The dreaded tax audit: How to lower your risk

For many years, the risk of a tax audit was barely on the radar for most veterinarians, but today the chances that the Internal Revenue Service (IRS) will flag a practitioner's tax return for an audit are noticeably greater.

During the 2006 fiscal year, the auditors' dragnet raked in a record $47 billion. Audits of individuals are up by about 20 percent and small-business audits have more than doubled.

Among contributing factors are the complexity of tax laws and the confusion veterinarians and other small-business owners feel in trying to keep up with rule changes.

Avoiding audits

Who wouldn't like to ensure that their tax return — or that of their veterinary practice — is not targeted for examination by the IRS? A few veterinarians have discovered one, highly illegal, way: do not file one.

At the opposite extreme, sure-fire ways to ensure that your return is flagged for audit include taking big-time losses, operating the practice as a cash business and keeping sloppy records.

Fortunately, the returns of most veterinarians fall between those two extremes.

There are ways to reduce the likelihood of an audit, but sacrificing valid deductions, even if large or unusual, is not one of them.

Obviously, all income and deductions must be reported truthfully, even if that means a higher chance of audit. (Keep in mind that income earned from third-party payers is usually reported to the IRS.)

One good strategy for avoiding an audit is to point out "oddball" items on the return. Give the IRS the answer before it asks the question. Attach a note, a brief statement, documents and explanations for unusual transactions.

For large transactions that may fall into one of several "gray areas" of our tax laws, there is yet another tax form. Form 8275, "Disclosure Statement," may help avoid penalties by disclosing questionable deductions, positions or investments. Few experts think using this form will increase the chance of an audit.

When offense is not enough

What happens if, despite your best efforts, the IRS requests your presence to review your tax returns? It goes without saying that the worst thing is to ignore an audit notice. A quick response is best. It also helps if the veterinarian works personally with the IRS to resolve issues.

If a small veterinary practice or business kept organized records, including bills, receipts and cancelled checks, and has in place the proper internal controls, there is little need to worry. The IRS may interpret the operation's situation differently, but there is no crime in having differences of opinion.

Thanks to the IRS Restructuring and Reform Act of 1998, small practices now have many new protections in the audit process. First, the IRS's ability to conduct so-called "lifestyle" or "economic reality" audits have been diminished.

Today, the IRS generally is prohibited from asking about a taxpayer's financial status, standard of living and similar factors in looking for unreported income. It can only ask such questions if it has a reasonable indication – for example, comments from third parties — that there is a likelihood of unreported income.

What the IRS is looking for

Most experts agree that sloppy or improperly prepared tax returns are among the first to attract an audit.

Those veterinarians who fail to report all income send up an instant red flag in today's computerized business world. Information mismatches produced by erroneous Form 1099s received by some veterinarians often create disparities in reported income. If the amount reported on the Form 1099 is wrong, the individual or firm that sent the form should correct it and file an amended version. Intentionally mismatching the information on the tax return can only draw attention.

The biggest problem for most veterinary practices, and their principals, is a lack of good expense records. The use of an automobile for business purposes is a classic example. Although the vehicle may have been used 75 percent of the time for patient or practice-related travel, many veterinarians fail to keep a detailed record and, thus, are unable to state that clearly on a tax return. Automobile records can be easily kept in a log.

Some veterinarians who use an office in the home to conduct business, keep records or perform management chores may find the tax deduction is not worth the audit risk. This is especially true if the deductions are minimal and records are poor.

The home office tax form (Form 8829, Expenses for the Business Use of Your Home) has been an audit flag for some time now.

Also, keep in mind that the use of an office in the home can substantially reduce or even eliminate the unique home-office exclusion. That exclusion allows up to $250,000 ($500,000 on a jointly-filed return) of gain from the sale of a residence to be excluded or ignored. A veterinarian cannot claim the exclusion for gains that result on any portion of that residence not used as a "personal residence."

Taxpayer rights

The Taxpayers Bill of Rights, part of the IRS Restructuring and Reform Act of 1998, requires the IRS to explain every taxpayer's rights and the IRS's obligations during the audit, appeals, refund and collection processes. A taxpayer is, for example, guaranteed the right to be represented by anyone currently permitted to practice before the IRS. Any interview must be suspended whenever a taxpayer clearly requests the right to consult with a representative.

Unless it issues an administrative summons, the IRS cannot require the taxpayer to accompany the representative to an interview.

Another important consideration for anyone being audited is where to hold that meeting. Should it be in the accountant's office, where all working documents are easily accessible? Should it be in the veterinarian's office, the place where all the records are kept, in order to demonstrate to the auditor that there is nothing to hide? Or, should the veterinarian and/or his or her representative trudge down to the IRS office armed only with the specific documents and information requested by the IRS? There is no one right answer.

Ignoring the IRS does not work. It may summon third-party record keepers (attorneys, enrolled agents, banks, brokers, accountants, etc.) to produce records of business transactions. Of course, the taxpayer must be notified of the summons and has the right to intervene. The taxpayer can, in fact, begin a proceeding to quash the third-party summons.

Appeal after appeal

As mentioned, the majority of veterinarians file honest returns. The occasional error, misinterpretation or honest disagreement in so-called "gray areas" may result in additional taxes.

However, from the initial screening for accuracy that each return receives until the final appeal, mistakes in favor of the taxpayer have been discovered only in about 25 percent of all cases.

The IRS usually is sympathetic to honest mistakes and more than willing to discuss underpayments that result from them. Sometimes it will negotiate the amount of tax due. It will not, however, tolerate fraud.

Honesty, clarity work best

Tax-law changes in recent years have resulted in tax professionals generally being more conservative in the advice they give and the returns they prepare.

After all, in the event that a transaction is labeled as incorrectly structured or if laws were ignored, both the preparer and the taxpayer face penalties.

Despite the conservative position now taken by many tax professionals, however, no veterinary practice – or veterinarian – should forego valid tax deductions.

Often, disclosing those transactions or deductions on the return will be enough to pass IRS scrutiny.

At worst, disclosure may help avoid penalties for taking a frivolous position, or claiming deductions that result in accuracy-related penalties.

Honesty and clarity go a long way toward preventing and dealing with an IRS audit.

Obviously, every veterinarian and practice can benefit from an audit strategy, as well as a fallback position should that strategy fail.

Mr. Battersby is a financial consultant in Ardmore, Pa.