Good Recordkeeping Saves the Day

Beginning with drawing Kimba the White Lion as a 5-year old in Philadelphia, ever since I have been painting, printmaking and eventually designing. Somehow this all lead to starting a design business in Washington, DC in January of 2005. To this day I still consider myself an artist first and an “accidental business-person” second.

I only started the company because I wanted to be my own boss. Over the years I have had some experiences I thought might be ideal to share — not because I am a great businessperson — but because I care about my profession and small businesses. In 2006 my startup return was almost immediately selected for a Random Sample Audit by the IRS also known as the Worst. Audit. Ever. I want other designers to know some basic book keeping principles in the event they get audited by the IRS and how they can survive it without losing both their minds and shirts.

First a bit of background: I was fortunate the year I started my design studio in 2005 that I sold my house in Baltimore, MD and had a nest egg to live off of and to fund the new business. That first year of business I made little income — the firm was a complete start up. In total maybe 10-clients came through the door that first year. I was lucky that I got good advice before starting the firm from the free classes that the SBA offers. I took to heart that even if I made a penny I had to track it. The SBA recommended I use an Intuit product called QuickBooks. I diligently saved every business expense receipt as well.

One of the most indispensable keys to success for any business, especially a design business, is accurate and complete books and records of business transactions. A designer needs those books and records to determine the amount of tax she or he must pay to the myriad of taxing and licensing authorities. Complete records always result in a lower tax bill.

Accurate records are needed to plan for large business expenses and slow times. They are needed to keep track of how much is owed, and how much income is expected. They are needed to help form projections to decide if a new business or a project is going to be profitable.

Designers in business for themselves with goals that are quantified in hard numbers almost always reach their goals. Those that do not at times flounder or just go through the motions without the focus they need to succeed in the long-term.

Complete books and records are essential if the government is auditing you. For Schedule C filers (which my firm is) with self employment income with gross (before deductions) receipts of $100,000 - $200,000, the chance of being audited in any given year is somewhere between around 4% to 5%. For folks planning to be their own boss for a large part of their career span, those numbers indicate that a Schedule C filer will almost certainly be audited at some point and time.

Take a look at some of these IRS penalties:

• Late Filing Penalty Individuals - 5% of tax due/month up to 25%, minimum $135 (no penalty if refund is due).
• Late Filing Penalties - S-Corporations $195 per month per shareholder, Multi-member LLCs - $195 per month per member.
• Late Payment Penalty - 0.5% of unpaid balance per month up to 25%
• Fraudulent Failure to File - 15% of tax/month up to 75%.
• Bad Check used to pay tax - 2% of balance due.
• Accuracy related penalties (disregarding the rules, failure to make a reasonable effort to comply with the rules, substantial understatement of tax) - Penalties up to 40% of tax due.
• Fraud - 75% of tax due.
• Frivolous return - $5000.
• Willful failure to pay tax or file return - Misdemeanor - up to $25,000 fine and 1 year in prison.
• Willful making and subscribing to a false return - Felony - up to $100 fine, 3 years in prison or both.
• Willful attempt to evade or defeat tax - Felony, up to $100,000 fine and 5 years in prison or both.

Of course interest will be charged in addition to all penalties. They have my attention.

Obviously we'd all like to avoid an audit if at all possible. Ways to avoid an audit include claiming all your income and deductions, keeping all your paperwork, and working with a good tax professional. Another more extreme way of trying to avoid an audit might be to change your form of business entity. Recent numbers indicate that S-corporations and multi-member LLCs have one-tenth the audit rate of sole proprietors and single member LLCs. The trade off is that S-corporations cost about $2,500 per year in extra professional fees to maintain, multi-member LLCs about $1,500 more, than a sole proprietor or single member LLC.

It is impossible, however, to be 100% audit proof. Some audits are purely random. Sometimes audits spread through communities, e.g. your biggest client gets audited, and the IRS agent sees your name on their books and decides to check you out. Some audits might be triggered by individual items that are shown on your return regardless of how correct or legal those items may be.

Audits are on the increase. IRS has decided that billions of dollars of the "tax gap" is being caused by small businesses underreporting income. There are five basic types of audit.

1. Letter audit - Taxpayer receives letter asking them to mail in additional documentation.
2. Office audit - Taxpayer (or their representative) must go to the IRS office with their documents.
3. Filed audit - A little worse than the Office audit. Agent comes to taxpayers home or business and examines all bank statements and most expense items.
4. Financial Status Audit - IRS uses standard of living, assets owned, credit reports, bills, loan applications, etc, to audit the taxpayer.
5. Random Sample Audit - The worst. IRS looks at EVERYTHING.

Being audited is difficult. It doesn't mean the taxpayer is a criminal, but the onus is on the taxpayer to prove the numbers shown on the return. Being audited is not necessarily an indication that the taxpayer has done anything wrong.

There is no way of knowing why my return was selected. Thank goodness I was very on top of my books and records, and my company had been entering my information into QuickBooks the entire year. My accountant Jonathan Mayo had all the records we needed to win. 

Being audited is like hitting the anti-lottery. It is a drain of time and resources. Even though my records were very tight, I must have spent 40 plus hours gathering the papers IRS requested. The audit itself took two full days. My accountant charged me somewhere around $4,000 to represent me at this audit and he was worth every penny. Representation is a MUST at any audit. DO NOT go in there alone. The taxpayer and the agent don't even speak the same language.

An agent could ask a question using some technical IRS wording, and if the taxpayer's answer is based on a misunderstanding of the question the taxpayer could technically be giving false information to a federal investigator. People rarely go to jail for what is on their returns. They go to jail because they got flustered and tried to talk their way out of something. Think Martha Stewart. She didn't go to jail for insider trading, she went to jail for lying to a federal investigator. 

Yes, representation is expensive, but the average cost to defend a tax fraud case is over $50,000. Borrow the money for representation if you have to. Don't be penny-wise and pound-foolish. Don't forget that it is always within your rights to say, "I don't understand this. I'm uncomfortable with this. While I'm really doing my best to co-operate, I don't think I should any questions without representation present." If the agent presses you ask for his supervisor. Agents are required to treat you in a respectful and business-like fashion. Also, there's an independent office within the federal government called the Taxpayer Advocate, who you can call if you feel that you're being treated unfairly.

IRS had me gather (among other things) all of my bank statements, cancelled business and personal check and deposit items, investment statements, and records proving the expenses they always like to pick on for a 14-month period. Travel. Meals and Entertainment. Mileage. Advertising. Home Office. And a few others. Just getting copies of the deposit items from the bank was a struggle, and expensive as well.

The agent sat both my accountant and myself down at my dining room table, picked up a bank statement and said, "January 2, deposit. $200. Was it income?" If it wasn't taxable income we had to prove it. I had a personal checking account, a business account, and a savings account, with money going back and forth between the accounts. Jonathan and I had to identify each and every deposit.

The agent worked her way through all the bank statements. This went on for days. For the expenses, we had a spreadsheet showing each individual transaction that went into the number that was claimed on the tax return, and a pile of receipts that corresponded to each spreadsheet. Jonathan pleasantly argued points of law with the agent's supervisor.

The IRS confirmed our income number. They allowed all of our expenses, except for one. In the end you have to give them something, or they'll never go away. Still, the adjustment wasn't enough to result in any tax due. We won! It was expensive for me, annoying, and stressful, but we defeated the most powerful police and confiscation agency in the U.S., and we did it with good recordkeeping. And that's a great feeling.

*****

Thanks to Jonathan Mayo of Tax Experience Inc., located in Baltimore, MD. And now for the fabulous illustration by Donald Ely.