While the IRS’s own figures reveal that, in general, only one or two percent of all taxpayers have their returns audited each year, the threat of an audit continues to strike fear in every car wash operator. And that fear increased dramatically with the IRS’s reported plans to hire an additional 87,000 workers.
What was once a large and inefficient federal bureaucracy, the IRS is changing to become more streamlined and, most importantly, catching more tax offenders. Today, the IRS enforces the tax law in several ways, including the increasingly more common correspondence (examination by mail) audits and the dreaded field (face-to-face audit) examinations.
Agents in back offices are being replaced by computers with complex algorithms that cast a wide net, one that pulls many law-abiding people into the chaos of an audit. The result is that the mere threat of an audit continues to strike fear into every car care service business owner, operator, and manager, many of whom believe they are being scrutinized far more often than the official numbers indicate.
Also, keep in mind that there are penalties, and then there is the fraud penalty -– equal to a whopping 75 percent of the unreported tax. Fortunately, there are perfectly legal strategies that can greatly reduce the threat of an audit.
Triggering Mistakes and Round Numbers
The IRS takes a dim view of a failure to report income more so than a minor overstatement of deductions. Moreover, the IRS obviously checks the math on every return, and too many errors will trigger red flags. Incorrect totals for expenses, missing Form 1099s, and transposed numbers are all believed to concern the IRS — even if the mistakes are not big.
The IRS is also reportedly on the lookout for numbers that are too round. After all, it is unlikely that all the numbers shown on any return will end in fives and tens or even thousands.
Hints from the IRS
The IRS offers a few steps that every operator can take to reduce the risk of their car wash becoming an audit target. For example:
• Be specific about expenses.
• Provide more detail whe needed.
• Be on time.
• Avoid amending returns.
• Match up all your paperwork.
• Don’t use the same numbers repeatedly.
• Don’t take excessive deductions.
• Don’t report a loss. Never report a net annual loss for any business.
Obviously, this list favors the IRS and the strict enforcement of the basic tax law. But remember, the U.S. Supreme Court has ruled that striving for the lowest possible tax bill is perfectly legal. Thus, reducing the possibility of an audit by not reporting a loss should be taken with a grain of salt.
Beyond the Obvious
While many unexpected and significant swings in income can usually be easily explained, large inconsistencies in income from year to year are often an area of concern to the IRS. Large shifts in income can indicate that someone is hiding income in either the current or a past tax year.
When taking a closer look at the income earned in different tax years (as well as substantiating documents), the IRS often finds discrepancies between what a car care service business earns and what was reported.
Despite the postponed requirement that third-party payors report payments to recipients, cash remains a major red flag because it creates all sorts of problems for the IRS. It is almost impossible to track cash transactions because cash can be easily hidden, it is difficult for the IRS to verify, and, despite the recently suspended reporting requirements, there are few electronic records to keep track of it.
Cash transactions go unreported by many who believe that cash doesn’t have to be reported or, more commonly, those who figure the IRS will never know that cash was received. However, today’s IRS targets returns where businesses may deal in large amounts of cash and consider it an audit red flag when a return contains a high probability of unreported income.
Many car wash owners and operators set up an S Corporation instead of an LLC to avoid the 15.3 percent self-employment tax. However, while they aren’t subject to self-employment tax on distributions, S Corporation shareholders working as employees must receive “reasonable compensation.”
The IRS is on the lookout for S Corporations Paying shareholder-employees unreasonably low (or even no) salaries. The IRS will compare compensation to the standard for a similar position in a similar industry.
Failure to provide shareholders/owners with reasonable compensation (as W-2 reportable wages) is an audit flag, often leading to a more comprehensive audit of the entire car wash or detailing business.
Even before the pandemic, the home office provided a place for car wash operators to catch up on paperwork, bookkeeping, and payroll. With many taxpayers shifting to “work from home” during the pandemic, it should come as no surprise that the home office deduction will be under extra scrutiny.
The deduction for home offices is more complex than many operators realize. The calculation for the home office deduction is based on square footage -– but only the square footage used exclusively for business purposes.
A workstation set up in the living room can, for example, be deducted -– but only for the square footage the workstation sits on -– not the entire living room. What’s more, that deduction can’t be taken if the dedicated square footage is used for any non-business purpose. If, for instance, the home office doubles as a guest room, no home office deduction can be taken.
If a car care operator uses a personal vehicle for business purposes, the business can often deduct a portion of the vehicle expenses. Of course, a depreciation deduction is often available if the vehicle is used exclusively for business. Unfortunately, because 100 percent business use is unlikely in most cases, claiming full business use of a vehicle is an audit red flag.
Triggered by the Tax Pro
Far too many business owners and operators have succumbed to the promise of big refunds when using the services of a particular tax pro. Beware, however, tax preparers have been a high-priority target of the IRS for years – as have many of their clients.
The IRS has many ways to uncover crooked tax return preparers. One of their clients may be audited, and the results are unrealistic enough that the IRS may look at other returns they have prepared.
Reality Versus Triggers
In reality, no one knows which tax returns will be singled out for audit by the IRS’s computer algorithms. Many so-called “triggers” have been developed through the experiences of many professionals. The proposed increase in IRS auditors may or may not impact the current audit rate that sees fewer than 2 percent of all income tax returns examined within a year.
The statute of limitations for an IRS examination is three years from the due date of the federal tax return or the date it was filed. This period is doubled to six years if the return reveals a substantial understatement of income, usually more than 25 percent of taxable income. There is no time limit for the failure to file a return for a particular year or if fraud is suspected.
Caught, Now What
If a tax return is selected for an IRS audit, the car care business (or its owner) will receive a notice in the mail. The notice is always sent to the last known address and is never by phone, e-mail, or social media.
If audited, it will most likely be through a correspondence audit. The letter will contain instructions on what information must be sent to them. If more information is needed, the IRS will reach out again.
Should the IRS request an in-person meeting, typically at their regional office, the notice usually contains instructions about preparing for the audit and the items being examined. Alternatively, Letter 2205, a shorter version of the audit notice, will request a phone call and usually prefaces a face-to-face meeting.
Unfortunately, those wishing to speak with someone about an audit are limited to calling a representative on a toll-free line. Getting through on the IRS’s toll-free line has proven difficult and time-consuming.
Battling the Impossible
While it is impossible to fully inoculate the car wash or detailing business or its operator or owner since a portion of all audits are truly random, steps can be taken to minimize the likelihood of receiving that feared notice from the IRS. Obviously, every operator should claim deductions to which they or their business are legitimately entitled. Of course, there is a need for vigilance and detailed record-keeping to defend those deductions in an audit.
Honesty and clarity go a long way toward preventing, dealing with, and surviving an IRS audit. Naturally, every car wash and detailing business operator, owner, and manager should have a strategy for avoiding audits and dealing with an IRS auditor. A fallback position should those strategies fail should also be in place.
Mark E. Battersby is an Ardmore, PA-based freelance writer, specializing in finance and tax issues.