The Inflation Reduction Act appropriated $80 billion of additional funding to the IRS, which includes funding for tax enforcement activities. For the average person, this sounds like increased potential for an IRS Audit.
So how do businesses navigate complicated tax issues and proactively prepare in case they are chosen for an audit? What are the best practices to keep an IRS audit from becoming too burdensome?
In this episode of The Wrap, our hosts welcome Ronald Levitt and Gregory Rhodes, both Shareholders and members of the Tax Practice Group at Dentons Sirote, as well as Warren Averett’s own Will Aderholt, CPA, CCIFP, to discuss how business owners and high-net-worth individuals can best prepare for a potential IRS audit.
In this episode, you’ll learn:
(00:00:00) Commentators: Hey, I’m Paul Perry. I’m Kim Hartsock, and you are listening to The Wrap, a Warren Averett podcast for business leaders, designed to help you access vital business information and trends when you need it so you can listen, learn and then get on with your day. Now, let’s get down to business.
(00:00:17) Kim Hartsock: Hi, everyone, and welcome to The Wrap.
(00:00:23) Paul Perry: Looking forward to this discussion, and this is Episode 58. Really good topic for today. We’ve got our friends with Dentons Sirote here in Birmingham, Alabama. Ronald Levitt and Greg Rhodes are going to be joining us to talk a little bit about preparing for all the different types of IRS audits that may come up.
Likewise, we also have internally, one of our Members, Will Aderholt, from the Birmingham office. Will, good to have you back on the podcast with us today and look forward to this discussion. Gentlemen, can you give us a quick introduction of yourselves?
(00:00:58) Ronald Levitt: Yes. Good morning. This is Ronald Levitt. I’m a shareholder in Dentons Sirote here in Birmingham. I’ve been practicing law for a long time. My practice has (over the years) been a little bit varied. In the first 20 years, it was primarily transactional with a little bit of tax controversy. In the last 20 years, it’s been mostly tax controversy with transactional on the side.
I work with Will on several clients and other folks in y’all’s office in representing closely held businesses. Sometimes, it has to do with audits; sometimes, it has to do with planning, but it’s all one big theme of representing closely held businesses.
(00:01:31) Gregory Rhodes: Yeah, good morning. Thanks for having us on today. I’m Greg Rhodes, also with Dentons Sirote as a shareholder here. Unlike, Ronald, all I know and all I’ve ever done is the tax controversy. Generally, people think of that as fighting with the IRS. We like to think of it as working with the IRS, so we spend a lot of time working with the IRS and sometimes going to trials. I’ve been here for about 16 years.
(00:02:00) Will Aderholt: This is Will Aderholt, I’m a Member in Warren Averett’s Birmingham office. I do a lot of things on a day-to-day basis. But my background is in tax planning, and that’s still where I spend a lot of my time. Primarily with middle market and privately owned businesses in a lot of different industries. I have the honor and privilege to work with Ronald and Greg a good bit. I appreciate you guys being on with us, and I appreciate Kim and Paul having me on again.
(00:02:29) Kim Hartsock: So, we’re just gonna dive right in. We’ll start with you, Ronald and Greg. What are some of the issues that you’re seeing business owners face with IRS audits? Is there anything that you are starting to anticipate based on your current experiences?
(00:02:45) Gregory Rhodes: Well, Kim, that’s a good question. I mean, everybody that we’re talking to has heard about the 80 billion dollars in IRS enforcement money, and I know that’s caught a lot of everybody’s attention. I really haven’t seen where all that’s going to be allocated yet. But one thing we are seeing is that the IRS really likes to focus on certain issues and get their employees really geared up in those issues.
Right now, you know, we’re seeing a lot of conservation easement audits, a lot of captive insurance audits. One thing that’s interesting is that recently the Employee Retention Credit was scored as an $80 billion cost to the government, which happens to coincide with the $80 billion that was allocated.
I think we’re going to see a lot of focus there as well. Ronald, do you have any thoughts on what you’re seeing?
(00:03:37) Ronald Levitt: If you look at the cases that are coming out right now (out of the tax court especially), you’ll see that there are a number of areas. We may not be seeing them in Birmingham as much yet, but we’re seeing a number of cases that deal with whether a deduction’s an ordinary, necessary business expense.
That’s just a plain vanilla audit, and it can boil down to almost any kind. We’re also going to see a bubbling up of the IRS going after unreasonable compensation issues for the few C-corporations that are out there. Another area that I’ve been following and speaking on for more than 20 years is the planning around the self-employment tax.
There’s a real big case that’s docketed in the tax court that’s going to be coming out, and we’re going to see the IRS focus on that. It particularly bothers people within the IRS that people are skirting the self-employment tax by using some strategies that we’ve been using for years.
So, I think those are areas that we’re going to see, but you really never know. If, for example, there’s not that many people who own airplanes, but anybody that does own airplanes needs to worry about the issues that they go after for airplanes. There’s excise taxes, there’s ordinary, necessary and business expense taxes.
A lot of it has to do with have people properly substantiated their deduction. So, the focus is going to be on key areas where the IRS thinks they can make a lot of money. It’s like the old adage, “Wiser robbers rob banks. That’s where the money is.” In this case, the IRS is going to go after those areas where there’s a lot of money that can be had.
(00:05:16) Gregory Rhodes: I think one of the common things among all these is that it’s really more of the high income, high net worth type audits that we’re seeing. That seems to be the common thread.
(00:05:28) Paul Perry: Will, when you’re working with some of your clients, what are you seeing in your dealings with the IRS from this side? Not maybe just from the case side, but just from the everyday dealing. What are some of the focuses of the IRS that you’ve seen?
(00:05:41) Will Aderholt: I would really echo what Ronald and Greg have said in a lot of respects, particularly as it relates to proactive enforcement in particular areas, primarily being conservation easements and captive insurance companies.
Those two transactions have been on the IRS’s the Dirty Dozen transaction list for a number of years. It’s really been a focus of theirs with the limited resources that they do have. They’ve really been targeting those for a number of years, and I think they’ll continue to do so.
I’ve had, as you would expect, a lot of conversations with clients about the additional funding that’s coming out as a result of the Inflation Reduction Act. What I’ve been telling folks is, you know, you’re reading a lot about them hiring 87,000 enforcement agents. You know, my response to that is good luck finding them. Then when you find them, you have to train them.
Here in my office, we would hire 30 people tomorrow if we could find the right people with the right background that could do a good job and those people just don’t exist. I think the IRS is going to have a hard time finding good people to do it, and then once they do, they’d have to train them.
I’m going to knock on wood when I say this, but you know, I’m not seeing much IRS audit activity outside conservation easements and captive insurance. I’ve had a couple of audits around farms, you know. There’s always a couple of red flag type things that high network taxpayers oftentimes have. Airplanes, boats and farms seem to be a common thing.
We have seen a few audits related to those, but it’s been somewhat limited. I think, again, that just goes back to the IRS not having as much funding, which obviously they’re trying to correct. But I think it’s going to be a pretty long runway before they solve that.
(00:07:41) Ronald Levitt: I just got back from the American Bar Association’s Tax Section meeting in Dallas from a couple of weeks ago, and while we were there, Chuck Reddig – who is the commissioner? The outgoing commissioner. His last day is November 12th. – He spoke to the group, and it was an interesting conversation. He’s a very upbeat guy. I’ve known him for years. We’re friendly from our common involvement with the ABA Tax Section. He was talking about they’re going to go out and hire all these people.
He recognizes that there are limitations on how quickly they can do that. I think Will’s right. Not only do they have to hire and train new people, but what Greg and I are experiencing, and I think you’re seeing it too, Will. There’s a lot of people from the IRS that have been there for decades who are retiring.
They not only have to replace the people who are retiring, then they have to hire new people. I think they’re going to have to come up with different approaches to really go after areas, and that’s why they’re specializing. I’ll tell you, over the years we’ve seen areas where they get locked in and focused.
The family partnership area was an area we used to see a lot. There were some transactions, where if you were involved in it, you were involved in it. Otherwise, you wouldn’t understand it. Pretty complicated. But eventually, they let go.
The captives and the conservation easement areas are two that are just not going away. I think it’s because they’ve decided they’re going to allocate those resources to those things. We haven’t seen a huge number of those audits, but like I’ve had some of those farm audits with you guys. They’re really interesting. They end up going into whether it’s a hobby loss or a passive activity loss.
So, we’re going to see those cases bubble up. Two or three a year. But again, it’s just the high-income people because that’s who’s making the money.
(00:09:33) Gregory Rhodes: I think what Ronald and Will are describing are these campaigns that the IRS get on, and it makes sense because it costs a huge amount of time and money for them to train up employees in an area.
Once they get that training set, it’s really hard to move forward beyond that because they put in the resources. So, we’ve seen these continuing campaigns and again, I think probably the next campaign that we really anticipate is the, the ERC credit, which is a really great tool for taxpayers to take advantage of.
But there’s always some areas of abuse. I understand the accountants are having a hard time because it’s a great thing for the clients, but they’re also trying to dispel what you shouldn’t do. It creates an interesting area for the IRS to focus on.
(00:10:28) Ronald Levitt: There was actually something in the tax news today that talked about how there are businesses out there helping secure those credits, and the CPA organizations of the world are happy that the IRS is looking.
The folks that are not really qualified, or I wouldn’t say that people who are just specializing in those areas. Uh, but not using the CPAs. I mean, our experience in Birmingham and our relationships with the good quality accounting firms like Warren Averett in Birmingham. Those are the folks we want to be doing that work, if at all possible.
They’ve been there, done that. So, I think that it’ll be interesting to see.
(00:11:13) Will Aderholt: I’ll piggyback on that, guys. You know, that’s usually where I pivot in my conversation with clients when they ask me about the 87,000 new enforcement agents is that it’s clearly going to be very hard to find those people and train them.
When you do find them, you know what’s easier? If I’m an IRS commissioner and go, “Ok, when I hire these people, what’s easier to teach? Schedule K of the tax code, conservation easement particulars or I teach them how to focus on employee retention credit audits, which is a very focused area.” I think, to your point, there’s a lot of money and revenue for the IRS to go get.
If I was looking in a crystal ball, I would say that’s where you’re likely to see a lot of focus going forward. I think we’re starting to see. In the IRS notices they’re putting out in the news, you know, they’re already starting to plant those seeds and try to put people on notice. They know that there’s some nefarious actors out there, and I think they’re gonna focus on those. I think that if I was the IRS, that’d probably be where I would focus.
(00:12:30) Commentators: Want to receive a monthly newsletter with Wrap topics? Then, head on over to warrenaverett.com/thewrap and subscribe to our email list to have it delivered right to your inbox. Now, back to the show.
(00:12:39) Kim Hartsock: Thank you for bringing that up.
I think that is a lot of what we spend our time on is making sure that we’re knowledgeable and aware of current things that are happening as soon as they happen, which is why we started this podcast. It was to make sure that we were putting out good, factual information for our clients to hear, so that they were hearing it from us early and often, and not hearing it from people who maybe had some different intentions on it. So, thank you for recognizing that. I think that it can be very scary, you know? Unfortunately, we’re in the middle of political ad season, and they’re really good at using the IRS as the bad guy for political ads. People have this scary feeling that the IRS is coming for them.
What are some things that you could tell business owners? What can they be doing to prepare? In the event that they do get selected for audits, what are some best practices that they can be doing so that it doesn’t have to be such a scary situation?
(00:13:54) Ronald Levitt: That it is probably one of the things that most people who don’t do tax work worry about the most.
“Oh my goodness, I’m going to be audited. What does that mean? Somebody’s going to be chasing me through the halls of hell for the rest of my life.”
We get a little bit desensitized to how stressed out it makes people. But really, most of the people that we deal with in the IRS are doing their job, and it is their job to make sure that the right amount of tax is collected.
Now, every once in a while, we’ll run into some overly zealous IRS agents, but by and large, it’s not like those guys are waiting around trying to get you. But, the best way to avoid the problems of it is to try not to get there, or if you’re going to get there, be prepared.
It’s like the old Boy Scout motto. So, what we tell people is work closely with your accountant and make sure that you do the things you’re supposed to do to document your records and follow the rules. This is not something you can freeform and make up.
I know the old joke that accountants talk about is that their very favorite client comes in on April 14th with a big box full of record and says, “I want to file my return.” Well, that don’t work. So, you know, the real key in a lot of these areas, whether it’s conservation easements, captive insurance companies, unreasonable compensation, passive activity loss rules or the deductibility of airplanes, it’s all about maintaining proper books and records.
There are rules that tell you how to do that, and your accountants are happy to tell you how to do that. The accountants have that relationship where they talk to the clients and deal with them on a regular basis. We meet with a bunch of our clients and give that advice, but it’s really we stay in our lane and y’all stay in your lanes as to how we do that and together. We hope the client understands what they’re supposed to be doing and then checks in from time to time to see if they’re doing it right.
We’ve had some really interesting cases where that was not possible. Greg and I were working on a case where this fella had had loaned a lot of money to a business in the South American country that is now having some serious problems.
So, the question was, was it a debt and if so, when? Was it bad? Those kinds of questions that would’ve been hard to tell. How do you keep those kinds of records? So, that’s the unusual thing. But most of the time you need to document what your debt is. When payments have been made, when it’s bad, why it’s bad. Just picking on bad debt as an example.
(00:16:30) Gregory Rhodes: That’s right, Ronald. One of the biggest questions I get. I’m joking, but no, the IRS agents are not on the commission. They’re human beings, so they are not looking to get as much money from you as they can when they audit you. Frankly, if you have your documents together and worked with your accountant, you’ve proactively substantiated what’s on your return.
You do get audited because we’re going to see more audits, especially with high-net-worth individuals. The agent shows up and if you have that documentation and the CPA can clearly present that, the IRS agents are more than happy to check you off the box and go on to the next person.
If you don’t have the documentation and you haven’t done any work on the front end, then they’re more likely to start looking closer and closer. Once they invest the time, then you’re more likely to deal with the longer audit.
(00:17:31) Will Aderholt: Yeah, I totally agree. I would say too that I always try to advise clients to obviously do things the right way, and that’s just a general comment that that goes for business.
But particularly as it relates to audits and the questions that we’re talking about. You know, it’s also good to always be proactive.
That’s one of my favorite words: “proactive.”
So, a lot of the planning that we do together, Ronald, you know, it’s proactive planning. Estate planning or self-employment, tax planning, business planning.
We oftentimes put these complicated structures in place that do result in a lot of tax, and you have to do that in a proactive manner. But then a lot of times, the ball can get dropped. What I would advise people to do is to make sure. The job’s not done when we’re finished planning and you draft the documents, right?
If we set up a management company structure and there’s supposed to be intercompany payments going back and forth or people are supposed to be getting paid out of a particular entity (a certain amount of dollars) and things are supposed to look and act a certain way, a lot of times it’s up to the client to continue to put the plan in place.
Going back to what I said about being proactive, I think really allows clients to have more runway to put things in place. If we come up with an idea, especially after year end, right? If we’re doing your tax returns in February or March of the next year, a lot of times, it’s too late.
So, you know, being proactive, leaving enough runway so that you can draft the document hopefully before December, and then that gives the client some time to really understand and put into place all of the things that need to be done. Additional documentation, moving employees around, moving money around, setting up systems and processes to be able to continue to do things the right way, I think is really important from a client standpoint to be able to be ready for an audit, especially when you’re doing really advanced planning.
(00:19:35) Ronald Levitt: Just thinking about what Will is saying. You know, we’ve just done exactly what he just said with a client where we ended up with a bunch of additional entities in different states and that was less about planning for an audit. It was more about planning for business and state planning and family business planning.
That’s what’s—to me, and I know Will feels this too—that’s what’s fun about doing what we do. I mean that dealing with the audit is the nominal thing that we do every day. But our goal is not just to avoid the audit, our goal is to set our clients up in the best way possible.
Audit’s just a piece of it, but it’s an important piece. So, when we meet with clients and say, if we’re going to go down this road, we have to make sure that you’re accumulating the right documentation so that if you do get to. There’s nothing better than sitting down with a revenue agent and having them… I’m using estate tax return as an example.
Give them this estate tax return, they start flipping pages, and you see them nodding as they’re going through it. Because they’re going through their little mental checklist of the things that they’re looking for. That’s how you get through audits and that’s what I think Greg is talking about is if you’re prepared, then the audit process is just a process that you go through.
(00:20:49) It’s when you haven’t kept up with it and you’re scurrying around trying to create records or manufacture records that after the fact as opposed to doing it at the time of the transaction, that becomes problematic. That’s a probably longer answer than y’all wanted, but that’s important and fun for a client.
(00:21:07) Will Aderholt: Just a routine run of the mill operating business without any really advanced planning. You know, I think in those instances, just focusing on following your retention policy with business records and receipts, particularly with an eye towards anything that could be deemed as being personal in nature or entertainment in nature. The client records those as being ordinary and necessary expenses.
Those get a lot of attention and so, try to keep those records and be mindful of if it could be questionable. So, I’m going keep this in a file somewhere so that I can go back and explain, “Hey, this is exactly what this was and why it was an ordinary and necessary business expense.”
(00:22:05) Paul Perry: Ronald, earlier you mentioned attending the ABA meeting. Anything else from that meeting that is pertinent to share with the listeners for planning for the future and looking forward? What were the major items discussed outside of what you’ve already mentioned?
(00:22:19) Ronald Levitt: What I mentioned is probably the one that’s gonna be on most of the minds of the people who are business owners. I will say the focus of the ABA tax section over the last few years is changing a little bit. We’re seeing a lot of movement in thinking about changes to sub chapter K, which Will actually referenced a minute ago. They are the partnership tax rules.
There are a lot of panels on the new BBA partnership audit rules. So, the government is in a state of flux and a funnier way to say it is it’s like a yo-yo. We keep going back and forth between parties in power. But there are big changes in how the IRS will be dealing with things like partnership packs and how those things are done.
Like I said before, the self-employment tax, and those are just by sitting through programs. 20 years ago, I’ve gone there. We would’ve been heavy on talking about S corporation issues, but most of those issues have been resolved and they’re not as uncertain. So, what we do in those meetings, and it’s a whole bunch of tax lawyers, you can imagine how exciting that is, is looking at the areas that are the most… controversial is not the right word… but most in flux are in play to see how it’s heading. One of the big areas that we had a really big panel on (one of our partners, Michelle, was on the panel) is how the Administrative Procedures Act is affecting how the regulations process is going to be done.
That’s a real wonky topic. It’s going to have a big impact on our practices as taxpayers challenge more and more regulations. In this case, it had to do with the conservation easement case, but we’re going to see that APA issue come about. So, the ABA meeting is more of a wonky place, and so, those are the wonky issues that we did talk about.
(00:24:21) Gregory Rhodes: Paul, one of the other things that was talked a lot about at the ABA and the focus of a lot of IRS notices and other administrative meetings is the cryptocurrency, which we also consider part and parcel to the foreign income reporting that’s going on. That is getting a huge focus from the IRS.
Our office is dealing with a lot of that and it’s an area where it’s not only a large revenue issue for the IRS, but it’s also getting a lot of attention because I think the IRS, in coordination with some other agencies, has clearly recognized that those type of assets—especially the ones that are not being reported—have an income tax and obviously huge penalties associated with it.
But, I think there’s a recognition that those assets are being used for things that the IRS and the government wants to discourage. There’s a double focus on that area, and we’ve already seen a lot of it. I think we’ll see a lot more.
(00:25:34) Paul Perry: That probably also stems, Greg, from the perspective of it’s new and still somewhat unknown and how it relates to businesses can. To some degree, like most technologies, and it’s not really a technology, but I would bucket it in that same vein of it’s unknown and when you don’t know what’s going on or you don’t understand all of it, there’s a lot of scrutiny and there’s a lot of, “Let me question everything that I can until I fully understand something.”
(00:26:02) Gregory Rhodes: That’s exactly right. And there’s that uncertainty, we saw it with the foreign income reporting. There’s a lot of people that were trying to do it right and just didn’t know all the rules. Then, you had the small sliver of people that were intentionally not doing it right.
So, you’ve got a lot of penalties that involve willfulness and not willfulness. And it’s really hard for the IRS to systematically classify those people into one bucket or another. So that causes a lot of audits and a lot of scrutiny. We saw that wave with the foreign asset reporting.
Now it’s the same thing with the crypto. It’s like you said, there’s just a lot of uncertainty that causes those issues to arise.
(00:26:49) Kim Hartsock: So, here on The Wrap, we always try to wrap it up in 60 seconds or less. So, what would you like to leave our listeners with as it relates to today’s conversation? We’ll just start with you, Ronald.
(00:27:00) Ronald Levitt: I think that I would tell people when you’re thinking about audits with the IRS is: Don’t freak out. Surround yourself with good advisors. Do what they say, follow their advice, maintain your records. Those kind of things that Will was talking about when you get into an audit, then you tee it up and you have to respond.
But if you do your job beforehand, it becomes a whole lot easier to deal with it and don’t get freaked out by the thing that we hear in the press, because the press is not talking about things to do anything but sell their services and their papers. So, you know, talk to your accountant, talk to your lawyer, and just keep it in mind to not get too freaked out about it.
(00:27:47) Gregory Rhodes: Yeah, Ronald, I would agree with that. Don’t freak out is a pretty good theme here. We’ve got a lot more IRS funding coming. There’s certainly going to be more audits. There’s certainly going to be more audits of high-net-worth individuals, but that shouldn’t discourage you from working with your accountants to take tax favorable positions that are correct. Then, documenting those positions and really making sure that you are ready for an audit if it occurs.
(00:28:20) Will Aderholt: I don’t know what to say other than just ditto. Ronald and Greg just summed it up so perfectly right there. I would just echo what they said: Don’t be discouraged or afraid to take advantage of any real, true and valid tax planning strategy. But when you do, make sure that you’ve documented it the way that you should and that you do follow the plan that your advisors laid out for you. We can’t promise you that you won’t get audited, but if you do, you’ll stand a greater chance of coming through unscathed.
(00:28:56) Gregory Rhodes: I do want to say thank y’all. This is the first podcast I’ve been on. It’s really neat. You’re doing a great service for your clients and the public, and I appreciate you letting us on.
(00:29:07) Kim Hartsock: Thank you for being with us today, and thank you, Greg, for your kind words. We know that everyone has a podcast these days, but we are trying really hard to focus on providing current, good information to our clients and to the listeners.
(00:29:30) Commentators: And that’s a wrap. If you’re enjoying the podcast, please leave a review on your streaming platform. To check out more episodes, subscribe to the podcast series or make a suggestion of other topics you want to hear, visit us at warrenaverett.com/thewrap.
Listen to additional episodes of Wrap—a podcast by Warren Averett designed to help business leaders access the information that you need, when you need it, in the time that you have, so you can accomplish what’s important to you.