For business owners, taxes are a significant concern. Fortunately, there are steps that can be taken to reduce a business’s tax burden by utilizing the deductions that are available. For many business owners, structuring a business as a pass-through entity can provide advantages. Pass-through entities such as partnerships, S corporations, and limited liability companies (LLCs) are popular choices among small businesses due to their flexibility and the pass-through deduction that was put in place by the Tax Cuts and Jobs Act of 2017. 

However, owners of pass-through entities need to be aware of the risk that they could face tax audits. Recently, the IRS announced that its Large Business & International (LB&I) division would be focusing on large or complex pass-through entities as part of its ongoing effort to address tax evasion. Business owners who are facing IRS audits may want to consider working with an attorney who has experience in cases involving pass-through entities.

The Importance of Properly Reporting Pass-Through Deductions

Pass-through entities allow business owners to report their share of profits or losses on their personal income tax returns rather than paying taxes at the entity level. This structure provides significant benefits, including a deduction of 20 percent of a person’s share of Qualified Business Income (QBI). However, it is important to ensure that all business-related deductions are reported accurately.

For most taxpayers, a visit, call, or letter from the IRS can be very concerning. If a taxpayer has failed to pay taxes as required, has not reported information correctly when filing tax returns and other forms, or has otherwise failed to comply with tax laws, they can face significant penalties. When a person is contacted by the IRS, this could be a sign that they will face a tax audit, and they may need to address a variety of complex financial issues as they determine how to address issues related to tax compliance. However, the IRS recently announced a policy change that may limit certain forms of contact between IRS agents and taxpayers. Namely, the IRS will no longer make unannounced visits to taxpayers in most situations.

IRS Policy Addresses Safety Concerns and Other Issues

In the past, IRS agents would occasionally visit homes or businesses without contacting taxpayers in advance. During these visits, they would address concerns about unpaid taxes or failure to file tax returns. However, in recent years, IRS agents have faced safety concerns when making these unannounced visits. Law enforcement officials have also noted the increased prevalence of tax scams in which people pose as IRS agents. Because of these concerns, the IRS has put an end to nearly all unannounced visits, effective immediately.

Instead of making unannounced visits, the IRS will contact taxpayers ahead of time and schedule meetings. An appointment letter (Letter 725-B) will be sent, and a taxpayer can then schedule a one-on-one meeting with an IRS official at a designated time and place. This can ensure that taxpayers will be prepared to address specific issues, and they can compile the necessary documentation and take steps to resolve any concerns about unpaid taxes, unfiled tax forms, or compliance with tax laws.

The Criminal Investigation (CI) division of the IRS regularly investigates taxpayers who are suspected of tax evasion, tax fraud, and other offenses. These investigations may be related to tax audits, or they may be performed independently. Those who are accused of committing tax-related offenses may not only face penalties for non-payment of taxes or failure to submit the proper information to the IRS, but they may also be subject to criminal prosecution. In recent years, offenses related to cryptocurrency have been a significant concern for the IRS. Agency officials have stated that hundreds of cases involving virtual currency and tax evasion or other offenses are likely to be prosecuted within the next year.

The IRS's Increased Focus on Cryptocurrency

As more and more people invest in cryptocurrency, use virtual currencies to make payments and purchases, and receive digital assets as income, the IRS has begun to scrutinize these transactions and enforce compliance with tax laws. It has also been able to prosecute some major cases involving tax fraud and other related offenses. In just one example, the founders of Bitqyck, a cryptocurrency investment company, were convicted of tax evasion after defrauding investors of around $24 million. The defendants in this case had failed to file corporate tax returns, and they had underreported their income to the IRS, resulting in tax losses of more than $1.6 million. In addition to being sentenced to prison, the defendants were required to pay a civil penalty of $8.3 million to the U.S. Securities and Exchange Commission.

While high-profile cases prosecuted by the IRS that involve millions of dollars may receive the most attention in the news, the hundreds of cryptocurrency investigations that are currently being performed are likely to involve smaller amounts. Currently, the IRS is using "John Doe" summonses to gather information about cryptocurrency transactions, and in many cases, these summonses involve transactions of $20,000 or more. These summonses may be served on third parties, such as cryptocurrency exchanges, in order to identify virtual currency owners and determine whether they have violated tax laws. Summonses may be used to identify "off-ramping" transactions in which cryptocurrency is exchanged for legal currency issued by the U.S. or other countries, as well as virtual currency that was received as income and was not properly reported to the IRS.

The U.S. tax system is complex, and there are a variety of issues that could trigger tax audits by the IRS, potentially leading to penalties. Audits can be a significant area of concern for people who are self-employed or who own small businesses. In these situations, it is important to understand the information that a taxpayer will need to provide to the IRS and the issues that may be raised during an audit.

Audit Information Related to Profits, Losses, Deductions, and Expenses

During an audit, the IRS may request a variety of records or other information that supports the information reported on a tax return. These records may be related to:

• Income - All forms of income that a person earns must be reported to the IRS. It is important for self-employed taxpayers to maintain accurate records of all sources of income. This can sometimes be difficult for those who regularly conduct cash transactions. Large deposits into a bank account or major purchases made using cash may be reviewed by the IRS, and a taxpayer will usually need to provide documentation showing how these amounts were earned.

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California’s Employment Development Department (EDD) handles state payroll taxes, as well as unemployment benefits. While the EDD has struggled to address the large amount of unemployment insurance claims during the COVID-19 pandemic, it is beginning to return to normalcy, and it has resumed payroll tax audits. Businesses that are facing these types of audits will need to understand their requirements, as well as the post-audit issues that they may encounter.

Issues and Records Addressed in an EDD Audit

Audits performed by EDD will review a company’s records to ensure that wages and other payments made to employees have been reported correctly and that an employer is in compliance with its requirements under the California Unemployment Insurance Code (CUIC). An initial EDD audit will generally cover a period of up to 3 years, and it may review records for the 12 most recent quarters. Worker classification is one of the primary issues addressed in an audit, and it may determine whether workers have been incorrectly classified as independent contractors rather than employees. 

A business will be required to provide its records during an audit, usually starting with the following: