How advisers can avoid IRS scrutiny

The IRS has just given the green light to Paul — on his 2007 tax return

The IRS has just given the green light to Paul — on his 2007 tax return.

The Midwest-based wirehouse adviser, who asked that his surname and affiliation not be disclosed, received a notice from the agency two years ago telling him that his 2006 return was being audited. Specifically, Internal Revenue Service agents wanted more information about business expenses that he had claimed and charitable donations that he had made during the year.

Because his documentation was in order, Paul wasn’t assessed any penalties, but it took nine painful months to settle the matter.

Then, just a month later, he received a notice that his 2007 return was also being scrutinized.

“It felt like harassment,” Paul said.

Although the extension of the Bush tax cuts for the next two years was great news for financial advisers and every other business in the country, don’t expect the good will to extend to IRS enforcement agents.

Given their dire fiscal situations, the federal government and states are putting more resources into collecting what is due the taxman. For advisers, keeping accurate records and not taking excessive deductions seem to be the key to staying off the IRS radar screen.

Larry Soukup, a certified public accountant and financial adviser who is the co-founder of Cambridge Financial Advisors LLC, has kept many small-business clients calm during IRS audits. He assures them that if they are reasonable in their deductions and have good documentation for their returns, they will be fine.

The triggers of most audits, Mr. Soukup said, are large reported Schedule C losses and large amounts of Schedule A itemized deductions.

Whether it is entertainment expenses, office supplies or depreciation on business assets, his advice is simple: “Don’t get greedy. The IRS has ranges for deductions they consider normal based on income levels. If you fall outside those ranges, you’ll get flagged for review.”

In many cases, advisers undergo a “correspondence audit,” which is less comprehensive that a full-blown audit and often results in their returns being amended, and additional taxes and even penalties being assessed. The method is being used more and more because it allows the IRS’ force of agents — close to 17,000 at the end of 2009 — to handle a lot more cases at once.

“Enforcement is definitely stepping up on the federal level,” said tax consultant Robert Willens, who noted that the chances of an IRS audit are as high has they have been in a long time. He is a CPA and the president of Robert Willens LLC.

And where better to enforce than the traditionally fertile areas of wealthy individuals and small businesses?

When a firm’s returns are red-flagged, the process for disputing the allegations is complicated. Patrick Cox, president of TaxMasters Inc., which represents taxpayers dealing with the IRS, recommends that business owners hire a knowledgeable representative if they are called into an audit — a position that he can justify despite his obvious self-interest.

“The IRS can take unreasonable positions,” he said. “At the same time, they are going to assume that you are as knowledgeable as they are, but unless you read IRS rulings as a hobby, that’s not likely to be the case.”

Mr. Cox has a few pointers for advisers about avoiding an IRS audit in the first place.

Because the IRS may consider an advisory firm that reports a string of money-losing years to be a hobby rather than a business, startup advisers should be scrupulous about expense documentation and have good explanations for why the business is likely to generate losses for an extended period.

A related hot button is capitalized expenditures.

The expensing of investments under Section 179 of the tax code is 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 may spur an audit.

Fully deducting an office renovation as a repairs-and-maintenance expense also will raise eyebrows.

“The IRS looks hard here for deductions that don’t make sense,” Mr. Cox said.

Employee-incurred expenses that businesses deduct, but don’t reimburse employees for, are a common area of abuse targeted by the IRS, he said. Be very careful about expensing items such as employee dry cleaning or clothes purchased for work.

Finally, watch charitable contributions. 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 for an audit to explain it,” Mr. Cox said.

E-mail Andrew Osterland at [email protected].