IRS May Conduct More Tax Audits for Pass-Through Organizations

 Posted on November 07, 2023 in Tax Audits

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.

One common mistake made by pass-through entity owners involves improperly claiming deductions. It is essential to understand which expenses qualify as deductible business expenses and ensure they are properly documented.

Examples of deductible business expenses include:

• Rent or mortgage payments for office space

• Employee salaries and benefits

• Business-related travel expenses

• Marketing and advertising costs

• Professional fees paid for legal or accounting services related to your business

There are a variety of situations where improper deductions may occur, including:

• Inflating deductions: Claiming deductions that are unreasonable or excessive can raise red flags with the IRS. It is important to make sure deductions are accurate and supported by proper documentation.

• Claiming personal expenses as business expenses: Deducting personal expenses, such as vacations or luxury items, as business expenses is a clear violation of tax laws. The IRS closely scrutinizes these types of deductions and may impose penalties if they discover such practices during an audit.

The Dangers of Tax Avoidance Schemes

In addition to improper pass-through deductions, other types of tax avoidance schemes can have severe consequences for pass-through entity owners. Attempting to avoid paying taxes that are rightfully owed to the IRS can result in substantial penalties or even criminal charges in some cases.

Some examples of tax avoidance schemes include:

• Underreporting income: Failing to report all income earned by a pass-through entity is a common tactic used to avoid taxes. A business owner must pay taxes on their entire share of a business’s earnings, even if all of these earnings were not distributed.

• Shifting profits between entities: Some businesses attempt to manipulate their financial records by reporting profits earned by one entity as income earned by another entity within a complex corporate structure. This strategy may attempt to take advantage of lower tax rates or exploit certain loopholes, but when these methods violate tax laws, they can result in penalties.

• Misclassifying employees as independent contractors: Some employers may misclassify workers in order to avoid paying payroll taxes and providing employee benefits. However, misclassification can trigger audits, as well as other legal issues. An employer may be required to pay back taxes owed, and penalties for noncompliance may also be assessed.

Contact Our San Jose Business Tax Lawyer

If you are facing a potential tax audit or need assistance navigating the complexities of pass-through entity taxation in California, John D. Teter Law Offices is here to help. Our San Jose, CA tax audit attorney understands the intricacies of tax laws and the best ways to respond to IRS queries and address potential tax penalties. We will review your case and develop a strategic plan to protect your interests. Contact us at 408-866-1810 to arrange a consultation.