IRS Announces Tax Audit Targets

by M. Robinson & Company, P.C.
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Over the past several years, IRS has reduced the number of its tax auditors by about 25 percent – from just over 12,000 tax auditors in 2011 to about 9,000 tax auditors in 2015. This staffing reduction has forced IRS to focus its limited tax audit resources on middle-market companies and high income/high net worth individuals. Consistent with its focus, IRS has announced a number of tax audit targets over the past few months.

This Blog is divided into the following sections.

          – Substantive Tax Issues Targeted for Audit. Seven of the thirteen substantive tax issues targeted for audit by IRS are outlined below. Of the seven tax issues outlined, four involve international tax compliance, an important emphasis of our office. We are competent, however, in all substantive areas outlined below. In each case, we also list the taxpayers who are the focus of the IRS tax audits. The remaining six tax audit issues have a narrow industry focus and are not outlined below.

         – Voluntary Disclosure Programs Evaluated. Vulnerable taxpayers may wish to consider an IRS voluntary disclosure program, outlined below. Generally, if accepted into a voluntary disclosure program, penalties are minimized and criminal responsibility is avoided.

Partial Listing of Substantive Issues in the IRS’ Crosshairs

 U.S. Companies Doing Business Abroad

U.S. individuals and businesses often use foreign corporations and subsidiaries when they do business abroad. Sometimes, these taxpayers are required to report the income earned by their foreign entity in the year earned as so-called “Sub Part F” income. Sometimes, however, taxpayers are not required to report their entity’s Sub Part F income until this income is repatriated to the United States. IRS has found that some middle-market companies have failed to properly report their deferred Sub Part F income in the year of repatriation.

  • IRS Focus: Middle-market companies doing business abroad.

Form 1120-F Non-Filers

IRS has provided fair notice that it intends to begin to conduct examinations of non-filer corporations who are organized abroad but have a “U.S. business nexus.” Generally speaking foreign corporations may be obligated to file Form 1120-F if the foreign corporation:

  1. Was engaged in a trade or business in the United States, whether or not it had U.S. source income from that trade or business, and whether or not income from such trade or business is exempt from United States tax under a tax treaty.
  2. Had income, gains, or losses treated as if they were “effectively connected” with the conduct of a U.S. trade or business.
  3. Was not engaged in a trade or business in the United States, but had income from any U.S. source, and its tax liability has not been fully satisfied by the withholding of tax at source under Chapter 3 of the Internal Revenue Code.
  • IRS Focus: Middle-market foreign companies.

United States Distributors of Inventory Obtained from Foreign Related Parties

United States distributors of inventory obtained from foreign related parties can manipulate their income by setting the so-called transfer price to minimize the income reported to IRS. IRS intends to conduct tax examinations that are specifically targeted on transfer pricing.

  • IRS Focus: Middle-market companies, which obtain inventory from foreign related parties. Related parties may presumably be related through ownership (parent/subsidiary relationships) or through common control by a third party or parties.

The Offshore Voluntary Disclosure Program

Over the past eight years – since 2009 – many taxpayers have applied for preclearance into the IRS Offshore Voluntary Disclosure Program in its various iterations. Presently, there are about 6,000 taxpayers who are unaccounted for. They applied for preclearance but did not participate in the OVDP programs. IRS wants to find out what happened to these taxpayers. At this point, participation in a voluntary disclosure program may still be an option for some.

  • Additional Information: For additional information, please see the Blog of Attorney Patricia Weisgerber dated June 14, 2017 entitled 2017 OVDP Declines and Withdrawals Campaign.
  • IRS Focus: Individuals and middle-market companies.

Related Party Transfers 

Often entities under common control transfer money back and forth. For example, a middle-market business may rent its offices or warehouse from an entity controlled by its major shareholders. IRS will examine these transfers to make sure that income is properly reflected by all taxpayers.

  • IRS Focus: Middle-market companies and their shareholders/partners.

Land Developers – Abuse of the Completed Contract Method 

IRS has found some abuses involving the completed contract method of accounting may exist. Specifically,

  1. Ineligible Developers. IRS has found that some ineligible land developers are using the completed contract method of accounting. IRS notes that developers are ineligible if their average annual gross receipts exceed $10 million – unless the contract is a “home construction contract.”
  2. Improper Use of Completed Contract Method. IRS has found that some land developers improperly defer gain until the entire development is completed.
  • IRS Focus: Middle-market companies using the completed contract method of accounting.

S Corporation Losses in Excess of Basis

S corporation shareholders are not permitted to deduct losses in excess of tax basis. Tax basis can include both “stock basis” and “debt basis.” IRS has found that many S corporation shareholders do not attach the required basis schedule and often report what is reflected on the Schedule 1120-S K-1 without taking into account other items that affect basis. IRS is planning audits that will target deductions of S corporation losses in excess of a shareholder’s tax basis.

  • IRS Focus: Middle-market S corporations and their shareholders.

Using IRS Voluntary Disclosure Programs

IRS “campaigns,” such as those described above, are carefully reviewed by IRS management, which invests significant resources in planning the “campaign” and training IRS personnel. Thus, taxpayers in the IRS’ crosshairs will want to consider their exposure carefully. Taxpayers may decide that it is in their best interest to come into full compliance with the income tax and disclosure laws of the United States.

There are two methods for coming into compliance:

  1. “Quiet Disclosure”

Under “Quiet Disclosure” targeted taxpayers file previously unfiled returns and amend (correct) previously filed erroneous returns. A so-called “quiet disclosure” does not prevent an audit and the possible imposition of substantial civil and even criminal penalties. Indeed, a so-called “quiet disclosure” may actually trigger the tax audit.

  1. Voluntary Disclosure

A so-called “voluntary disclosure” is made directly with IRS Criminal Intelligence Division. There are three basic voluntary disclosure programs:

a) Domestic Voluntary Disclosure Programs for domestic cases.

b) Offshore Voluntary Disclosure Programs for United States taxation of foreign income and the tardy disclosure of foreign financial assets.

c) Offshore Voluntary Disclosure of Foreign Financial Assets for the tardy disclosure of foreign financial assets where all related income was properly and timely reported.

Voluntary disclosure programs allow most taxpayers accepted into a voluntary disclosure program to either avoid all penalties (domestic voluntary disclosure) or to substitute the certainty of a smaller civil penalty for the potential, if caught, for a larger civil penalty or even for criminal prosecution (offshore voluntary disclosure).

Acknowledgement

I acknowledge the assistance of Attorney Patricia Weisgerber, an associate at M. Robinson Tax Law, and Anisa Bame, a paralegal at M. Robinson Tax Law, who reviewed this Blog and made numerous helpful suggestions.

 

 

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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