Own an LLC? The IRS May Come Calling!
Tips on Avoiding the Call
By Earl H. Cohen, Attorney at Law
Limited Liability Companies ("LLCs") have become the entity of choice for many new entrepreneurial ventures and for good reasons. LLCs are "tax pass-through" entities that provide the same owner liability protection as a corporation. LLCs are easy to establish and as a "tax pass-through" entity, all profits and losses accrue to the owners in proportion to their ownership of the entity. In the early years of the business when it expects to incur losses, those losses can be used by the owners as a deduction against other ordinary income. Unlike a corporation that issues stock, an LLC issues membership interests, usually expressed as a percentage of ownership of the company. For entities with only one member (referred to as a "Single Member LLC") the IRS has said that such an entity will be disregarded for tax purposes. In those cases, the LLC does not file an informational tax return, as would be the case with a multi-member LLC (with two or more members). The single member merely reports the financial results of the LLC, including profits and losses on Schedule C of his or her own personal income tax return (IRS form 1040). As with a multi-member LLC, a Single Member LLC is still required to maintain proper books and records.
Some owners of Single Member LLCs may believe that maintaining informal financial records is sufficient and that given the small size of their business, it's unlikely that the IRS will review or audit their business. The IRS has taken notice of this trend in the quality, or lack thereof, of record keeping and now the owners of Single Member LLCs have become the "low hanging fruit" in the IRS's quest to increase tax revenue.
We have known for some time that there had been an increase in the number of reviews and full audits. In February of this year alone, we have had the owners of two Single Member LLCs contact us to represent them in their IRS audits. In each case, the owners had revenues for the prior year of less than $200,000 and had records that were insufficient in several ways: they lacked records substantiating the source, purpose and amount of deposits and lacked a credible system to report financial transactions, including both revenues and expenses. In both cases the owners had merely provided their tax preparer a spreadsheet showing revenue and expenses without sufficient information to judge the characterization of their expenditures and their deductibility. In both cases, before our involvement, as we would expect, the IRS agent sought information from the owners, including their bank records, invoices for purchases and information regarding their customers and revenue. The agent then recalculated the tax due based upon their restructuring of the revenues and expenses and was prepared to issue a final report and bill the owner for the tax due.
In cases like these we have been able to assign an accountant to clean up the records and prepare an amended return for the year under review and negotiate a settlement with the IRS including a payment plan for any excess tax, penalty and interest.
But all of this is avoidable economically. From the initial point of organization of the company, it is vital that an appropriate financial record-keeping system be established with the help of an accountant. Whether the system is paper based or uses off-the-shelf software, the company and its management must be committed to maintaining accurate financial records as well as meeting all compliance requirements, including all payroll reports and tax returns. At its core, to properly maintain information on revenues, financial records must provide a credible means of confirming the company's receipts during the year. Deposit records must include the source, amount, date and purpose of the deposit (eg., sale of product, fees for services, reimbursement of advanced expenses, sales tax collected or receipt of loan proceeds). For disbursements/amounts expended each year the records must include invoices/receipts for all purchases, explanations for disbursements such as loan repayments and be sufficiently categorized to permit the preparation of a tax return for the company or a Schedule C for the company's owner, in the case of a Single Member LLC. The establishment of categories, the chart of accounts, should be accomplished at the time the reporting system is established to assure that the all transactions are properly categorized. As time goes on, additional categories can be added.
For more information on how a Single Member LLC should be established and managed, or to obtain assistance with an IRS or state revenue department review or audit, call Earl H. Cohen or Jeffrey C. O'Brien at 800-4016-194.
