We’ve discovered a new report by the IRS, due to come out December 2008. You might remember 2 years ago when we broke the story about the IRS gearing up to audit real estate professional status. I kick myself for not sounding the alarm louder at the time. I never thought we’d end up with an Acting Chief of the IRS who used to be head of Collections. And, that it would happen at a time of a housing value meltdown. So, what are they coming after next? Read on. You may need to make some changes very quickly to avoid the next wave of the storm from the IRS.
The IRS has just completed an extensive study of the tax returns of the American population. There are two systems, not by design. One system effectively taxes people with wages, while the other system is a sieve of untaxed income for investors and business owners. The data show that 99% of wages people report on their income tax returns matches what employers list in verification reports. In contrast, the share of actual income from capital gains and business, which is not independently verified, is much less. Only about half of Schedule C profits show up on tax returns.
Congress tasks the IRS to treat Americans who work for wages, claim deductions for spouses and children, collect interest and dividends, and withdraw from pension and retirement savings accounts differently. It’s as if Congress does not trust this vast majority of citizens to report their incomes honestly and demands verification by employers, banks, brokerages, and mutual funds. Congress also requires Social Security numbers for all dependents. That’s the system most of us are familiar with.
Business owners and investors are another story. Congress trusts them to fully and accurately report their revenues, their profits, and their capital gains and not to charge personal expenses as tax-deductible expenses. For these favored citizens, there is no independent reporting, except for capital gains, in which only the amount realized at sale is reported and the individual is trusted to accurately report basis. In fact, audits have reduced for this segment.
My prediction is that we will see a HUGE jump in the number of Schedule C (Sole Proprietorship and LLC – default taxation) audits. These are easier for the auditors to audit as they don’t have to understand accounting like they do if they are auditing corporate or partnership returns.
And if they’re right that income is understated by half, they’ll come down on this segment just like they are doing with the real estate professionals now. Get ready! Incorporate today! Or better yet, form an LLC and elect S or C. We’ve got a couple of discussions going on about that at the First Class Lounge right now.