Ever wonder how the IRS is able to maximize their return on their audit efforts and choose those who may be audited? Well how do you as a small business maximize the fruits of your efforts?
Let’s look at a typical scenario we as business owners contemplate when we roll out a new service?
“I want to offer my clients a new service, what do I do? How do I know it will work? How should I roll it out?” Well as a student of business I was always taught the way to roll out a new revenue stream is to:
1. Identify a market
2. Determine a need that is not being satisfied
3. Create a product or service that will satisfy that need
4. Roll it out to a sample
5. Determine if the return on investment (ROI) requirement was met on the sample roll out
6. If the ROI was met, then move forward and roll it out to the entire market.
OK Dan, very interesting, but what does this have to do with taxes and the IRS?
Have you heard of IRS form 1099 K? On July 30, 2008, President Bush signed into law, the Housing and Economic Recovery Act of 2008. A law that was meant to help ease the housing crisis by having the FHA guarantee certain sub-prime mortgages thereby helping to restore confidence in the system. As with all laws, there are many times irrelevant special interest attachments made. As part of this law, the IRS tax form 1099-K was created to increase compliance in reporting sales run through merchant services and other third parties. In case you haven’t received one, the 1099K reports all payments made to your business by merchant companies. The first year it was required was 2012 for tax year 2011. Basically the form reports how much revenue you did in credit card sales.
It was only a matter of time until the IRS would monetize the use of this form by collecting more taxes. The other day one of my clients received IRS letter 5403 “Income Reporting Verification Notice.” The letter referenced the amount that was reported on Form 1099K. It also referenced his total gross receipts for the year stated on his tax return. It then drew the conclusion that his credit card to total sales was at 57% and that similar businesses (there was no mention of who those similar businesses were) usually had a ratio of 26 to 46% and as a result he may have understated his income. Wow! What a fishing expedition! As I did my research and queried other CPAs and tax attorneys I found out that the IRS had chosen 20,000 small businesses to send this notice to and my marketing light went on – Brilliant! (Unless you received one of the notices). Let’s take the six points above:
1. Identify a market – Small Service Businesses
2. Determine a need that is not being satisfied – Potential Under Payment of Taxes and Money due the government
3. Create a product or service that will satisfy that need – A Fishing Letter softly telling taxpayer to recheck their work and amend their return if needed. In addition you may be audited if the IRS does not agree with your explanation.
4. Roll it out to a sample – 20,000 Small Businesses
5. Determine if the return on investment (ROI) requirement was met on the sample roll out – While I don’t know what the threshold is, I’m sure someone at the IRS will have that information
6. If the ROI was met, then move forward and roll it out to the entire market – Stay tuned this is the new kinder gentler IRS using advanced techniques to catch those taxpayers who under report their income
OK, so why is this so important and why do I find it so relevant? Because we as business people are not the only ones using technology to increase efficiency in our businesses. Technology and analytics are in every aspect of our life including your chances of being audited by the IRS. The above is a textbook example of what college kids are learning in their business classes about how to roll out a profitable product or service and the IRS is practicing what’s in most business textbooks. Again, Kudos to the IRS for employing sound business techniques to catch tax cheats. But, unfortunately when it comes to tax inquiries and audits it may appear that we are thought of as guilty until proven innocent instead of the other way around causing us grief while we demonstrate our innocence.
Unless you’re a CPA or tax attorney a letter from the IRS is a very scary experience. Some folks would rather pay and move on than deal with the IRS whether they are guilty or innocent. This is where competent industry specific consulting is paramount. In case you receive one of these notices or any correspondence from the IRS for that matter, you should get in touch with your CPA making sure that he/she has a total understanding of your business as well as our industry.
You see a competent CPA may know the tax laws and rules as they pertain to most general businesses. But does he know that one of the most successful trends in our business that has been developing over the past several years, are prepaid service programs that are paid at the beginning of the year usually by credit cards? Or that many pest and lawn companies are offering their recurring services using plans whereby customers pay monthly, bi- monthly or quarterly by an automatic credit card draft at the beginning of the month? These billing practices improve cash flow, reduce collection problems and, oh yea, drive that credit card sales to total revenue ratio way up.
While answering IRS letter 5403 and explaining the above will not guarantee aversion of a full blown audit, a competent CPA who understands our industry will certainly be in a better position to answer such an inquiry or audit.
By Daniel S. Gordon, CPA
Daniel S. Gordon is a CPA in New Jersey and owns an accounting firm that caters to PCOs throughout the United States. Visit www.pcobookkeepers.com for information about his firm, PCO Bookkeepers. He can be reached at firstname.lastname@example.org.