Dan Isard
on
Fear of going to jail for noncompliance of filing taxes is not the first reason you
need good accounting. Bankruptcy is a much more frequent event. Still, it’s better to
be prepared.
By Daniel M. Isard
At the young age of 19, I was promoting concerts in Philadelphia when I got a call from a bar owner who wanted to have three concerts at his large venue. This guy was, as we would say in South Philly at the time, “mobbed up.” But I didn’t care who hired me – I needed money for college.
As the first concert was taking place, I sat in the box office doing “the count” – confirming receipts versus tickets sold. When I finished, I found the bar owner in the rafters watching the concert where the sound and light guys were and said to him, “Congratulations! You made a great profit. You sold 8,613 tickets.” He looked at me and replied, “You miscounted. We sold 14,147 tickets!” My heart leapt into my throat and I said, “No, I just finished the count.” “Kid, you don’t get it,” he said. “I am going to certify that we sold 14,147 tickets. This way, I can declare more income and put more money in a bank account!” I asked, “But if you do that, you are going to declare $60,000 more revenue and pay more taxes. Why would you do that?” His reply: “We never go to jail for what we do, we go to jail for what we don’t do, which is pay taxes!”
Why do I confess, 44 years after the fact, that I aided and abetted a money laundering scheme for a Philadelphia mobster? Two reasons: First, the statute of limitations and the client are both long expired, and second, it helps you understand that tax compliance is a myth. The fear of going to jail for noncompliance of filing taxes is not the reason you need to have good accounting. Bankruptcy is a much more frequent event than tax conviction.
Accounting should be used first and foremost to keep you out of bankruptcy. A positive way of phrasing this is, “Accounting should help you maximize the profits from your business.” There is no debtors’ prison anymore. However, people like Darryl Strawberry, Leona Helmsley, Wesley Snipes and Al Capone prove that some people do go to jail for tax evasion. There are also some well-known funeral crooks who stole money from the preneed trust and didn’t report it; they got added jail time to their other criminal sentences.
A tax audit is a review by the compliance department of the federal government called the Internal Revenue Service. It is an examination to ensure that information is reported correctly and accurately. The IRS will hold you accountable to what you filled out on your tax return, business and/or personal. After all, when you sign the tax return, you state, “Under penalties of perjury, I declare I have examined this return and accompanying schedules and statements and to the best of my knowledge and belief, they are true, correct and complete.” While some people think the IRS has to prove them wrong, that is incorrect. You have to prove that your entries are true, correct and complete or you are committing perjury.
You should understand the tax audit steps:
- Computerized audit: Almost 100% of all business tax returns are scanned for changes from their historical past for revenue and deductions. Individual returns are also scanned, but they are scanned for the above and 1099 compliance issues as well.
- Random audit: If the computer spits out your return for some matter, you might get a letter telling you of an “adjustment” that needs to be made to your tax return. For example, if one year you take a straight line depreciation deduction for an auto and the next year increase the depreciation rate, the computer can spit the tax return out and an agent in the audit office will review and send you a simple notice of a change. This will almost always lead to a tax due and interest due; it could also include added penalties.
- Mail audit: Sometimes in a random audit, the examiner will have questions and he or she will write to you or the preparer. This is more likely to happen if you live a long way from the site of the IRS office. Your chances of a mail audit becoming a field audit are greater if you live in the service area of the local IRS office.
- Field audit: This is when you are given notice that an agent will review your tax return in person. Fewer than 1% of all individuals and businesses actually undergo a field audit. If you do, you don’t need to be there, but you do need to be represented. If the accountant files the return as a “signer,” then the accountant should be there.
The IRS can perform a routine audit for three years from the date of filing. So if you sent in a tax return April 15, 2017, you can be notified of an audit until April 15, 2020. Thus, you need to keep all material records used to process that return for at least three years.
If the IRS thinks you have materially understated income, which is a 25% or more decrease from your actual income, it can go back up to six years. This is typically not an overstatement of expenses but more an understatement of revenue. This is a very serious charge and should be treated only by a qualified professional.
For some audits, the period is three years from the last reported recognition of principal. For example, if you sell your business and carry back a 10-year loan, you could be audited for up to 13 years. And it could actually be 14 tax years if some payments are made monthly and the sale is recognized over 11 tax years (for example, 120 monthly payments beginning in February has the last payment due in January, and it is now 11 calendar years that the taxable gain is being recognized).
We’ve heard that some corporations are audited every year. Yes, but that is more for compliance purposes. Of course, some taxpayers are very antagonistic. Taxpayers may want to interpret the law their own way and take deductions aggressively. Taxpayers can do that, but they will be defending this deduction every step of the way.
Keep in mind that the three years or six years are only guidelines. If you have not filed a tax return or have filed one devoid of accurate filing information, the statute of limitations has not begun. So if you have never filed a tax return, it is not just the last three years or six years that are in question. Every year you had taxable income can be audited.
Should you have a tax assessed for one item in a recent year, expect that every year previously that is still auditable will be audited immediately and this same deduction challenged, with penalty and interest. I had a client a few years ago who was writing off a houseboat as a business deduction. He was audited and the agent disallowed the deduction for that year. Within a day, we were served with a notice of audit for the previous two years as well. The client didn’t help himself at the audit when he said, “If you keep challenging my deductions, I am going to cheat again next year!” Sometimes it’s better to stay quiet.
You have three outcomes when an audit is concluded. The examiner might issue a “no change” result, which means you have substantiated all of the items being reviewed. The auditor might find something and you agree with the change. You refile your tax return and pay the added tax, if any, with interest and penalty (if any). Of course, if the examiner finds something, you can “disagree.” In this case, the IRS has proposed changes and you understand but disagree with the changes. You can appeal an audit’s results. You can appeal internally to a supervisor or you can contest the outcome and go to tax court. This is where it gets expensive. You want to be remembered for your deeds or at least on a headstone, not for a tax case. More than 50% of the names in tax cases are memorialized as losers, not winners.
By the way, at the second concert, after finishing the count, I found my entrepreneurial friend in his same spot in the rafters. I said, “Howard, guess how many tickets we sold? He said, “We had a great night. We sold 16,642 tickets!” I said, “Wow, you guessed it right on the button!”
Daniel Isard, MSFS, is president of The Foresight Companies, a Phoenix-based business and management consulting firm specializing in mergers and acquisitions, valuations, accounting, financing and consumer surveys. Isard can be reached at 800-426-0165 or danisard@theforesightcompanies.com.