“Wall Street has correctly predicted 11 out of the last 5 recessions.” (Old street saying)
Independent Contractors (ICs) — Bad News
As I have written about, perhaps 100 times over the years, there is a continual fight between the IRS and many businesses — over whether an individual is an “employee” or an “independent contractor (IC).” The major difference in costs to the employer is, of course, all the related payroll tax costs — plus the extra expense of reporting individuals as “employees.” For example, even at the highest levels, there is a current fight over the status of delivery persons, between two of the largest companies. One classifies all drivers as employees (UPS) and the other (FedEx) as ICs…and the fight with the IRS goes on. (In December 2007 the IRS ruled that 13,000 ground delivery drivers at FedEx were really employees and not ICs — and presented FedEx a bill for $319 million in back taxes and fines.)
The IRS has come up with a new and deadly attack that will keep the heat on those who casually classify individuals as ICs. It’s a brand new and dangerous (to employers) IRS Form 8919. Taxpayers, who believe they were incorrectly classified as ICs, can file this form as part of their individual tax return. SO, a lot of you employers may have already been reported on Form 8919!
Incorporated in this new form is what some regard as a bribe to the individual, for reporting their employer. By giving the IRS the necessary information about the company they work for, and declaring themselves employees — they can legally avoid paying the full IC self-employment tax (15.3%) — and only pay the IRS their share of the Social Security and Medicare tax (7.65%) — as if they were employees!
Gee, what do you think the IRS is going to do when they receive hundreds or thousands of Forms 8919? Can’t you guess? I predict that when they get enough of those forms, they will form a specialized audit section and audit the hell out of many of the reported employers! Since they have at least three years to audit any particular tax return, the time bomb is now ticking away on many companies — and it will probably be about two years or so before they first get the bad news. Finally, since the IRS reports their audit results to most states (including California) — you can count on a state audit or bill based on the IRS results as well.
P.S. In 2006 the nation had an estimated 26.8 million small businesses, of which only 6.1 million reported as having employees.
Form 8919
This rather confusing form can be downloaded. Go to www.irs.gov and click on “Forms and Publications” and then ask for Form 8919. You can bet that a lot of individuals will fight it through filling out this form — or use a paid tax preparer to do so. Particularly those who resent being classified as ICs, or are angry with their employers in general, or want to save half the cost of self-employment taxes….
Business Mileage Changes
As of January 1, 2008 the new rate for either reimbursing or deducting business mileage is 50.5¢ (up from 48.5¢). Medical and moving expense mileage is now 19¢ (down from 20¢). Charitable mileage is unchanged at 14¢ (since Congress and not the IRS sets this one). Remember, those are a maximum and not a minimum “no-questions-asked” number for each category…you can always reimburse or deduct less. Also, keep in mind that you still must obtain or maintain the necessary records to confirm the mileage numbers.
Social Security Reporting
The Social Security Administration no longer accepts magnetic tapes, cartridges, or 1½” diskettes. All wage reports must be filed either electronically or on paper.
The Top Five Red Flags for IRS Audits
(1) Location. You are more likely to get an audit if you live in one of these places:
- Los Angeles
- North Central District (ND, SD, MN).
- Southern California
- Northern California
- Manhattan
- Central California
- Brooklyn
- Southwest (AZ, NV, NM)
- South Florida
- Houston
(2) Your Income. (a) Individually owned businesses (filing Schedule C) that makes less than $25,000 a year. (b) Filing a Form 1040A without a business and total income of less than $25,000. (c) Very high income.
(3) Business Entity Form. You are ten times more likely to be audited as a sole proprietor (Schedule C), than if you are filing as an S Corporation or a C Corporation.
(4) Under-reporting Income. If you do not report the same amounts as reported to the IRS (Forms: W-2, 1099, K-1, 1098, etc.) — your return will be pulled for at least an inquiry,
(5) Who Prepares Your Return? If you have a complex tax return that is self-prepared, or if someone on the IRS list as a “problem preparer” prepared your return — you are more likely to be audited.
And also, let me add: 1031 Exchanges. The IRS is stepping up audits of these tax-free exchanges of property as a result of a report from the Treasury Department urging the IRS to do so. There are strict rules that must be followed exactly to make such exchanges really tax-free….
Contributing Property to a Charity
A Tax Court case contains a warning that is ignored by even some of the largest charities. This individual was in the court fighting a number of disallowances, and I guess he managed to irritate the Tax Court judges. SO, they ruled strictly in accordance with the law, but on a point that is rarely questioned in most cases. On a donation to the Salvation Army, the Court noted that the receipt reflected a donation containing clothing and three boxes of toys. However, it failed to state whether the Salvation Army provided any “goods or services” in exchange for the contribution! Of course that’s highly unlikely, but the statutory language requires such a statement for all contributions in excess of $250. (Lorn and Claiborn, Tax Court Summary Opinion 2007-172)
I’m not going to name any of the major charities that neglect this same statement on their receipts for goods — but there are plenty of them! To be safe, you should really ask for that statement on all receipts for goods contributed that are over $250. Watta’ pain….
Frugal Taxpayer
Mr. and Mrs. Kim Huynh reported taxable income in 2000, from their two nail salons, of $7,578 and their tax bill was $195. The IRS discovered assets, including a $77,000 Mercedes, a five-carat diamond ring, four other cars, etc. The IRS says their 2000 taxable income was $273,000. Mr. Huynh is serving 18 months in jail and his wife will follow him. The IRS wants at least $365,000 in back taxes, interest, and penalties.
A New Increase in Special IRS Audits
The IRS has announced that they have changed the frequency of their special “compliance” audits used to develop audit statistics that are then applied to future audit selection procedures. Their last compliance program was in depth looks at 46,000 individual tax returns for the year 2001. The new study will provide a recurring look at compliance by annually selecting and examining 13,000 individual income tax returns EVERY YEAR, beginning with the 2006 tax returns (filed in 2007). The information from each annual study (from now on) will be incorporated into new formulas for selecting individuals to be audited.
The new annual program began October 2007 to examine those 13,000 tax returns selected for the year 2006. Letters to those unlucky taxpayers were supposedly all sent out by the end of October 2007, so if you didn’t get one by now — you are probably safe in this regard — but only for the year 2006. Remember — this is going to happen every year from now on.
Their new study involves “case building,” in which the information on each return is correlated with previous returns, public information, and third-party returns. Experienced examiners will then classify all the data on the return and decide what can be verified without contacting the taxpayer — and what cannot. For example, large charitable contributions are not generally verifiable without reviewing the taxpayer’s actual documentation. Additionally, the IRS says they will use a “stratified random sample” that divides the tax returns into different categories such as wage earners, self-employed individuals, farmers, etc. — plus sub-samples of individuals at different income levels.
Says the IRS: “Our approach will…improve audit selection techniques and give us more timely information to help reduce the tax gap. Using research from the prior study, the IRS updated its audit selection system…enabling the IRS to audit more efficiently and improve the detection of underreported income and overstated deductions and credits.” (Emphasis mine.)
S Corporations — Special Limitation
A very common misunderstanding is that S Corporations are, in fact, identical to partnerships under IRS rules. This is primarily true, in that the tax treatment is virtually identical. However, there is a special rule for S Corporations that poses some problems. It derives from the rule requiring only one class of stock for S Corporations.
This means that all allocations and distributions must be made pro rata based on the number of shares owned by each S Corporation shareholder. EXAMPLE: If there is to be a total distribution of $100,000 and you own 43.5% of the stock — your distribution must be $43, 500. Further, if a second shareholder own 38.5% of the stock, he or she must receive a distribution of $38,500 at the same approximate time. And so on for all other shareholders. (One shareholder cannot receive his or her distribution unless they all do.)
The above absolutely strict rules make it impossible to bring in outside investors that might own a small amount of the stock — but to whom you would like to make a larger and preferred distribution. There are only two solutions to this problem:
- Set up the outside investment as debt, instead of an investment in stock. Then you can pay interest on that debt as a preferred payment without regard to the stock distribution limits.
- Generate working capital by not making distributions of all the profits to the shareholders and simply retain them in the business. (Problem: The shareholders still owe taxes on those profits — whether distributed or not.)
Note that both partnerships and LLCs taxed as partnerships are allowed to make disproportionate distributions to owners — but not S Corporations.
