Stay straight with the IRS

It's tax season, and the pressure is building. You're gathering documents, meeting with your preparer, and scratching your head over deductions and documentation. As the filing deadline approaches, let's put things in perspective. Yes, the IRS is scrupulous, and you must dot every i and cross every t. But if you're aware of the most common slip-ups that bring the taxman calling (or sending a letter, or knocking on your door), you can avoid them—and him—for another year. Here's what to watch for when you file.

Missed deadlines

If you need a couple of extra days to wrap things up, you're in luck this year. The IRS is granting everyone a two-day reprieve by moving the national filing deadline to April 17. This year April 15 falls on a Sunday, and the government always extends the deadline to the next business day when the normal filing due date is on a weekend.

Gary I. Glassman

Why not the 16th? Well, April 16 is Emancipation Day in Washington, D.C., and the IRS says legal holidays observed in the nation's capital have an impact nationwide. The extension applies to filing the actual returns (electronic or paper), requests for extensions, balance-due payments, and tax-year 2006 contributions to Roth and traditional IRA accounts. One warning: Your state may not offer the same extension. Some may require you to file on April 16.

If you need more time than that, you can apply for an extension. Remember, though, that the extension applies only to filing the return. You must still pay your taxes by the filing deadline. If you can't calculate them, estimate—but be realistic. Underpayment of estimated taxes can put you on the line for interest and penalties. A valid extension must show the full amount of expected tax, whether paid or not.

Remember also that if you file estimated tax forms throughout the year, they're still due on the same schedule. Estimated taxes for 2007 are due April 17, June 15, Sept. 17, and Jan. 15, 2008.

Basic errors and oversights

If you hear from the IRS right away, there were probably errors in the basic information on your return. Some IRS verification processes have been automated, and with more and more people filing electronically, the agency can match data quickly. Common errors that generate quick notices include math errors, incorrect estimated payment amounts, and incorrect Social Security numbers for you or your dependents. The lesson here: Double-check your returns to make sure these items are accurate before you file.

The "A" word

Only a small percentage of returns actually get chosen for audit these days—less than 2 percent. What types of returns are likely to get picked? The following are red flags for the IRS:

• particularly high incomes

• large itemized deduction amounts in proportion to income

• tax shelter investment losses

• complex or unusual investment and business expenses

• high business expenses in relation to reported income

• rental expenses

• a history of a prior audit that resulted in a tax deficiency

• a complex transaction that's not adequately explained

• being a shareholder or a partner in an entity that has been audited.

You must report all of your income on your tax return, and failing to do so can create problems when the IRS matches the income on your return to the amounts reported from other sources. For example, if you received an IRS 1099 form for relief work and forget to put it on your return, or if the amount you report doesn't match what the hospital reported, you may hear from the IRS. Always double-check the amounts reported to you for dividends, interest, and other payers to make sure what you put on your return corresponds with information provided by other sources.

On the other hand, don't ever refuse to take a legitimate deduction simply because you're afraid it will increase your chances of being audited. Just be sure to document. Mileage should be one of your top concerns—auto expenses are a common audit item for veterinarians. The IRS requires mileage documentation to substantiate an auto expense deduction, and my past experience shows that without this documentation, you won't keep your auto deduction if you're audited. So keep a mileage log showing the business miles you've driven.

If you are audited, the IRS will handle it in one of three ways: through correspondence, an office visit, or a field analysis.

The correspondence audit

This is the most common type of audit, and it often results from the IRS matching program. An example might be dividends earned but not reported on your return. With correspondence audits, the IRS will usually change your return and send you a bill. They will ask if you agree with the change and request that you send them a check if so. But don't be too quick to comply. The IRS sometimes makes mistakes. Complete a thorough review of the notice and your actual return before paying anything. If you used a professional tax preparer, run everything by him or her first.

But whatever you do, don't ignore the letter. If you don't respond, the IRS views your silence as acceptance and will begin collection action if not paid. If you do not agree with the computations, write the IRS and provide full documentation for why you believe they're wrong. You have 30 days from the date of the letter to do so.

The office audit

With this type of audit, you receive an appointment letter listing the issues the IRS would like to question. Usually these issues are more complex than what can be covered in a correspondence audit and are related to individual taxes, although a business schedule as part of an individual tax return is within the realm of these audits. When the agent arrives, try to be prepared and have all the documentation you'll need to address the issues the IRS is raising. This way you can complete the audit with one meeting and be done. You may want to speak with the auditor to see if you can mail in the appropriate documentation and forgo the face-to-face meeting. Sometimes this works.

The field audit

This complex audit is completed by a field agent. It's usually business-related and requires an on-site review of your practice's books and records. These audits usually take several days, and it's in your best interest to seek help from your professional tax preparer if you used one. The process starts with an inspection of the facility and an interview with the agent so he or she can get a better understanding of the practice, including the services and products you sell or provide.

Be careful about assuming that the agent doesn't know about veterinary medicine. About 10 years ago, the IRS developed an audit guide specifically focused on veterinary medicine. This guide provides IRS agents with background information on the profession and tax issues unique to veterinary practitioners. It was last updated in April 2005 and is available online at www.irs.gov/pub/irs-mssp/vet.pdf

The key element to a field audit is that once you open your books and records, everything on your return is fair game. And most of these audits focus on much more than a few specific issues. The general statute of limitations for an open audit is three years, so if the agent finds something wrong in one year, he or she can go to any other open audit year and look there as well. And if an issue affects your individual tax return, the agent can examine those, too. At the least, the agent will recompute your individual taxes based on any changes from the corporate audit.

Following are the most common audit issues we see in veterinary medicine. (They can be addressed in any type of audit but usually come up in a field audit):

• Rent. Do you pay a fair market rent? You may be audited if your rent is too high and you therefore avoid paying self-employment taxes for partnership LLCs.

• Inventory. If you report on an accrual basis, have you included a full inventory count in the amounts reported on your tax return? A full inventory count includes drugs and supplies both held for resale and consumed throughout the year. One of the worst things you can do is to not report inventory or to understate inventory on your return. This is unreported income—and a potentially ugly audit. Another mistake: The inventory number on your tax return never changes and is a round dollar amount. This could be a major red flag to the IRS.

If you use the cash basis of reporting, you need to pay attention to inventory too. If your gross receipts are between $1 million and $10 million, you must report as inventory the dollar value of supplies you've paid for but not yet sold to clients.

• Owners' wages. If you operate as an S corporation, your own wages should reflect the value of the services and management duties you provide the practice. Owners should be paid 20 percent to 22 percent of their professional production for veterinary services and 1 percent to 4 percent for management duties.

If you operate as a C corporation, the issue is whether you pay yourself too much salary. The IRS is looking for dividends, which in a C corporation are subject to double taxation.

• C corporations. If your practice is a C corporation, do you report as a "qualified personal service corporation" subject to a flat 35 percent tax? Using the business code 541940 on your tax return is the IRS's first clue that you might be subject to this tax. If 95 percent of more of the corporation's stock is owned by the service provider (the veterinarian) and 95 percent or more of the corporation's activities are from providing veterinary services, the corporation is a qualified personal service corporation and must use the 35 percent flat tax rate. This is the highest tax bracket rate in the individual tax rate chart.

Other issues that may lead to an audit tend to center on expenses that are either nondeductible by the nature of the expense or personal with no substantiated business purpose.

Not many people look forward to tax season with enthusiasm. However, organized recordkeeping and well-documented expenses will keep you out of trouble. And with a good tax preparer who understands the tax laws pertaining to veterinary medicine, you should stay safely out of the taxman's way. Happy filing!

Veterinary Economics Editorial Advisory Board member Gary I. Glassman, CPA, is a partner at Burzenski and Co. PC in East Haven, Conn. Send questions or comments to ve@advanstar.com