Are your ducks in a row?

In the IRS five-year strategic plan released last fall, a promise was made for more IRS audits. These audits come under the guise of; "enforcement initiatives." The highest percentage of these audits are targeted at small business.

Four specific areas were identified by the IRS as being their main focus.

1. Misclassification of workers as Independent Contractors, or 'ICs'.

Employment taxes Can cripple a small business. In Oregon alone, there are seven taxes related to workers – four of which are separate from the matching taxes of social security and Medicare. Many small business owners try to find ways to cut costs by reducing their number of employees.

One way to reduce employees is to use a higher percentage of IC's who work in a business.

Too many small business owners don't look into the correct way to use this opportunity. Using IC's is a legitimate business tactic. But if this tactic is implemented incorrectly, it can cost a business owner thousands of dollars. There are significant taxes involved that include penalties and interest if you use IC's without first learning the rules of what constitutes an IC versus an employee.

You can find a list at the IRS here.

(This paragraph taken from the IRS.gov website) "Before you can determine how to treat payments you make for services, you must first know the business relationship that exists between you and the person performing the services. The person performing the services may be -
• An independent contractor
• An employee (common-law employee)
• A statutory employee
• A statutory nonemployee

In determining whether the person providing service is an employee or an independent contractor, all information that provides evidence of the degree of control and independence must be considered."

Employment taxes are a prosperous source of revenue for the government so based on a study from the Government Accountability Office, showing where workers were misclassified as IC's, the IRS is randomly performing an estimated (low end number) 6,000 audits of small businesses. Robin Arnold, a senior IRS program manager and field specialist, made this announcement on April 22.

The random audit project is a method being used by the IRS to develop their audit program. There are plans to expand the program and increase audits for small business owners. The IRS is hiring over 2,000 agents this year alone to develop and monitor this plan.

Audit results will be given to corresponding states for any additional state taxes owed on misclassifications of workers.

It is NOT illegal to use independent contractors.

There are guidelines you must follow in using them to be in compliance.   For instance, your office secretary is not an IC, your in-house bookkeeper may (or may not) be an IC. Make sure you understand what an independent contractor is and if you have any doubts then compare what the duties are for the independent contractor to the guidelines for an independent contractor and it becomes clear.

2. Non-filers of Employment tax returns

The IRS is increasing enforcement for businesses that don’t file their employment tax returns or pay employment taxes on time.

Make sure you get copies that your taxes were filed correctly from your bookkeeper or payroll agency. When an employer doesn't file the correct paperwork they are considered in violation. If you don't want to be held personally responsible for taxes – know your rights.  And if you are having financial problems, call the IRS and state agencies to see what arrangements can be made for payment. Taxes, interest and penalties can shut a business down.

The IRS is performing random audits to confirm small businesses is in compliance for employment taxes. For best results, make sure your business complies with the rules.  File all monthly, quarterly, and end of year tax paperwork.  If you don't know what forms should be filed you need to find out and get a list with the corresponding filing date requirements.

IRS.gov has that posted on their website.  Ignorance will not be considered an excuse, although you may get leniency because of it, but the government needs money right now and that is simply the bottom line.  $10,000 fines for not filing W-2/W-3 end of year forms are not uncommon.

3. Fringe benefits Paid to Employees

Not all fringe benefits are excluded, but if those benefits are payment of money, property or services of any kind as compensation for services then it is a taxable income. If a person receives goods in exchange for services, those goods are taxed at the fair market value. For instance, if you want a website built and trade the website builder software for their services instead of money . . .

Exclusions are limited and are expressly defined. When a benefits exceed those limits, they are taxable. Be aware of the limits.

Audits targeted at small businesses will also focus on employee fringe benefit payments.

4. Corporate Officer Payments

The tax code states that corporate officers who provide services to a corporation must be compensated by the corporation. A “reasonable salary,” guideline is used based on fair market value of the services rendered.

Often, corporate officers don't take salary. Complete compensation is often taken as a dividend at the end of the year.

A dividend is generally not subject to social security tax. Salaries are subject to taxes.  Sadly, many tax return professionals will calculate reasonable compensation on a lesser scale than the IRS and the IRS will challenge that compensation package. Being caught unaware might cost you.

True to form you can look for the IRS to work on taxing every possible benefit that’s paid – and they can go backwards through the years.

What's new is the aggressive tactics used to audit and monitor small business owners. What's old is tax code.

Develop your Business Plan and keep it current.  Be aware-Knowledge is power.

I had a post in mind for this week, but ran across this article and it had so many great tax shelter tips in it that I am posting it instead.  This aticle comes from an article by Alan Reynolds,  "Printed in The Wall Street Journal, page A19"  "THE RICH CAN'T PAY FOR OBAMACARE"

By ALAN REYNOLDS

President Barack Obama's new health-care legislation aims to raise $210 billion over 10 years to pay for the extensive new entitlements. How? By slapping a 3.8% "Medicare tax" on interest and rental income, dividends and capital gains of couples earning more than $250,000, or singles with more than $200,000.

The president also hopes to raise $364 billion over 10 years from the same taxpayers by raising the top two tax rates to 36%-39.6% from 33%-35%, plus another $105 billion by raising the tax on dividends and capital gains to 20% from 15%, and another $500 billion by capping and phasing out exemptions and deductions.

Add it up and the government is counting on squeezing an extra $1.2 trillion over 10 years from a tiny sliver of taxpayers who already pay more than half of all individual taxes.

It won't work. It never works.

The maximum tax rate fell to 28% in 1988-90 from 50% in 1986, yet individual income tax receipts rose to 8.3% of GDP in 1989 from 7.9% in 1986. The top tax rate rose to 31% in 1991 and revenue fell to 7.6% of GDP in 1992. The top tax rate was increased to 39.6% in 1993, along with numerous major revenue enhancers such as raising the taxable portion of Social Security to 85% of benefits from 50% for seniors who saved or kept working. Yet individual tax revenues were only 7.8% of GDP in 1993, 8.1% in 1994, and did not get back to the 1989 level until 1995.

Punitive tax rates on high-income individuals do not increase revenue. Successful people are not docile sheep just waiting to be shorn.

From past experience, these are just a few of the ways that taxpayers will react to the Obama administration's tax plans:

• Professionals and companies who currently file under the individual income tax as partnerships, LLCs or Subchapter S corporations would form C-corporations to shelter income, because the corporate tax rate would then be lower with fewer arbitrary limits on deductions for costs of earning income.

• Investors who jumped into dividend-paying stocks after 2003 when the tax rate fell to 15% would dump many of those dividend-paying stocks in favor of tax-free municipal bonds if the dividend tax went up to 23.8% as planned.

• Faced with a 23.8% capital gains tax, high-income investors would avoid realizing gains in taxable accounts unless they had offsetting losses.

• Faced with a rapid phase-out of deductions and exemptions for reported income above $250,000, any two-earner family in a high-tax state could keep their income below that pain threshold by increasing 401(k) contributions, switching investments into tax-free bond funds, and avoiding the realization of capital gains.

• Faced with numerous tax penalties on added income in general, many two-earner couples would become one-earner couples, early retirement would become far more popular, executives would substitute perks for taxable paychecks, physicians would play more golf, etc.

In short, the evidence is clear that when marginal tax rates go up, the amount of reported incomes goes down. Economists call that "the elasticity of taxable income" (ETI), and measure it by examining income tax returns before and after marginal tax rates claimed a bigger slice of income reported to the IRS.

The evidence is surveyed in a May 2009 paper for the National Bureau of Economic Research by Emmanuel Saez of the University of California at Berkeley, Joel Slemrod of the University of Michigan, and Seth Giertz of the University of Nebraska. They review a number of studies and find that "for an elasticity estimate of 0.5 . . . the fraction of tax revenue lost from behavioral responses would be 43.1%." That elasticity estimate of 0.5 would whittle the Obama team's hoped-for $1.2 trillion down to $671 billion. As the authors note, however, "there is much evidence to suggest that the ETI is higher for high-income individuals." The authors' illustrative use of a 0.5 figure is a perfectly reasonable approximation for most purposes, but not for tax hikes aimed at the very rich.

For incomes above $100,000, a 2008 study by MIT economist Jon Gruber and Mr. Saez found an ETI of 0.57. But for incomes above $350,000 (the top 1%), they estimated the ETI at 0.62. And for incomes above $500,000, Treasury Department economist Bradley Heim recently estimated the ETI at 1.2—which means higher tax rates on the super-rich yield less revenue than lower tax rates.

If an accurate ETI estimate for the highest incomes is closer to 1.0 than 0.5, as such studies suggest, the administration's intended tax hikes on high-income families will raise virtually no revenue at all. Yet the higher tax rates will harm economic growth through reduced labor effort, thwarted entrepreneurship, and diminished investments in physical and human capital. And that, in turn, means a smaller tax base and less revenue in the future.

The ETI studies exclude capital gains, but other research shows that when the capital gains tax goes up investors avoid that tax by selling assets less frequently, and therefore not realizing as many gains in taxable accounts. In these studies elasticity of about 1.0 suggests the higher tax is unlikely to raise revenue and elasticity above 1.0 means higher tax rates will lose revenue.

In a 1999 paper for the Australian Stock Exchange I examined estimates of the elasticity of capital gains realization in 11 studies from the Treasury, Congressional Budget Office and various academics. Whenever there was a range of estimates I used only the lowest figures. The resulting average was 0.9, very close to one. Four of those studies estimated the revenue-maximizing capital gains tax rate, suggesting (on average) that a tax rate higher than 17% would lose revenue.

Raising the top tax on dividends to 23.8% would prove as self-defeating as raising the capital gains tax. Figures from a well-know 2003 study by the Paris School of Economics' Thomas Piketty and Mr. Saez show that the amount of real, inflation-adjusted dividends reported by the top 1% of taxpayers dropped to about $3 billion a year (in 2007 dollars) after the 1993 tax hike. It hovered in that range until 2002, then soared by 169% to nearly $8 billion by 2007 after the dividend tax fell to 15%. Since very few dividends were subject to the highest tax rates before 2003 (many income stocks were held by tax-exempt entities), the 15% dividend tax probably raised revenue.

In short, the belief that higher tax rates on the rich could eventually raise significant sums over the next decade is a dangerous delusion, because it means the already horrific estimates of long-term deficits are seriously understated. The cost of new health-insurance subsidies and Medicaid enrollees are projected to grow by at least 7% a year, which means the cost doubles every decade—to $432 billion a year by 2029, $864 billion by 2039, and more than $1.72 trillion by 2049. If anyone thinks taxing the rich will cover any significant portion of such expenses, think again.

The federal government has embarked on an unprecedented spending spree, granting new entitlements in the guise of refundable tax credits while drawing false comfort from phantom revenue projections that will never materialize.

Mr. Reynolds is a senior fellow with the Cato Institute and the author of "Income and Wealth" (Greenwood Press, 2006).