to negotiate with the IRS.  Indeed, 71% represent themselves in audits. They are overwhelmed by the complexity of the tax code.  Only aggressive outreach and education designed to help small businesses understand their tax filing obligations will significantly reduce the tax gap attributed to them.

BizBest will email the full 54-page report in PDF, free of charge, to anyone interested. Email your request to editor@bizbest.com, and be sure to include the email address you’d like the report sent to.

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What You Must Know about Hiring Independent Contractors

If your business uses independent contractors, the best tax advice is simple: Watch your back! Why?  Because state governments are lining up to help the IRS nab businesses they believe have misclassified workers as independent contractors instead of employees.

In tax terms, the difference is huge. If the IRS says you did it wrong, the taxes and penalties will do some serious damage.  And states now want their pound of flesh as well.  Pennsylvania, for example, just enacted a law that can impose civil and even criminal penalties on businesses that misclassify workers. Other states with similar laws include CO, CT, DE, IL, MD, MA, NE, NJ, NM, NY and WI.  Others won’t be far behind.

And be aware that the IRS uses leads and other information it gets from all states to identify and audit small businesses it feels are misclassifying workers.  In short, small business is a big target, and thousands of audits are underway already, with thousands more to come.

Using independent contractors or “contract workers” properly has long been one of the stickiest issues that small business owners face.  Are the people you bring in to provide specific services “independent contractors” (non-employees)? Or are they actually employees?

Because independent contractors are responsible for paying their own taxes, using them can save your business a bundle in payroll taxes, insurance, benefit costs, training and other areas. Independent contractors work for themselves. They operate their own business and have you as a client. You are not their employer and don’t set their hours or control how they perform their work.

But the IRS sees it this way: A worker is an employee of your business unless you can prove otherwise.  “Determining whether a new worker is an employee or an independent contractor can be tough,” says Keith Hall, National Tax Advisor for the National Association for the Self-Employed (NASE).  “Keep in mind that you can’t just choose which one is easiest.  It really depends on who calls the shots day to day.”

If you’re unsure how to classify a worker, here’s quick advice from NASE:

  • If you control the Who, Where, When and How the work is done, they are probably an employee. This means that you, as the business owner, must file a Form W-2 and withhold income and payroll tax, among other things.
  • If the worker controls their own work product and even has other customers besides you, then they are most likely independent contractors.  Payments to independent contractors are reported on IRS Form 1099, and the independent contractors are responsible for their taxes and their own tax forms, including Schedule C, Profit or Loss from Business and Schedule SE, Self Employment Tax.

And also know that workers who believe they’ve been improperly classified as independent contractors can file an Uncollected Social Security and Medicare Tax on Wages form asking the IRS to calculate and collect the employer portion of those two items that would have been due from you.

Here are 12 other things you should do and know:

  1. Using an independent contractor agreement can help (a little): A simple agreement that specifies the independent contractor relationship can help validate your position, but it won’t be enough by itself. Sample independent contractor agreements that you can use or adapt for your own business are available online at Business Owner’s Toolkit and DocStoc.com.
  2. Know the rules for your specific business or industry: Some industries or types of businesses have established a tradition of using independent contractors rather than employees and have cleared this with taxing authorities. But at the same time, firms in certain lines of business are at high risk for aggressive worker “reclassification” audits – especially construction and landscaping.  IRS Publication 15-A, The Employer’s Supplemental Tax Guide (PDF) has detailed guidance including information for specific industries.
  3. The Independent Contractor Report, which has been tracking legal issues in this area since 1986, has detailed information on industries most at risk.   
  4. Know what the IRS says: This is an area where’s it’s important for business to look at what the IRS is saying about the business relationship between you and the person performing the services. The links below have what you need.
  5. Contractors control when and where they work. While they might receive job specifications from a client, they are not given specific instruction on how to accomplish a task.
  6. Avoid setting a pattern of daily or weekly work hours dictated by your business.
  7. Contractors do not usually have a permanent or continuing relationship with your business and have time to pursue other clients. Compensate contractors on a per-job basis, rather than weekly or monthly.
  8. Contractors are paid to complete a set task and may bring in others to complete it, at their discretion and on their payroll.
  9. Contractors use their own tools and technology and are responsible for their incremental expenses. They have an investment in their own “business” and should be able to perform their duties without your facilities.
  10. Contractors can’t be fired as long as they produce results that meet their contract specifications.
  11. Contractors are not covered under health insurance or other benefits you have for employees.  They should have their own.
  12. Legal self-help publisher Nolo has a great guidebook that shows you how to: create a valid contract, assess who qualifies as an independent contractor, hire ICs without risking an audit, retain ownership of intellectual property when using ICs and take advantage of the IRS “Safe Harbor” law.  Details at Nolo.

These IRS resources will also help:

10 Tips to Avoid a Tax Audit for Small Business

As Washington digs for every dollar to stem the federal deficit, IRS audits of small business tax returns are up – way up, and headed even higher.  And know this too:  Sole proprietors – the dominant type of small biz ownership – are 10 times more likely to be audited than other business entities such as LLCs, S-corps and partnerships. But here are ten tips that can help you lower your IRS audit odds:

1.       Be “DIF” score savvy. DIF is hush-hush Fed-speak for “Discriminate Information Function,” the secret IRS formula that decides if you’ll be audited. While DIF details are, well, secret, the steps below can help you avoid the audit hook. Each choice you make – including how to file (e-file or paper), when to file (early? last minute? extend?) and what deductions to claim (home office? entertainment?) – impacts your DIF score and your audit odds.

2.       Be accurate, thorough, neat and on-time (but not early). Sloppy returns, math errors and rounded numbers raise red flags at the Internal Revenue Service.  Having an accountant prepare your taxes, or using a tax prep service or tax prep software makes your return look professional and lowers chances of obvious errors.  But don’t be in a hurry. Filing early only gives the IRS extra time.

3.       Do not file electronically. The IRS hires temps to enter data from millions of paper returns. But they capture only about 40 percent of the info. Electronic filing gives the IRS quick and easy access to 100% of your return.  That’s why they like it so much.

4.       Explain yourself.  Avoid vague expense categories.  For example, “Miscellaneous” is a definite no-no.  If your biz is claiming unusual deductions, provide explanation or specific documentation with your return. Whatever it is, there’s probably a form for it.

5.       Make quarterly tax payments and issue 1099s, W2s and other mandatory filings on time.  Do these electronically. Late quarterly and estimated payments, non-payments and underestimated amounts draw serious IRS ire. Know the deadlines and meet them. File 1099s and W-2s using easy online tax services such as FileTaxes.com. The BizBest Guide to 2011 Tax Forms and Answers has the info and links you need.

6.       Beware of your income-to-deduction ratio. Your audit odds rise if the difference between expenses and income exceeds 52 percent. But total deductions are only part of it. One large deduction can also raise flags.

7.       Inc. yourself. Sole proprietors who file a Schedule C for each business get audited most. To avoid the higher risk of sole proprietor audits, consider making your biz a corporation or limited liability company (LLC).

8.       Hire a tax pro.  If your return is complex or you are uncertain about treatment of deductions, income or other areas, don’t hesitate to bring in a CPA or other business tax pro.

9.       Take a home office deduction carefully. It’s a prime IRS target, so if you plan to take a home office tax deduction, make sure you know the rules.

10.   Get real. Every year, the IRS gets better at using high-tech means to track your business income with cooperation from companies you do business with as well as state and local agencies. And some things are just obvious. If you claim lots of expenses, but show little revenue to pay for them, the tax folks get curious.

BizTaxes.com, a BizBest site, has more helpful tax-saving advice.

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