Author: Jim Payne

Jim Payne, a Florida Certified Public Accountant (CPA) since 1976, offers candid insights on getting square with the IRS — with the least pain, and at the lowest cost — with (or without) the help of a tax representative. Mr. Payne is a former IRS agent and expert in business profitability, IRS audits, IRS payroll tax, and IRS non-filer issues. As a Tax Representative, his goal is clear: " I will speak on your behalf to all IRS agents, so you never have to, and I'll guide you in executing a strategy to resolve your IRS problem so you can get back to enjoying life."

Understanding the Different Types of Offer-in-Compromise: A Path to Tax Relief

An Offer-in-Compromise (OIC) can be a lifeline for taxpayers with overwhelming tax debt. It lets individuals settle their tax liabilities for less than what they owe, but only if they meet specific criteria. This isn’t a free pass. The IRS closely reviews each application, considering your ability to pay, income, expenses, and assets. There are three main types of OICs: Doubt as to Collectibility, Doubt as to Liability, and Effective Tax Administration. Each one applies to different situations. Knowing which one fits your case can help improve your chances of approval.

1. Doubt as to Collectibility (DATC)

This is the most common type of OIC. It applies when you can’t afford to pay the total tax debt. The IRS looks at your income, assets, and allowable expenses to see if you can’t pay the total amount. You must provide detailed financial documents like bank statements and pay stubs to qualify. If the IRS determines that you won’t be able to pay off the debt within the remaining collection period (usually ten years), they may accept your offer for a lower amount.

Given your current financial situation, your offer must be the most the IRS could reasonably expect to collect from you.

2. Doubt as to Liability (DATL)

This type of OIC applies when you disagree with the tax debt or believe it’s incorrect. You might submit a DATL offer if you think there was a mistake in the audit process or if you have new evidence that reduces your liability.

To succeed with this offer, you’ll need robust documentation showing why the IRS’s assessment is wrong or why the amount should be lower.

3. Effective Tax Administration (ETA)

An Effective Tax Administration offer is used when paying the full tax would cause serious hardship. This type of offer is rare. It’s for people who can technically pay the debt, but doing so would leave them unable to meet basic living expenses. For example, an ETA offer might apply if you liquidated a brokerage or IRA account due to fraud and now face high taxes on top of the loss. Even though the debt is valid, the IRS may accept less if collecting the total amount would cause undue financial strain.

Conclusion

Choosing the right Offer-in-Compromise is crucial to improving your chances of acceptance. The OIC process offers a possible solution, whether you’re facing financial difficulties, disputing the tax, or dealing with hardship. Be sure to meet the eligibility requirements and provide the necessary documentation to back your case.

How to Calculate Reasonable Compensation for S Corporation Owners

One of S corporation owners’ most crucial tax considerations is determining “reasonable compensation.” The IRS scrutinizes S corporation shareholders’ compensation because it impacts how income is taxed. While S corporation shareholders can take salary and distributions, only the salary is subject to payroll taxes. Distributions are not, making it tempting to underpay salaries. However, doing so can lead to IRS penalties if the salary is deemed unreasonably low.

What is Reasonable Compensation?

Reasonable compensation is the salary an S corporation owner must pay themselves for the services they provide to the business. The IRS expects this salary to reflect what someone in a similar role with similar experience would earn in the market.

The IRS looks at factors such as:

The shareholder’s duties and skills
Time and effort spent on the business
Comparable salaries in the industry
The company’s gross revenue and profits

How to Calculate Reasonable Compensation

1. Research Comparable Salaries
Use resources like the Bureau of Labor Statistics (BLS) or salary surveys to find salary data in your industry and region. For example, if the owner is both a CEO and performs technical work, combine salaries for those roles.

2. Consider Hours Worked
Estimate the time spent on each role and calculate compensation based on that split.

3. Factor in Company Financials
Your compensation should also reflect the financial health of your business. Higher profits may justify a higher salary while struggling businesses might opt for more modest compensation.

The Importance of Documentation

Maintaining documentation or a study to support your salary calculation is crucial. Without this, you leave the determination of what is “reasonable” to an IRS auditor if you’re ever examined. This could result in the auditor setting a higher salary than you paid yourself, leading to back payroll taxes, penalties, and interest.

If the IRS determines underreported wages, they will likely apply the adjustment to all three open tax years, increasing your liabilities.

Conclusion

Determining reasonable compensation for S corporation owners is critical to avoiding payroll taxes and penalties. To protect yourself in the event of an audit, be sure to document your approach based on industry standards, duties, and financial performance.

What is Considered ‘Reasonable Compensation’ for S Corp Owners and Why It Matters

For S corporation owners, reasonable compensation is crucial for staying compliant with the IRS. As both shareholders and employees, owners must pay themselves a fair salary based on their work. This is important because shareholder-employees receive funds through wages (subject to payroll taxes) and distributions (not subject to payroll taxes). If the IRS believes an owner is underpaying themselves in wages while taking excessive distributions, it can lead to audits, penalties, and back taxes.

But what exactly is considered reasonable compensation, and why does it matter?

How the IRS Defines Reasonable Compensation

The IRS defines reasonable compensation as pay reflecting the value of services provided by the shareholder-employee. The salary should match what the company would pay someone else for the same duties. When determining reasonable compensation, the IRS considers several factors:

The Role and Duties Performed: Different jobs require different levels of compensation. For example, someone handling administrative tasks, like scheduling, would earn less than someone responsible for strategic planning or overseeing finances. The more complex and critical the role, the higher the pay should be. If an owner shapes the company’s vision or manages large teams, their salary should reflect that.
Industry Standards: The IRS compares the owner’s pay to what others in the same role, industry, and region earn. Owners can use salary surveys to ensure their pay aligns with typical compensation for similar duties.
Business Size and Financial Health: The IRS examines company revenue, profits, and size. Larger, profitable businesses are expected to pay higher salaries. A highly profitable S corporation that pays a modest salary but takes large distributions may raise red flags for the IRS.
Time and Effort: An owner’s time in the business also matters. An owner working full-time in a key role should receive a higher salary than someone working part-time or doing less critical tasks.

Why Reasonable Compensation Matters

Avoiding IRS Scrutiny: The IRS monitors S corp owners who pay themselves low salaries while taking large distributions, which avoids payroll taxes. If they suspect underpayment of wages, it can lead to an audit.

Tax Compliance: Payroll taxes fund Social Security and Medicare. If the IRS reclassifies distributions as wages, the business will owe back payroll taxes, interest, and penalties.

Ability to Borrow: Reporting a fair salary helps when applying for loans or working with investors, showing that the company complies with IRS rules.

Conclusion

Understanding reasonable compensation is vital for S-corp owners to avoid IRS scrutiny. Pay should reflect the role’s complexity, align with industry standards, and consider the company’s financial condition. By balancing wages and distributions, owners can protect their businesses from penalties and keep operations compliant.

What Situations Are Most Likely to Trigger an IRS Audit?

While the thought of an IRS audit can be stressful, the reality is that only about 0.4% of individual tax returns are audited each year. However, certain red flags can increase your chances. Understanding these triggers can help you avoid mistakes and reduce your audit risk. Here are the most common situations that could lead to an IRS audit:

1. High Income Levels

The IRS is more likely to audit higher-income taxpayers. According to IRM 4.1.5.4, the IRS prioritizes cases where significant tax revenue is at stake. While the overall audit rate is low, those with incomes over $500,000 have a 1.1% chance of being audited. This jumps to 2.6% for individuals earning $1 million or more.

2. Unreported Income

Failing to report all income is a quick way to get the IRS’s attention. The IRS matches your tax return with the W-2s and 1099s they receive from employers and other sources. Any discrepancy, like income from freelancing or side jobs, could result in a CP2000 Notice, signaling a potential audit.

3. Large or Unusual Deductions

Claiming deductions that seem large relative to your income can raise red flags. For example, reporting $80,000 in income but claiming $40,000 in charitable donations may lead to scrutiny. Similarly, large deductions for business expenses or home office use could be questioned. The IRS uses DIF scores to identify unusual return patterns (IRM 4.10.5.2).

4. Claiming the Earned Income Tax Credit (EITC)

The Earned Income Tax Credit (EITC) is a valuable tax break for low-income families but is also heavily audited due to frequent errors. 1.2% of returns claiming the EITC are audited, which is higher than the general audit rate. If you claim the EITC, ensure that all information is accurate and supported by documents like proof of income and household size.

5. Self-Employment Income

Self-employed individuals are likelier to be audited because the IRS knows there’s more opportunity to underreport income or inflate deductions. High deductions for business expenses or home office use are common triggers. Keep detailed and accurate records to avoid issues.

6. Foreign Accounts and Assets

U.S. taxpayers must report foreign accounts if their value exceeds $10,000 at any point during the year. Failing to do so can trigger an audit and severe penalties. The IRS partners with foreign governments to find unreported foreign income, so compliance is key.

7. Round Numbers on Your Return

Filling out your return with rounded numbers, like exactly $5,000 for business expenses or $10,000 for donations, can look suspicious. While rounding to the nearest dollar is fine, avoid numbers that seem “too perfect.”

While the overall audit rate is low, knowing what behaviors increase your risk can help you avoid being flagged. By keeping accurate records and filing a precise, honest return, you can reduce the likelihood of facing an audit.

Defending the Schedule C “Hobby Loss” Exam

If you run a small business and report income and expenses on a Schedule C, the last thing you want is for the IRS to categorize your endeavor as a hobby. Why? Because hobby losses aren’t deductible, while business expenses are. The IRS scrutinizes businesses that consistently report losses, and if they suspect your business is more of a “hobby,” you could find yourself facing a Schedule C “Hobby Loss” examination. Here’s what to expect and how to defend your business if you’re audited.

What is a Hobby Loss Exam?

The IRS uses the “hobby loss” rule under IRC Section 183 to prevent taxpayers from deducting losses from activities that aren’t conducted to make a profit. If your business hasn’t generated a profit in three of the last five years (two out of seven for horse-related activities), the burden of proof to show your profit intent moves from the IRS to you. In that case, the IRS may challenge the legitimacy of your deductions. This triggers a “hobby loss” examination, where they’ll determine if your business is a legitimate for-profit activity.

Proving Your Business is Not a Hobby

If you’re facing a Schedule C audit, the burden of proof is on you to show that your activity is a business with a profit motive. The IRS looks at several factors, including:

Business-like Manner: Do you keep accurate books, maintain separate bank accounts, and professionally conduct your activity? The more you treat your business like a serious venture, the better your chances.
Time and Effort: Do you spend significant time and effort in the business, or is it more of a casual pastime? Documenting your working hours and your attempts to grow and improve the company will help bolster your case.
Expertise: Do you have knowledge or expertise in the industry? Showing that you’ve sought advice, attended relevant training, or engaged with professionals in your field strengthens your claim.
History of Income and Losses: While reporting losses is not unusual for new businesses, a pattern of profitability, even if sporadic, helps demonstrate intent. You don’t have to show profits every year, but consistent and serious efforts to make the business profitable are crucial.
Appreciation of Assets: If your activity involves assets that appreciate over time (like real estate or collectibles), it suggests a potential for profit, even if income isn’t immediately apparent.

Preparing for the Exam

Gather and organize your financial records if you receive notice of a Schedule C exam. Documentation like receipts, invoices, contracts, and tax returns are essential. In addition, prepare a narrative that explains your efforts to make a profit, any challenges faced, and your future business plans. It’s also helpful to work with a tax professional experienced in defending hobby loss exams, as they can provide guidance on specific documentation the IRS may request.

Conclusion

While facing a Schedule C “Hobby Loss” exam can be stressful, being proactive and organized in demonstrating your profit motive can turn things in your favor. By treating your business seriously and documenting your efforts, you can defend your deductions and keep your tax bill in check.

The Problem with IRS Auditors Using Outdated Industry Statistics in Indirect Methods: Cash vs. Credit Card Deposits

When IRS auditors examine a business, they often use indirect methods to estimate income. This is especially common when records are incomplete or inconsistent. One method compares a business’s cash and credit card deposits to industry averages. However, a growing problem is that the IRS sometimes uses outdated industry statistics. This can lead to inaccurate conclusions and inflated tax bills for businesses.

The Lag in Industry Statistics

The IRS uses industry data that is often a few years behind. This can be a problem in fast-changing sectors like retail and food service. Payment methods have shifted rapidly in recent years. More businesses now rely on digital payments and credit cards, while cash transactions are declining. The COVID-19 pandemic sped up this shift as people moved to contactless payments.

Despite these changes, IRS auditors sometimes use old benchmarks. Comparing a business’s cash-to-credit ratio to data from five or ten years ago could lead to errors. Back then, cash payments were more common. Using those figures now may falsely suggest a business is underreporting its income. As a result, businesses could face unjust penalties based on inaccurate data.

Cash vs. Credit Card Deposits: A Changing Landscape

The cash-to-credit deposit ratio is a key metric in IRS audits using indirect methods. Auditors compare this ratio to industry averages to estimate total receipts. However, if these averages are outdated, audit results can be misleading.

Many industries, especially restaurants, bars, and small retail businesses, now handle mainly credit card payments. If an auditor uses old data from when cash was more common, it can look like a business is underreporting cash income. This issue is worse for businesses in areas where digital payments are more popular, as they have shifted even more away from cash.

The Impact of Outdated Data

Outdated industry statistics can seriously harm businesses. If an audit relies on old data, it may wrongly suggest that the business is handling more cash than it is. The IRS could then conclude that cash income is being underreported. This may lead to inflated tax liabilities, costly disputes, and unnecessary penalties.

Businesses in rapidly changing industries or areas are especially at risk. For example, a restaurant in a city where contactless payments are standard may be compared to outdated data from cash-heavy regions. Similarly, businesses with tech-savvy customers may see most payments come via credit cards or digital wallets. These patterns won’t match older statistics that assume a larger reliance on cash.

The Need for Updated Industry Statistics

For IRS audits to be fair, they must use current data that reflects today’s business practices. The payment landscape is evolving quickly, and using statistics that are several years old can disadvantage businesses. Relying on outdated industry averages forces businesses to defend themselves against data that no longer applies.

Conclusion

Using outdated industry statistics in IRS audits, especially when comparing cash and credit card deposits, is a major challenge for businesses. The lag in updating benchmarks means audits may rely on figures that no longer reflect how businesses operate today. As industries shift toward digital payments, IRS auditors must use up-to-date data. Without it, businesses risk facing unfair tax assessments and lengthy disputes based on an outdated view of their industry.

How Best to Utilize IRS Collection Appeals

Knowing how to use the IRS Collection Appeals Process (CAP) can help protect your rights if you’re facing IRS collection actions like levies or liens. CAP lets taxpayers challenge IRS enforcement actions. It may also delay or prevent those actions while your case is reviewed. Here’s a guide on how to make the most of IRS Collection Appeals:

What is the IRS Collection Appeals Program (CAP)?

The Collection Appeals Program (CAP) lets taxpayers appeal IRS collection actions. CAP covers liens, levies, installment agreements, and property seizures. It’s faster than other appeal processes, often resolving cases within five days.

When to Use CAP

There are several situations where CAP can help:

Lien Filings: If the IRS places a lien on your property, you can appeal it through CAP. This gives you time to devise another solution, like an Installment Agreement.
Levies: If the IRS plans to seize your wages or bank accounts, you can file a CAP appeal to stop or reverse the levy.
Installment Agreement Rejection: If your request for an installment agreement is denied or an existing one is modified or terminated, you can appeal through CAP. This is useful if the IRS is misjudging your ability to pay.
Seizure of Property: If the IRS is about to seize your property, CAP can force the IRS to reconsider before taking your assets.

How to File a CAP Appeal

To file a CAP appeal, complete Form 9423 (Collection Appeal Request). Send it to the IRS office that took the collection action. File your appeal quickly since you can only request a hearing before the action occurs—except for liens and levies, which you can appeal after they happen.

Tips for Success

Act Quickly: The CAP process is fast. File your appeal as soon as you receive notice of a collection action. Once the action occurs, you have fewer options.
Provide Strong Documentation: Support your appeal with financial documents, hardship information, or reasons for unfair action. This can boost your chances of success.
Seek Professional Help: Consider working with a tax professional experienced in IRS appeals for complex situations. They can help present your case effectively.

Conclusion

The IRS Collection Appeals Process can stop aggressive collection actions. You can potentially reverse liens, levies, and more by acting quickly, filing an appeal, and providing solid documentation. Getting professional help can also improve your chances of a successful outcome for tricky cases.

Exploring the Taxpayer Advocate Service: A Lifeline for Taxpayers

Dealing with the IRS can be frustrating, especially when problems aren’t resolved through normal channels. The Taxpayer Advocate Service (TAS) is here to help when things go wrong. But when should you turn to TAS? Here are key situations where they can make a difference:

1. Financial Hardship or Imminent Adverse Action

TAS can intervene if an IRS action, like a lien or levy, is causing you severe financial distress or facing an immediate threat of a levy or seizure. They can work to resolve the issue quickly or delay the action while your case is reviewed.

2. Unresolved Issues Despite Repeated Attempts

If you’ve tried multiple times to fix a tax problem but keep hitting a wall, TAS can help. TAS can break through the red tape, whether it’s a persistent error or communication breakdown.

3. Unreasonable Delays

If the IRS takes too long to address your issue, causing hardship, TAS can intervene. They can push the IRS to prioritize your case and prevent further complications.

4. Incorrect Interpretation of Tax Law

If you believe the IRS misinterprets tax law or its procedures, TAS can help challenge this. They ensure the law is applied correctly, so you aren’t unfairly penalized.

Conclusion

TAS is there when standard IRS processes fail. Whether it’s financial hardship, delays, or incorrect application of the law, TAS provides the help you need. If you’re stuck with an unresolved tax issue, contacting TAS could be your best step toward a fair resolution.

What is an “Equivalent Hearing”?

When dealing with IRS collection actions, it’s crucial to know your options for appealing or disputing those actions. One such option is a Collection Due Process (CDP) hearing. But what happens if you miss the 30-day deadline to request a CDP hearing? Fortunately, the IRS offers another option known as an “Equivalent Hearing.” Let’s explore what an Equivalent Hearing is, how it works, and how it can still provide valuable opportunities to resolve your tax issue.

Understanding the Equivalent Hearing

An Equivalent Hearing is similar to a CDP hearing but is available if you miss the 30-day deadline to request a CDP hearing. You can request an Equivalent Hearing within one year of receiving either a Final Notice of Intent to Levy or a Notice of Federal Tax Lien. Although an Equivalent Hearing doesn’t offer all the same protections as a CDP hearing, it still provides a formal process to appeal IRS collection actions.

Key Differences Between CDP and Equivalent Hearings

While an Equivalent Hearing closely resembles a CDP hearing, there are important distinctions:

No Automatic Halt to Collection Actions: Unlike a CDP hearing, an Equivalent Hearing does not automatically stop IRS collection actions, such as levies or liens. The IRS can continue pursuing collection activities while your case is being reviewed.
No Access to Tax Court: One of the biggest drawbacks of an Equivalent Hearing is that it doesn’t preserve your right to take the case to U.S. Tax Court if you disagree with the outcome. This limits your legal options if the decision doesn’t go in your favor.
Timing: As mentioned earlier, you have 30 days to request a CDP hearing from the date of the IRS notice. For an Equivalent Hearing, you have up to one year to make the request. This extended window gives you more time if you initially missed the CDP deadline.

Why Request an Equivalent Hearing?

Even though an Equivalent Hearing lacks some of the protections of a CDP hearing, it’s still a valuable opportunity. You can present your case to an independent Appeals officer who will review the IRS’s proposed actions and consider any alternative resolutions you propose. You might be able to negotiate an installment agreement, Offer in Compromise, or Currently Not Collectible (CNC) status.

In addition, an Equivalent Hearing allows you to raise similar arguments that you would in a CDP hearing. You can dispute the validity of the IRS’s actions or demonstrate why their collection methods would cause financial hardship.

How to Request an Equivalent Hearing

To request an Equivalent Hearing, you must file Form 12153, the same form used for a CDP hearing. Be sure to indicate on the form that you request an Equivalent Hearing. After submitting the form, you’ll work with an Appeals officer to review your case, discuss your options, and possibly reach a resolution.

Final Thoughts

An Equivalent Hearing is a useful backup option if you miss the deadline for a CDP hearing. Although it doesn’t automatically stop collection actions or provide access to the Tax Court, it still allows you to challenge the IRS and propose alternative solutions. If you’ve received a notice and missed the 30-day window for a CDP hearing, don’t lose hope—an Equivalent Hearing can still be a valuable tool in resolving your tax issue.

The Benefits of a Collection Due Process Hearing

If you’ve received a notice from the IRS about a lien or levy, you might feel overwhelmed and unsure of what to do next. Luckily, the IRS offers a key safeguard called a Collection Due Process (CDP) hearing. This hearing lets you appeal actions like liens, levies, or a denied installment agreement. Let’s explore how a CDP hearing can benefit you and help you manage your tax situation.

What is a Collection Due Process (CDP) Hearing?

A CDP hearing is a formal process where you can challenge the IRS’s proposed collection actions. You can request a CDP hearing after getting certain notices, such as a Final Notice of Intent to Levy or a Notice of Federal Tax Lien. Once you receive one of these notices, you have 30 days to file a request using Form 12153. During this time, the IRS typically pauses most collection actions. This pause gives you valuable time to figure out a solution while your case is under review.

Key Benefits of a CDP Hearing

Halt to Collection Actions

One of the biggest benefits of requesting a CDP hearing is that it stops IRS collection efforts. Once you submit your request, the IRS generally can’t proceed with liens, levies, or garnishments while your case is being reviewed. This break gives you extra time to work on a resolution without fearing your assets being seized.

A Fair Review by an Independent Officer

Your case is handled by an Appeals officer who wasn’t involved in the original decision. This independent officer reviews the facts, listens to your side, and determines whether the IRS’s actions are justified. A fresh perspective often leads to more reasonable solutions that the original enforcement team may have overlooked.

Explore Alternative Resolutions

A CDP hearing isn’t just about disputing the collection action. It’s also a chance to propose alternative solutions. You can request options like an installment agreement, Offer in Compromise, or Currently Not Collectible (CNC) status. The Appeals officer can decide if these alternatives fit your financial situation, giving you a key opportunity to negotiate better terms for settling your tax debt.

Preservation of Your Rights to Appeal in Tax Court

If you’re unhappy with the outcome of your CDP hearing, you still have the right to take your case to the U.S. Tax Court. This extra layer of protection ensures you have every chance to argue your case and seek relief. The CDP process is one of the few pathways that preserves this important right.

Preparing for a CDP Hearing

Preparation is key to achieving the best outcome. Gather all relevant documents and be ready to explain why the IRS’s actions are too harsh or unnecessary. If you’re proposing an alternative resolution, like an installment agreement or Offer in Compromise, ensure you have detailed financial records to support your proposal.

Final Thoughts

A Collection Due Process hearing is a powerful option for taxpayers facing aggressive collection actions. It gives you time to find a solution and ensures that an independent officer reviews your case fairly. By taking advantage of this process, you can avoid severe actions like levies and liens while working toward a manageable resolution with the IRS. If you receive a notice qualifying you for a CDP hearing, don’t miss out on this chance to protect your rights and explore better options for resolving your tax debt.