The IRS Issues Warnings to Tax Preparers Regarding Schedule C Errors
Since tax return preparers are well-paid and market themselves as capable professionals, the IRS expects high-level conduct from them. Given the errors, neglect of tax law, and a fair amount of overall professional negligence found through tax examinations, the IRS sent out a notice, Letter 5510. Letter 5510 is a formal document issued to tax return preparers that have been flagged for submitting suspicious Schedule C forms. Analysis of tax returns and cross-checking credits, income and deduction claims across relevant tax and business laws revealed strong hints of professional negligence or false claims by sole proprietors and/or their tax return preparers.
Sole Proprietor Taxes
Given the plethora and complexity of deductions and credits that a sole proprietor could take, there is an understandable incentive to interpret tax law to one’s favor. However, when tax filers or their preparers “interpret” such rules and regulations beyond the scope of law, the IRS typically notices and issues penalties accordingly. Though penalties and enforcement have been relatively light in tax year 2014, the gist of Letter 5510 was for tax return preparers to improve performance or face harsher penalties in the upcoming 2015 tax year.
Two situations and associated penalties for tax return preparers are specified:
– A minimum of $1,000 penalty per filed return for tax liability understatement “due to an unreasonable position”
– A minimum of $5,000 penalty per filed return for tax liability understatement “due to reckless or intentional disregard of rules and regulations”
Future Penalties: Determination and References
A discussion of what exactly constitutes an unreasonable position is beyond the scope of this article. Nevertheless, those interested can reference 26 U.S. Code, Statute 6694. The text therein specifies definitions and penalty amounts for taxpayer liability understatement. “Unreasonable position” is defined in the statute, with clarifications in associated notes and references to other parts of the U.S. Code, as well as guidelines and notes in the Code of Federal Regulations.
Regarding filling out Schedule C forms properly, the IRS offers further instructions:
– Circular 230, Section 10.22, diligence as to accuracy
– Circular 230, Section 10.34, standards with respect to tax returns and documents, affidavits, and other papers
These sections specify the extent of “due diligence” and negligence that a tax return preparer has to keep in mind when assessing and filing clients’ Schedule C paperwork.
Improving tax return preparer performance has several main aspects. First, return preparers need to keep up with tax laws regarding the fine points of allowed sole proprietor deductions, credits, expenses and income claims. To be fair, this is not as straightforward as it sounds. Sole proprietorships cover a very diverse set of small businesses, many of them one-person operations that can vary in their specialty, core competency and operational scope.
Income and legitimate business expenses can be incurred sporadically. This makes bookkeeping a bit confusing, especially if payments are not sent or received at the same time that a transaction occurs or a contract is signed. The onus is on tax return preparers to double-check claims about income, expense deductions and the like. If a sole proprietorship is complex and has multiple streams of revenue and expenses, business receipts and accurate bookkeeping is invaluable. Prudent bookkeeping defrays much of the difficulty of categorizing income and expenses. It also serves as a great insurance policy and legal defense to dispel any suspicions the IRS may have about a tax return.
As a side note, the security of your data is also something to pay attention to. Whether you store your data on a remote server, with a 3rd party host, or on a desktop computer in your office, you need to make sure the data is encrypted with the latest technology. If you’re e-filing your tax forms, or those of clients, make sure you select the most secure way to transmit that data.
Personally, when I efile 1099 forms or W-2s for my clients, I use eFile4Biz.com. I found them last tax season when I was looking for an online provider. This company is a leader in the industry because not only do they have one of the safest e-file platforms, but they manage all of the printing and delivery of the tax forms to my clients’ recipients. That saves me days of printing and running to the post office during the tax season mania. After using them, I could never file 1099 online with another company.
Income and Deduction Plausibility
In addition to expenses and credits, tax return preparers need to ask some probing questions about a client’s alleged income. Here, the incentive is to understate income to further reduce tax liability. Though the tax return preparer doesn’t need to operate on the level of an official investigator, he or she should flag the outliers one may reasonably expect a competent professional to notice. For instance, if deductions are an unrealistically large fraction of alleged income, this could be cause for further questions and clarification. Another red flag would be if alleged income seems significantly different from typical revenue from similar businesses in similar markets.
Letter 5510: Notice, not Indictment
Once again, it should be emphasized that recipients of Letter 5510 are not automatically suspected or involved in a crime or examination that implies any kind of guilt. The letter recipients are, however, selected based on returns they have filed that imply a higher than likely chance, though not guarantee, of errors in Schedule C documentation.
Sole proprietors are often specialists in their entrepreneurial field, but unless they are also experts in the tax and accounting fields, chances are that they are not well-versed with the finer points of tax laws. Most likely, sole proprietors have heard that one can deduct business expenses. Generally, this is true, but just to be sure and to take advantage of every opportunity, many business proprietors enlist tax return preparers. Though tax return preparers are generally competent and honest, mistakes happen.
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