In Brief

• The IRS has signaled its intent to prosecute more small businesses for relatively low-value tax violations.
• In doing so, the IRS has increased its reliance on data-driven analyses of the characteristics of businesses, with a particular emphasis on businesses conducting high volumes of cash transactions.

Small businesses should take note that Internal Revenue Service (“IRS”) examinations and actions are increasing. According to Margaret Leigh Kessler, assistant chief of the Western Criminal Enforcement Section, Tax Division, of the Department of Justice, the IRS has begun prosecuting more tax-related cases in recent years, has increased the number of business tax cases it pursues and has demonstrated a willingness to prosecute matters involving smaller amounts of tax loss. For example, on July 24, 2013, the owner of a home improvement company operating in the Pittsburgh, Pennsylvania area was sentenced to 18 months incarceration and three years supervised release for failing in 2006, 2007 and 2008 to pay over to the IRS taxes withheld from his employees. The amount not remitted equaled roughly $87,500 in total for the three years.

Prosecution of such cases continues a recent IRS trend emphasizing greater scrutiny of small businesses generally, whether they be small corporations, subchapter S corporations or partnerships. While examination of tax returns filed across all business categories increased more than 12 percent in fiscal year 2012 compared to 2011, the greatest areas of increase came in audits of smaller entities, especially flow-through entities. For example, 293 more tax returns belonging to large corporations – i.e., those with assets of $10 million or more – were examined by the IRS. However, the number of tax returns of small corporations that were examined increased roughly five times more than that of large corporations, increasing by 1,467. Subchapter S corporations had an even larger increase in returns examined: 3,139; and the increase in partnerships tax returns examined totaled 2,921.

While the IRS does not reveal exactly how its agents determine which entities to target for examination, the agency runs every tax return through a classified computer program designed to determine the possibilities of collecting more tax revenue through an audit. The program assigns a Discriminant Inventory Function (“DIF”) score to every tax return. Returns that receive a higher score are more likely to be audited because, the IRS believes, they are more likely to have misrepresented taxable income.

A recent National Taxpayer Advocate study using confidential IRS data found that DIF scores vary across industries. For instance, construction entities and real estate rental companies have higher scores. So too do small businesses within certain geographic regions, such as Los Angeles and San Francisco, California; Houston, Texas; Atlanta, Georgia; the Maryland suburbs of Washington, D.C.; and the District of Columbia. Higher DIF scores likely result from a variety of causes, such as taking unusually high deductions, claiming inordinately large expenses, and dealing in significant volumes of cash, something common in many small businesses.

The focus on small businesses’ handling of cash has also increased, along with prosecutions and examinations. The IRS has instituted a specific new program designed to combat underreporting cash transactions, which it considers to be a failure of many small businesses. In 2008, the IRS obtained broader access to merchants’ credit and debit card transaction records, and the IRS has been examining such information alongside that reported on small businesses’ tax returns. Where the IRS’s data analysis reveals a disproportionately large percentage of receipts originating from credit and debit card transactions, the agency has this year started sending letters to certain small businesses asking that they explain why their cash receipts appear to be so small. Sent to roughly 20,000 businesses thus far, these letters typically begin with the sentence, “Your gross receipts may be underreported[,]” and go on to instruct the businesses to complete a form within 30 days explaining “why the portion of your gross receipts from non-card payments appears unusually low.”

With the IRS’s increased scrutiny of small businesses, attention to tax compliance is now more important than ever. That is especially true considering: (a) that small businesses with higher DIF scores are less likely than those with lower scores to use a third-party tax preparer, or, if they do, to follow the preparer’s advice; (b) the IRS’s recent overall conviction rate of roughly 93 percent; and (c) that the average criminal sentence ordered thus far in 2013 amounts to 44 months imprisonment.