The 800-pound Gorilla

Editor’s note: The City Wire has invited David Potts, an accountant with more than 25 years of experience, to provide a series of detailed commentaries on the accounting side of starting and maintaining a business.

guest commentary by David Potts

The Internal Revenue Service’s most effective strategy to secure taxpayer obedience is fear. This week the IRS and the FBI raided a local business and seized certain documents. I don’t know anything about this specific case but I do know that it made the news during the height of tax season. The business owner could be totally innocent but I’m confident the IRS purposely times the release of their announcements of high profile cases for this time of year. Why? As a reminder to you and me … that we should be careful when we prepare our income tax returns.

Some of you have had the unfortunate circumstance to owe the IRS without the means to pay the tax when due and have received correspondence or heard an IRS employee on the other end of the receiver tell you that you can make payments with penalties and interest but if you fail to make one of these payments they can levy your bank accounts, file liens on your assets, or garnish your wages. They have scripted phrases to invoke fear to expedite compliance. Why? Because it works. The worse part of a levy, lien or garnishment is not the fear the IRS could suddenly seize your bank accounts. Hey, you’re already broke or you would have paid your taxes. The worse part of your situation is that it is no longer a secret between you and the IRS. It is now secret with you, the IRS, your boss, your banker, your friends and your neighbors.

The most common fear evoked by the IRS is the perpetual threat of an audit of your income tax return. IRS employees are ruled by this fear too. I once represented an IRS employee who had a small side business. The employee was honest, reported all income and only deducted valid business deductions. The IRS treated their own employee as guilty until proven innocent.

The IRS purposely perpetuates fear to elicit compliance with the tax law. You won’t see this written in their mission statement. You won’t see it written in the Internal Revenue Manual. But like my mother always said, “Actions speak louder than words.”

Am I afraid of the IRS? No, but they do have my respect. Should you be afraid of the IRS? No, but they should have your respect. How do you live without fear of the IRS? As with most fears it can be banished with knowledge.

Last week the IRS released their 2008 data book. Approximately 1% of individual income tax returns filed were audited in 2008. Three-fourths of this 1% was correspondence audits, audits where a taxpayer is only contacted by a letter requesting additional information. Most people don’t think of requests for additional information by letter as an income tax return audit. The remaining one-fourth of 1% received personalized service. These “in-person” audits tend to be the most gruesome, time wasting, and costly audits but your overall odds to be selected for this type of audit are only 1 in 400. There’s not much fear in these odds.

For most taxpayers, the odds are in their favor NOT to be audited — ever. For some taxpayers the odds of being audited are slightly greater. For example, individuals reporting businesses income and loss or investment transactions on their income tax returns are more likely to be selected for audit than others. One of the most audited groups of tax returns were returns reporting gross receipts between $100,000 and $200,000 on a Form 1040 Schedule C Profit and Loss from Business (Sole Proprietorship). Almost 1 in 4 returns in the group were audited. (If your business falls in this category you might consider converting to an S corporation).

Keeping adequate records can give you reason to relax with regard to the IRS. In my experience with the IRS, most individuals and small businesses have their deductions disallowed during an income tax audit due to lack of adequate records to document their business transactions rather than differences in interpretation of the Internal Revenue Code and its regulations. Learn to keep good records.

For those of you who are now thinking you should deduct anything and everything since the odds are in your favor that you won’t be selected for an income tax return audit, think again. The IRS scores every return they receive with their own secret formula based on audits of over a million individual returns a year. Recklessness will increase your odds of being audited. Intent to reduce your income tax by use of fraud makes you a criminal – whether you are caught or not. Who wants to be a criminal? With proper planning you can reduce your income tax liability and sleep peacefully. Don’t fear the IRS but give them proper respect. They are an 800-pound gorilla.

One final note: I work with IRS personnel on a regular basis, especially the Fort Smith office. For 25 years, with one exception years ago, they have always performed their duties professionally and honorably. They are good competent people. They are not evil people. Many are my personal friends. They deserve respect for who they are, not out of fear. They have to work with the same 800 pound gorilla that you do.

E-mail topic suggestions or questions to [email protected]

David Potts is a certified public accountant also accredited in business valuation. Owner of Potts & Company, Certified Public Accountants for more than 25 years, his practice focuses on small and medium size businesses and their owners in the areas of taxation, accounting and bookkeeping, business valuation and business advisory services. He is a Fort Smith native and a graduate of the University of Arkansas at Fayetteville. You can follow his blog at ThePottsReport.com.