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To listen, click on the Play button below.  Blog transcript follows.
Almost daily the media reminds us that small business drives the American economy.  The IRS is listening and with increasing zeal has hitched a ride on the small business engine.

Latest statistics show that the IRS Examination Division – the army of feared auditors – focuses on small business owners with positive incomes between $100,000 and $200,000.  Many of our neighbors fall into this category.  Even with a limited number of revenue agents to conduct audits, in 2009 the IRS targeted almost 40,000 small business owners.  Of those, 88% ended up with increased tax assessments between $23,000 and $32,000.  For someone living on $150,000, for example, that’s a big chunk to come up with.  Add penalties and interest and the number often rises to as much as $50,000.  Could you come up with a third of your annual income for quick payment to the IRS?

If you’ve ever faced off against an enthusiastic revenue agent, you know it’s wise to bring a pair of sunglasses to shield against the glint in the eye of the hunter.  Focused on the trapped taxpayer sitting in the cross-hairs, IRS auditors love to blast away using the feared indirect methods of assessment to raise the small business person’s taxes.

The Internal Revenue Manual defines indirect methods as “…the use of circumstantial evidence to determine the tax liability based on omitted income, overstated expenses, or both.” IRM 4.10.4.6. 

Circumstantial evidence.  Just think about it.  As the fictional but wise Sherlock Holmes taught:

“Circumstantial evidence is a very tricky thing…It may seem to point very straight to one thing, but if you shift your own point of view a little, you may find it pointing in an equally uncompromising manner to something entirely different."

Here’s an example of one indirect method used when the taxpayer doesn’t deposit a lot of cash and doesn’t volunteer cash outlays.

The indirect Markup Method invents an estimated income based on the use of percentages or ratios considered typical for the business under examination.  The revenue agent analyzes sales and/or cost of sales and the application of an appropriate percentage of mark up to arrive at the taxpayer’s Gross Receipts.  The revenue agent determines sales, cost of sales, gross profit or even net profit.

We all know that there is no such thing as the “typical” business.  Statistics may give an idea but cannot deliver the truth.  With a bit of imagination, the over-zealous revenue agent can get a joy ride on the back of the small business owner. 

Small business owners:  your mother was right when she told you to never pick up hitchhikers – especially when they’re wearing an IRS badge.
 


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Murray Singerman, JD, LLM

Author

Self-dubbed "Tax Knight," Murray Singerman writes in defense of the "humble citizen," often beaten down by the IRS and state taxing authorities.  Enjoy his short ruminations about the ever-changing area of tax controversy law.  Written with accountants in mind, Murray offers useful info and a chuckle to make your day a bit more enjoyable.

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