You, Inc. And The IRS

Got this from a reader regarding the post You, Inc.

'This is the absolute fastest way to get audited.'  Signed, Anon.  I assume that Anon is short for anonymous as this is what he appears to want to be.

But first, if you want to be rich or try and get rich YOU HAVE TO GET OVER YOUR FEAR OF THE IRS AND THE FEAR OF AUDIT.

Somehow the IRS has gotten a reputation second only to Freddie in those slasher movies for scaring people.  Sure, getting a letter from the IRS is no fun and I've gotten a few so I know.  But if you are going to be a good businessperson you have to know how to minimize your taxes.  If you have a business expense, deduct it.  And if the IRS asks what it is, you explain it.  If they disallow it you either appeal it or they recalculate your taxes and you pay the incremental tax and a interest penalty.  They will not boil you in oil.  Or send you to jail.  I don't think.  You go to jail for tax evasion, not disagreements on how much to pay.  If you are doing tax evasion, move to Switzerland.  Tax evasion is not illegal there which I have never understood.

My first introduction to the IRS was at work.  In the old days you could deduct sales tax but most people didn't because the guidelines said that you must keep all receipts in a box and so on and so forth.  Well, one year we spent a lot of money so I decided to look into this but I knew I did not have all my receipts so took a quick trip down to the Tax Department to see my old buddy, Phil.  And Phil was good and an ex-IRS agent.  Told him my story and half way through he stopped me and said "Here's what I do.  At the beginning of the year I take my cash and then I add my take home pay for the year and then I deduct my ending cash number.  Then I multiply that number by the sales tax percentage and I enter that number on my tax return."  What?  No receipts, no sweating the numbers, no fear of audits?  Phil continued.  "First, my chance of being audited are miniscule.  Second, my number is going to be plus or minus 10%.  Third, the agent will know that.  Fourth, the agent won't get promoted for getting an extra $50 out of me.  And fifth, I'm not going to go nuts collecting receipts all year."

I really got over the IRS when a tax attorney at another job said I had to declare on my personal tax return that I was a signer on bank accounts in foreign countries.  This tax attorney was the opposite of Phil.  Very by the book and more.  The background was that our company had subsidiaries in just about every country in the world and since I was in International Treasury there was a dumb rule that I be a signer on every account.  Don't ask me why.  And this idiot demanded that I include each country on my personal tax return.  I fought and fought and it went up the chain of command when I realized I was becoming a nuisance so I dropped it.  But my personal tax return ballooned by about twenty pages and the IRS knew I had financial dealings in every country from Afghanistan to Zaire.  And I sat back and waited for the dreaded audit.  Never heard a peep.

The lesson is be reasonable and know the rules, the general rules, and use a computer program like Turbo Tax so you don't miss anything.  And if you do get rich the IRS will be looking at your return anyway.  But so what?  It is a cost of doing business.  To maximize the utility of the tax system you have to be willing to deal with the system.  Or do as Anon. seems to be saying--here's all my money, IRS.  Take it and leave me alone.   

The following is rather bad article, and rather dated article, on the tax system.  But I couldn't find any good articles so this will have to do.  How you handle taxes is your decision but audits don't really bother me as I am comfortable defending my financial transactions.  Fear should not be the determining factor when making business decisions. 

Let's throw in the Supreme Court here as Judge Learned Hand said

"Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the treasury. There is not even a patriotic duty to increase one's taxes. Over and over again the Courts have said that there is nothing sinister in so arranging affairs as to keep taxes as low as possible. Everyone does it, rich and poor alike and all do right, for nobody owes any public duty to pay more than the law demands."

The article.  Like I said not very good but worth reading.

Maybe you think deciphering your bookkeeping and filing your taxes is tough. Well, it is, sort of, but it's kids' stuff compared to the big enchilada: getting called on the carpet by the IRS and asked to explain and defend your tax return. (For those of our readers outside the US, the Infernal Revenue Service, our beloved tax-collection agency, is one of the gentle joys of being an American.) In all fairness, the IRS has a big job to do -- namely, collecting annual dues from those of us who work and live in the United States. Fulfilling this mission means making sure that every taxpayer pays his full share, and the IRS achieves this in part by subjecting suspicious tax returns to a careful and official review, or audit.

The IRS conducted approximately 1.1 million closed books and records audits of individual (i.e., non-corporate) tax returns in the three-year period 1992-1994, exacting from the audited individuals an average additional sum of between $2,000 and $10,000. As if having to pay the additional sum weren't unpleasant enough, people who get audited have to endure the time-consuming and aggravating process of the audit itself. And in an IRS audit, unlike in a U.S. criminal trial, you're guilty until proven innocent. The burden of proof rests with you.

The bottom line, therefore, is that you want to do your best to avoid attracting the notice of IRS agents. Unfortunately, if you file a Schedule C along with your 1040 -- as you probably do if you have 1099 income -- you're more likely to be audited than are people who only have W-2 income. (A September 1997 IRS press release, for example, notes that, in fiscal year 1995, more than three percent of all Schedule Cs reporting between $25,000 and $50,000 of income were audited, compared with about one percent of 1040A returns reporting income in the same range.)

You'd probably rather not get audited. But what, specifically, is likely to get you audited? Unless you're a masochist, you should probably take extra care not to mar your return with the following red flags:

Deductions. Although Uncle Sam allows for all kinds of deductions, his nephews and nieces at the IRS pay close attention whenever taxpayers claim them. Some kinds of deductions are more questionable than others, and the Home Office Deduction is one of the most frequently contested of all, largely because it's easy to fudge. In order to claim a Home Office Deduction, your home office must, in most cases, be your principal place of business, which means that you do most of your work there. More importantly, you have to use the space exclusively for running your business, and not for personal use as well. Otherwise the space simply doesn't count as a home office and may not be deducted as such. The rules can get pretty specific. Read IRS Publication 587 ("Business Use of Your Home: Schedule C Example) for the IRS' own explanation of what's permissible and what isn't.

Inconsistencies between your new return and last year's. For example, if you changed your name (from, say, John Doe to The Taxpayer Formerly Known as John Doe), or your spouse or your children changed their names, or if you're suddenly taking new types of deductions, the IRS is likely to notice and inquire about them.

Disagreements between your state and Federal tax returns. If you told the state treasury that you earned $50,000 last year, don't tell the Feds that you earned $52,000 or $49,000 or even $50,001. They'll wonder why you did, and then ask. The potential for discrepancies lies elsewhere as well. Remember that, as a contractor, you receive 1099s from all the people who paid you -- at least in theory. And when clients send you a 1099, they also send a copy to the IRS. If you report gross income that's less than the total amount indicated by all the 1099s submitted with your name on them, you run a high risk of being audited. (Yes, state and Federal tax authorities do share and compare data.)

Drastic changes in income. If you took in $50,000 last year, but report that you earned only $15,000 this year, the IRS will ask, "What the hell happened? Where's the money? Under your mattress? Up your butt?" Flashlight in hand, the IRS will look.

Round numbers, like "$3,000." These don't occur much in everyday life, and if your return is sprinkled with them, IRS agents will take notice.

Incomplete or sloppy returns. Don't leave any blanks where you should really leave numbers. Also, don't dash off your return with a blunt and chalky number-2 pencil; use a typewriter or a computerized tax-filing program like Intuit's TurboTax (for PCs) or MacInTax (for Macs). Otherwise you might end up translating your return -- in person.

Suspiciously low income. If your tax return indicates that you, your spouse, and four dependents live on Rodeo Drive in Beverly Hills on an income of only $18,312, agents will marvel at your ability to stretch a dollar -- and call you in for an explanation. In short, the IRS might question the accuracy of any return that shows both a low income and considerable financial obligations.

Most of the tax returns chosen for audit in a given year are chosen by a computer looking for returns likely to yield big bucks for the Federal Government, not by people trained to spot red flags, so maybe all this extra vigilance isn't worth it. On the other hand, do you really want to bet against the computers? Wouldn't you feel like an ass if you had to endure an income tax audit because you were too busy oiling your Weed Whacker to fill in the forms properly?