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February 23, 2006

Sole Proprietorships Likely to Be Audited by IRS

The Internal Revenue Service (IRS) released data last week based on random audits of 46,000 tax returns for 2001 that showed a tax gap of about $354 billion a year. IRS Commissioner Mark Everson said, according to Bloomberg.com, that most of the noncompliance occurs in businesses where there isn’t automatic reporting of information to the IRS, such as sole proprietors who report income and deductions on Schedule C.

Sole proprietors, independent contractors, self-employed workers and others accounted for $68 billion in missing taxes, the IRS said, the Associated Press reported.

"That is a very significant noncompliance rate," Everson told reporters. "We do not have specific conclusions as to how much of this is willful or confusion."

Sole proprietors are at least 10 times more likely to be audited this year than other business entitie. Last year, with more enforcement personnel available, the IRS audited almost twice as many individuals as five years previously.

Daniel Kehrer, writing in dailybreeze.com, advises sole proprietors to consider making their businesses corporations or LLCs to avoid audits and to hire a certified public accountant for tax advice.

What are the red flags the IRS will be looking for in sole proprietor returns? Kehrer says that underpayment of quarterly estimated payments, or late payments, could be significant to the IRS. Sole proprietors should also watch their income-to-deduction ratio. If this ratio exceeds 52 percent, an individual is more likely to be audited, according to tax attorney Stephen Fishman, Kehler reports. Finally, beware the home office deduction – a prime IRS deduction, he says, and avoid vague expense categories, such as miscellaneous.

Kevin McKeon, an IRS spokesman for the metro area, was asked by the New York Daily News what red flags the agency looks for and "how it determines who would get audited."
McKeon said that common errors that tip off the bureau are invalid or incorrect Social Security numbers for the filer or dependents, math errors, and incorrect bank deposit numbers or routing numbers. Returns will get special attention when the taxpayer fails to sign and date the return or fails to attach W-2s.

Generally the IRS assigns a numeric score "somewhat like a credit rating" to each return, the Daily News says, and thereby determines which returns will require more review. But "the major reason of all audits is illegal tax shelter," McKeon said, "or the use of offshore credit cards." "Sometimes we (the IRS) look at an industry and if you work in that industry you might be audited," he added.

Returns prepared by CPAs and other licensed professions are often audited less than those prepared by the taxpayers themselves or by unlicensed store front tax preparers.

February 9, 2006

IRS Eases Extensions Rules

Temporary regulations issued under IRC section 6081 (TD 9229, 11/4/05) simplify how individuals, partnerships and others can obtain an automatic six-month extension of time to file a number of income tax returns with a single request. The rules also remove the requirements for a signature and an explanation of the need for an extension, and render the use of certain other extension forms obsolete.

Generally, the temporary regulations are effective for certain returns due after 2005, so CPAs need to be familiar with them this filing season.

INDIVIDUALS
The timely submission of a completed application for extension on Form 4868, Application for Automatic Extension of Time To File a U.S. Individual Income Tax Return, now provides an automatic six-month extension, with no need for a signature or explanation. (Previously, a first extension request was good for four months; a taxpayer needed to file an additional request to gain two more months.)

As always, the extension does not extend the time for payment of tax. Taxpayers must make a proper estimate of any tax due. While no tax payment is required to obtain the extension, failure to pay any tax as of the original return due date may subject the taxpayer to penalties and interest.
CORPORATIONS AND OTHER ENTITIES
The new rules do not change the current method for filing extensions for corporate income tax returns; rather, they broaden its scope. The form previously used for a corporate extension (Form 7004, Application for Automatic Extension of Time to File Corporation Income Tax Return) will now also be used by partnerships, real estate mortgage investment conduits, certain trusts and taxpayers requesting additional time to file various excise, income, information and other returns.

The regulations have changed the title and appearance of Form 7004. Now called Application for Automatic 6-Month Extension of Time to File Certain Business Income Tax, Information, and Other Returns, the form will apply to a larger number of returns than did its predecessor.

OTHER RETURNS
Certain employee plan returns now are eligible for an automatic 21¦2 month extension, and gift tax returns for an automatic six-month extension, if the proper form is filed. Neither extension request requires a reason or a signature. Donors who do not need an income tax filing extension will use a new version of Form 8892, Payment of Gift/GST Tax and/or Application for Extension of Time to File Form 709, to request the gift tax extension.