Thanks to the Inflation Reduction Act the IRS is hiring thousands of new field agents and examiners. Before this new funding, taxpayers of all stripes and income brackets enjoyed a period of very low audit rates due to the IRS’s shrinking workforce, which further exacerbated the audit statistics. As a result, the chances of getting audited became about the same as the odds of winning the Power Ball lottery. Consequently, taxpayers took on some bad habits. While we’re waiting on the IRS to ramp up, now is a good time to take the opportunity to reassess your tax “strategies” and compliance. As the saying goes, the best offense is a great defense.

The IRS is aware of the “creative” schemes some taxpayers employ to lower their tax bills. At times, some taxpayers even use “strategies” sold by promoters who have built their entire reputation by flouting the tax code. Many of these strategies will not withstand an audit, and even if the promoters know this, they often are just playing the audit lottery. Now, the IRS’s ability to audit these schemes and strategies is about to change.

Perhaps the worst news for tax evaders is not the IRS’s expected hiring binge; rather, it should be strides the IRS is making in another area – data analytics. The IRS has learned how to use the vast amount of data at its disposal to identify compliance issues and reporting anomalies.

Combined with the newfound funding, IRS agents will become “Audit Ninja’s.” They will be able to identify noncompliant taxpayers much faster, to target issues more efficiently, and to proceed with assessment and collection functions much quicker. Those who still challenge the system with aggressive deductions and underreported income may find themselves confronting a criminal charge of tax evasion.

10 Troublesome Tax Schemes

With this in mind, below are 10 troublesome tax schemes I have seen used by taxpayers. Should any of these sound familiar, you may want to consider amending prior tax returns and changing your ways going forward.

  1. Subchapter S corporation reasonable compensation: Perhaps the worst kept secret in entity planning is using a S corporation rather than an LLC or sole proprietorship. There’s even YouTube videos on this topic. Income from S corporations, unlike that of partnerships, LLCs or sole proprietorships, is not subject to self-employment tax. Therefore, S corporation shareholders, assuming they are not passive investors, must receive “reasonable compensation” for the work they perform. This a requirement that somehow gets missed. The IRS reclassifies distributions from the S corporation as wages, triggering employment taxes, if it does not believe the owners were compensated at market value for their services. This is a pronounced problem for service businesses.
  2. Independent contractors: Perhaps we should ask Uber how it feels about this issue. Classifying an individual as a subcontractor is a well-known method to avoid employment laws, allowing employers to save significant amounts of money not only in taxes but also in employee benefits. Employers have tried all the window dressing you can imagine, including having an individual “employee” form his or her own LLC to be the service provider. In the end, the federal government and individual states are blowing up these arrangements, reclassifying people as employees and charging the employers with back employment taxes. The IRS even has a webpage dedicated to understanding the differences between employees and subcontractors. Note that many states have similar but sometimes slightly different criteria.
  3. Cash wages: Anyone who has ever been paid in cash and not reported the income raise your hand. Yeah, I thought so! The payment and deduction of cash “wages” has several problems, not the least of which is that wages often are not reported by the recipient and taxes therefore go unpaid. The government is also suspicious about wages paid in cash because the payments are hard to substantiate. In addition, in many cases, the recipient is not eligible to work in the United States or will not be covered by unemployment or workman’s compensation insurance, exposing the employer to other liabilities.
  4. Unreported income: Failing to report income is a longstanding tax evasion scheme, but the prevalence of cashless payment methods such as credit cards and Venmo has made underreporting more difficult. There are of course still many industries where cash is still a primary means of conducting business. Cash tips fall into this category. States learned this long ago and began using alternate means to compute income in sales tax audits. The IRS has long used bank account deposits and lifestyle to uncover unreported income as well. Taxpayers that underreport income also should be aware of the IRS’s new capabilities in artificial intelligence and data mining.
  5. Personal expenses: Expensing the personal expenses of owners is commonplace in business. There are numerous expenses owners seek to deduct including personal vehicle purchases and operating costs, trips and vacations, school supplies, entertainment, home repairs, nannies, tuition, food, transportation and commuting, utilities, cell phones and other costs that are unrelated to the business and just serve to lower taxable income. Expect them to be denied.
  6. Unsupported travel and entertainment expenses: The tax laws have very specific documentation requirements for travel and entertainment expenses. The rules are so detailed that even the most legitimate of expenses can be disallowed if not properly documented. Should you be unfamiliar with the record keeping requirements I recommend you read IRS Publication 463 as a starting point.
  7. Crypto: Unless you have been under a rock for the past few years, you know the IRS is doing everything in its power to identify those who are transacting in cryptocurrency. The IRS’s prowess in data science is mirrored by its capabilities in the crypto space. The services focus in this area has manifested itself into a crypto question on the front page of the individual tax return. If you have underreported some or all your income transacted in crypto, amend those prior year tax returns now.
  8. Offshore tax compliance: Another area the IRS has been targeting for over a decade now is offshore compliance and reporting. This area is extremely complicated, has numerous ways to trip yourself up, and carries perhaps the steepest of fines at $10,000 per form. Should you have any connection to assets, investments, bank accounts, businesses, or have family in another country, you need to be talking to a knowledgeable professional. Not only do you face fines and penalties for failures in reporting foreign assets and income, but this can also become criminal very quickly.
  9. False or padded deductions: One of the most common questions tax professionals get is what expenses are permitted to be deducted. Some taxpayers think it is acceptable to estimate the amount of their expenses. This is not the case. While estimates are permissible in very limited circumstances, over estimating is a problem. This is one of the reasons the charitable deductions got enormous scrutiny several years ago and now require documentation from the charitable donee. The home office deduction and the former unreimbursed employee business expenses are also ripe for abuse. The tax rules require taxpayers to maintain appropriate documentation for all claimed deductions.
  10. Failure to file: Do I really need to explain this one? Remember the data science I mentioned. Thanks to third-party reporting, the IRS in most cases today knows if you haven’t filed income tax returns, especially if your income is high. If your income is high and you have not filed tax returns, expect to be contacted by the IRS.
  11. Credits: Okay, I said 10 troublesome tax schemes, and this is the eleventh, so consider this one a bonus. The tax code has seen numerous credits added in recent years. Many of these credits are designed to help those at the lowest end of the income scale. Others target specific behaviors or investments. Scammers, identity thieves, unscrupulous preparers, and others have found ways to exploit the criteria for the credits and their clients by manipulating their income and deductions to attain the credit. Be alert for something that sounds too good to be true!

The games people play are many, but the Twister board and punch bowl are about to be removed from the party. Consider the filing positions you have or have not taken in the past 3 to 6 years. Then consider if those positions should be continued or if you need to amend your tax returns. A final word of caution, if your issues are significant, or if you have been contacted by the IRS you need to consult a seasoned professional.

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Disclaimer: Please note this blog does not provide accounting, tax or legal advice and is intended for informational purposes only. Consult your Withum advisor with any specific questions.