For most people, a night out at their favorite restaurant produces the anticipation of a wonderful meal partnered with outstanding service. The most successful restaurants are those that consistently deliver both. A happy customer, sometimes memorialized by a stellar review, is the cherry on top for the restaurant owner beyond what hopefully will be a long run of solid profitability.
For restaurant owners, however, there are certain “reviews” they would prefer not to receive—specifically IRS tax audits. Let’s face it: No one ever really wants to smell what the IRS is cooking in its kitchen unless it comes from a recipe for a tax refund. To add to restaurateurs’ angst, businesses that operate in the restaurant industry present a greater concern to the IRS because they are cash-intensive, and the IRS sees them as a higher risk for underreporting income. This article will explain how those who operate in this industry can reduce their audit risk and prepare if an audit is unavoidable.
How to Reduce Your Audit Risk
First, it’s important to understand what an audit is. The IRS website defines it as “a review/examination of an organization’s or individual’s accounts and other financial information to ensure that information is reported correctly according to the tax laws and to verify the reported amount of tax is correct.” During 2023, the IRS audited fewer than a half percent of individual returns filed and only about three-fourths of a percent of corporate returns filed.
There are three main types of audits:
- Correspondence—the most common audit type; it is conducted by mail.
- Office—the type is more common with complex tax returns. An office audit invites taxpayers to have the audit conducted at an IRS office
- Field—the most comprehensive type. A field audit is conducted in the taxpayer’s home or business.
For each audit type, the IRS provides a written request for documents via a formal Information Document Request (IDR) form. The IRS will not call a taxpayer or business to start a civil audit. If you receive a phone call as a first communication, it is likely a scam. If you are unsure of a communication’s authenticity, you can contact the IRS at (800) 829-1040.
Common Audit Triggers
Inadequate reporting and supporting documents. A taxpayer is generally responsible for every item claimed on the individual’s tax return; some sort of book or record must exist to support each item listed on the return. Accurate bookkeeping is an essential ingredient for successfully defending oneself in an audit. Whether it is full disallowance of a deduction or refusal to release a frozen refund, without accurate bookkeeping, every meal offered at Café IRS will taste terrible. To avoid that, taxpayers should keep supporting documents for the duration of a potential audit. Generally, the IRS has three years to audit a return. However, there are situations such as substantial omission where the examination/audit period is six years or, if the taxpayer committed fraud or is a nonfiler, forever.
Business versus hobby losses. Generating profits on a regular basis can pose a significant challenge for many businesses. However, businesses that show consistent losses where deductions exceed income can draw the attention of the IRS. This scrutiny arises because the IRS presumes that a taxpayer who generates consistent losses is not necessarily engaging in a bona fide business activity for profit but rather a hobby for which losses are nondeductible. This does not necessarily mean that the IRS is correct, but it does increase the taxpayer’s risk of an audit and the likelihood that the IRS will hold it to a higher standard of proving that it really is operating the business with the intent to make a profit.
Fortunately, the likelihood of an audit is lower during a business’s initial years because losses are more commonplace for a startup. However, businesses are expected to eventually become profitable; therefore, the longer they operate unprofitably, the greater the burden of convincing the IRS that the business owner is engaging in a business activity and not a hobby. To demonstrate this point, the IRS has a safe-harbor rule to qualify as a legitimate business if the business can demonstrate profitability in three of the past five tax years.
Worker classification. A business must accurately report the status of its workers as employees or independent contractors to avoid back taxes, penalties and interest. Generally speaking, independent contractors have more autonomy in setting their work schedules, while employees work under employers who determine the work schedules and procedures. Employers are responsible for withholding taxes from employees’ paychecks and contributing to programs like Social Security and Medicare. Independent contractors are responsible for their own tax withholdings. Businesses sometimes misclassify workers as independent contractors to avoid paying payroll taxes, but the IRS has clear guidelines on who can be classified as an independent contractor versus an employee.
Fraud. Being found liable for the tax fraud penalty can be costly. Tax fraud is an intentional wrongdoing with the specific purpose of evading a tax known or believed to be owed. The tax code imposes a 75 percent civil penalty on the portion of tax underpayment attributable to fraud. Common evasion schemes include intentional understatement or omission of income; claiming fictitious or improper deductions; false allocation of income; improper claims, credits or exemptions; and/or concealment of assets. In all criminal and civil tax fraud cases, the burden of proof is on the government. Classify
How to Handle an IRS Audit
There are three outcomes of an audit:
- No change – an audit in which you have substantiated all of the items being reviewed and results in no changes being made from your tax return.
- Agreed – an audit where the IRS proposed changes and you understand and agree with those changes.
- Disagreed – an audit where the IRS has proposed changes, and you understand but disagree with the changes.
How you handle yourself during the audit can have a huge impact on your audit outcome. The following items should be considered during an audit:
Timely respond to IRS requests for documents and information. If the IRS believes an adjustment to your tax return is necessary, the agency will start asking questions via IDRs. Prepare a complete response to every item in the IDR and ensure that you reply by the deadline in the request. Always send your responses to the IRS using a delivery confirmation service.
If you agree with the audit results, make payment arrangements. If you agreed with the audit findings and received a “no change” letter, congratulations. If you agree with the audit findings but those findings contain proposed adjustments to your tax return, you will be asked to sign the examination report that contains the IRS’ proposed adjustments. If the adjustments result in a balance due, you can seek a payment arrangement that best suits you. Various payment options include but are not limited to full pay, installment agreements, partial payment plans, offers-in-compromise and currently not collectible.
If you disagree with the audit results, appeal to the appropriate venue. If you disagree with the IRS’ findings, the agency will issue a “30-day letter” that allows you 30 days to appeal. The Appeals Office is separate from and independent of the agency’s Examination and Collection functions. After 30 days, the IRS will send you a statutory Notice of Deficiency, which closes the tax audit and allows you to petition the U.S. Tax Court to resolve the issue.
Unless you are a master at IRS procedures, it is highly recommended that you do not dine in at Café IRS alone. Get a licensed tax professional to represent you and advocate your tax return positions before the IRS.
Jerrika Anderson is a former IRS attorney with substantial experience litigating tax disputes for both the IRS and now as a private practitioner at Chamberlain Hrdlicka in Atlanta, GA, representing business and individual taxpayers. You can reach her at Jerrika.Anderson@chamberlainlaw.com or (404) 658-5469.
