Dairy Financial Times: IRS kicks your audit risk up
By Danielle Emel
You are already coping with an unstable milk price, high feed costs, environmental requirements, employment laws, and numerous other issues. Now, I am going to tell you your chance of being audited by the Internal Revenue Service (IRS) has risen. With their need to find money, it comes as no surprise the IRS has increased their number of examinations.
Are you at risk?
Not only does this general increase put you at risk, but some of the top audit triggers can already be found in the tax returns of taxpayers in your industry. What is more frustrating is an audit will cost you “something” even if it is not in the form of additional tax liability from understated income or overstated deductions.
Sure, the risk of being audited is still not much over 1%, but that’s of all tax returns filed. This includes simple individual tax returns reporting W-2 earnings and a couple of dependents. If you are filing your business income and expenses on a Schedule C or F, or from a pass-through entity, then your chances of being audited are already higher than a W-2 wage earner because self-employed taxpayers are more often targeted.
Partnerships get new scrutiny
You can also expect the IRS to focus more attention on partnership tax returns as this appears to be a new area of scrutiny. It is understandable the IRS would target these areas since the opportunity to find inaccuracies in tax returns of these business types is typically higher.
Continuing to report losses on your tax return will also attract attention from the IRS. I realize the condition of the dairy industry will not help you avoid this audit trigger. You have a right to claim losses on your tax return. Unfortunately, you are not given a chance to defend your position on why those losses were incurred until after your tax return has already been selected for review.
Explain after the fact
The selection process itself does not determine whether or not to rule out a taxpayer because of the economic status of an industry. This would need to be explained during an audit. Even in good times a dairy farmer often claims large losses on Schedule F. However, when combined with other revenue, including cull cow income (which is treated as capital gain and is not reported on Schedule F), they may still have income to report overall.
Losses on Schedule F will put the tax return into a high risk area for being pulled for an audit regardless of usual tax practices. Again, something you will explain during the examination of your tax return, not before it is selected for review.
If you currently work in this industry, then it will come as no surprise to see a dairy producer report on their tax return feed expense that will seem suspiciously high and income that will appear suspiciously low. Isn’t that how income and expenses in this industry have been? You can explain this to your auditor, but this will be after your tax return has already been chosen for examination. You will be able to explain your position, but you will still be well on your way to a formal examination of your tax return and all other areas your auditor wants to review.
Since you are at high risk for being pulled for a review, then you want to make sure you have proper documentation to substantiate your deductions. With numerous and constantly changing tax laws it is easy to unintentionally miss something in your recordkeeping.
It’s receipts, not statements
Properly reporting and filing Form 1099s for your independent contractors, keeping receipts (not statements) for credit card transactions and cash expenses are just a couple of things that could be overlooked in your day to day recordkeeping.
Remember to re-familiarize yourself with documentation requirements. It is a common misconception that showing a credit card statement will substantiate expenses, but this is not the case. You must have a receipt to support any charges you deduct as business expenses. The name and amount on your credit card statement are simply not enough proof to support a deduction.
If you have partnership agreements, rental contracts or promissory notes, then you should be following them. If you do not have them, you should get them. These documents often contain details on how expenses should be treated by the business when it comes to transactions like partner salaries or related party transactions and the auditor assigned to your case is likely to require these documents.
It will cost even if you’re clean
An audit will cost you something. You may feel confident you have done your best to accurately report your income and expenses, and have no doubt the IRS will find no changes during their review. In spite of that, you will use your own time and resources to work through the examination process. You will likely pay your tax professional to put together information requested during the audit.
Unfortunately, an audit will come with its costs even if the Internal Revenue agent assigned to your case finds your tax return needs no changes. Regrettably, this is just another cost of running a business.
I do not know if the IRS will continue to increase their audit work or back away. It is the beginning of the year and knowing where your risk lies should prompt you to start making changes, if necessary. A review of your tax return by the IRS could be less painful and costly to you by simply keeping proper documentation and by making other changes to your business practices.
• Danielle Emel, CPA, and partner in Modesto, Calif., with Genske, Mulder & Co., LLP, a certified public accounting firm representing clients who produce 12% of the nation’s milk in 29 states. Danielle can be reached at 209-523-3573 or e-mail danielle@genske mulder.com.