Advisers: How to avoid an IRS audit this year

The extension of the Bush tax cuts for the next two years was great news for financial advisers and just about every other business in the country.
But if the government is trying to encourage companies to invest and create new jobs, don’t expect that good will to extend to Internal Revenue Service enforcement agents. With the dire fiscal situation, the federal government and states are putting more resources into collecting what’s due the taxman. “Enforcement is definitely stepping up on the federal level within budgetary constraints,” said tax consultant Robert Willens.
The chances of getting audited by the IRS are as high as they’ve been in a long time, according to Patrick Cox, president of TaxMasters Inc., which represents taxpayers dealing with the IRS. And the situation isn’t likely to improve for businesses any time soon.
For advisory firms, there are a number of things that will raise red flags with IRS agents and lead to either an amendment of the return (bad) or an audit (really bad). If your return stands out as atypical for your industry, there is a good chance you’ll be audited, and your returns this year and in the past could suddenly be of interest to the IRS.
“The IRS has returns from everyone in your industry. If you’re a broker or adviser, they know what you typically spend on things like rent, office supplies and entertainment,” Mr. Cox said. “They’re looking for outliers.”
In many cases, advisers escape a full-blown audit, but have to amend returns pay additional taxes. Such “mail audits” have increased dramatically over the past several years, as the IRS’ force of agents — close to 17,000 at the end of 2009, — can handle a lot more of these cases at once.
The process for disputing these positions is complicated, and Mr. Cox recommends two things to business owners: Hire a preparer to do your return, because IRS agents generally expect more problems from taxpayer-prepared returns. And if you’re facing an audit, get representation. A little self-serving perhaps, but he makes a good point: “The IRS is going to assume you’re as knowledgeable as they are, and they can take unreasonable positions,” he said. “Unless you read IRS rulings as a hobby, that’s not likely to be the case.” TaxMasters charges as little as $3,000 for a simple audit representation, more if the situation is complicated.
Beyond hiring him if you get in trouble, Mr. Cox has a few pointers for advisers about avoiding an IRS audit in the first place.

> Don’t be a hobbyist. For startup advisers, it can take years to assemble a big enough client book to start making money. But if a taxpayer reports losses in his or her business for a couple of years in a row, the IRS could take the view that advising people on investments is more of a hobby than a going concern. In that case, the income from the business is taxable and the expenses aren’t deductible. It’s imperative that small-business owners have thorough documentation for their activities to avoid that business-killing situation, and have good explanations for why the business is likely to generate losses for an extended period.

> Employee expenses. Employee-incurred expenses that businesses deduct but don’t reimburse employees for are a common area of abuse targeted by the IRS, Mr. Cox said. Be very careful about expensing items such as employee dry-cleaning, or clothes purchased for work. Preparers of tax returns can get a taxpayer in trouble by being too aggressive in this area.

> Charitable contributions. Remember when the Clintons got slammed for claiming contributions of clothes to charities back in the 1980s? Such donations are legitimate but they can get a lot of attention from agents. The general rule is simple — if you didn’t make the donation, don’t claim the deduction. “It’s easy to catch. You won’t get the refund and they’ll call you in on audit to explain it,” Mr. Cox warns.

> Capitalized expenditures. The expensing of investments per Section 179 of the tax code is currently favorable for many businesses, allowing accelerated depreciation on a variety of assets that normally would be deductible over a longer period. This is a very common area of focus for agents, however, and unusual deductions could spur an audit. In other words, a $25,000 deduction for pens and pencils will raise eyebrows. The full deduction of an office renovation as repairs and maintenance expense will, too. “The IRS looks hard here for deductions that don’t make sense,” Mr. Cox said.