IN SMALL BUSINESSES there is usually a fine line between business and personal tax responsibilities. Most small business entities are established as proprietorships, partnerships or Subchapter S corporations. As such, the net profits are recorded as personal income directly to the owners.
Owners often pay themselves a salary and leave any excess in the business. In the eyes of the Internal Revenue Service, undistributed profits are considered personal income. The IRS treats the owners as if they had received the money and then reinvested into the business. This is phantom income -- the money never makes it to your pocket, but you must pay personal income tax on it. When ownership is shared among a number of people, the phantom income is also shared based on their percentage of ownership.
Help: The government does not provide free assistance for the completion of business tax returns. However to get free personal taxpayer assistance, call (301) 962-2590. To attend seminars or obtain basic information of the use of various business tax forms, call Taxpayer Education at (301) 962-2222. To order business or personal tax forms, call (800) 424-FORM for mail delivery. For information on Maryland tax forms, call (800) MD-TAXES.
Audits: Since the days of the Roman Empire, successful taxation systems have operated through a combination of citizen honesty and the threat of punishment for dishonesty. To encourage people who decide they want to reduce their level of participation, the IRS has an audit procedure. However, the IRS can not afford an audit staff large enough to check all the returns submitted by either individuals or businesses. In fact, the IRS staff in Baltimore consists of only 400 auditors and support people who examine about 1,000 business returns and 1,800 individual returns each year from Maryland and the District of Columbia. They receive an estimated 300,000 business and 2,600,000 personal tax returns each year.
The Baltimore office of the IRS performed 1,051 business audits in fiscal 1989. These produced $123,429,000 of additional income for the federal government in the form of taxes and penalties.
To select returns to audit, the IRS established the Taxpayer Compliance Measurement Program. It scrutinizes returns in categories. For example, it looks at a profession such as dentistry by reviewing the returns of a number of dentists from around the country. The process may include individual audits. Once the IRS is comfortable that a dentist's tax information is accurate, the data may be used to create a model of a typical dentist's return.
If you are a dentist, your return will be compared to the model. If deductions seem out of line, you may be audited. Some returns, however, are selected at random.
Scrutiny: The depth of the examination is determined by the IRS reviewer's judgment and how far the return varies from the norm. There are three levels of audits. The IRS may perform a mail audit with just a few basic questions to be resolved by mail. A person-to-person audit can take two different approaches. The first is called an office audit, which is a visit by you to the IRS office in Baltimore where you will be required to bring confirmation of specific information. The other is a field audit. A visit by the examiner is the most serious since the agent may spontaneously review files at your office.
Depending upon the seriousness of the inspection, you may decide to have your tax lawyer or accountant help you.
Appeals: You can appeal any decision made by the auditor through the Appeals Office of the IRS. If you remain dissatisfied after a review, you may take the challenge to the U.S. Tax Court. If you already paid the tax amount in question and think you are entitled to a refund, you can opt to take the case directly to the U.S. District Court.
Penalties: If you fail to file your tax forms, you are penalized 5 percent per month on what was due. In addition, you are penalized one-half percent per month for failure to pay your taxes.
Suppose you are audited and found to owe more tax, but do not have the money. The IRS agent has the authority to take possession of your assets. After they are auctioned, any excess money collected will be returned to you. On the other hand, the agent may choose to work with you and establish a payment plan. In that case, the agent will look at the profitability of the business and other probable sources of personal income. Then the IRS will set up a schedule of monthly or other periodic payments. Under IRS regulations, payments can be stretched over 10 years. However the agent may set a shorter schedule if it appears you can manage the payments. If you fall behind, throw yourself at the mercy of the IRS and pray for a new payment plan.
If the IRS finds "willful disregard" of the tax laws, you may be charged in Civil Court. If found guilty, you will be liable for the tax, the penalties and interest, plus civil penalties. In fiscal 1990, 200 cases went to trial. Currently the IRS office has about 100 cases in its Criminal Investigation Division.
You can't dodge the tax collector by filing for bankruptcy or by shifting money to your spouse. If you filed a joint personal return, the IRS can go after your spouse's assets or income unless you can prove he or she was not involved in any aspect of the business.
The bottom line: Tax responsibilities are serious and one key to success is good record keeping. Should you be audited, your written records are generally your only defense.
Patrick Rossello, president of the Towson-based Business Consulting Group, is a member of a number of local advisory boards including the Baltimore Technology Development Center. Send questions or suggested topics to him c/o Money At Work, The Evening Sun, 501 N. Calvert St., Baltimore, Md. 21278.