After being audited and hit with a $200,000 tax bill, a professional services firm took steps to make sure it never happens again.
Every business owner dreads the prospect of getting that letter — the notification that you’re being audited by the IRS. Audits are a procedural nightmare that divert your key people away from running the business as they rush around, digging up documents and stressing out. And if the auditors find irregularities, the financial costs could be substantial, adding yet another thing to worry about to an already overworked CEO.
So when a closely held professional services firm in the Bay Area filed its taxes and then received a letter that the IRS was auditing its tax return because some things didn’t add up, the company’s leaders were worried. That worry turned out to be founded; when the IRS finished reviewing the tax data, it slapped the firm with a $200,000 tax bill. After being hit with that crushing blow, the firm’s owner immediately took steps to ensure that it would never happen again.
The owner needed help to put measures in place to ensure any future audits would have a more positive outcome, and contacted BPM to help.
How We Helped
To understand what safeguards were needed, BPM first had to understand what had led to the audit in the first place. The firm started by going through the company’s financials to identify the issues that led to the audit. After in-depth research, the firm found three main issues.
- The company was paying taxes at the regular graduated rates paid by most companies, but professional services companies have to pay at a higher flat rate.
- The owner had borrowed money from his company but hadn’t paid it back. The result was that the IRS designated the money as taxable dividends paid to the owner.
- The owner deducted the company’s rental losses on his personal return. The company was housed in a property that belonged to the owner. The owner deducted rental losses on his personal tax return, whereas the losses should have been deferred, to reduce rental income in future years (if and when there is any), and as a result, the IRS disallowed those losses.
Looking at the company’s financials through the eyes of an IRS auditor, it was easy to see why the company was singled out, and why it was hit with a substantial tax bill. The company was paying taxes at an incorrect rate, and the business wasn’t organized as the right kind of entity to ensure the owner wasn’t penalized for borrowing money or deducting rental losses.
All three problems could be corrected with two revisions to how the company was doing business. BPM recommended the following actions.
- Restructure the company as an S corporation. This adjusts the company’s tax standing. S corps don’t pay taxes because everything flows through the shareholders, immediately solving the tax rate issue. In addition, dividends paid to the owner are not taxable to the owner. The IRS can classify loans as dividends paid, but those dividends — in almost all cases — are not taxed.
- Draw up a new lease agreement to reflect a third-party arrangement between the owner and the company. The company worked with a local real estate broker to determine a range of market rates for similar properties in the area, then used that information to draw up a new lease agreement in a third-party format, ensuring the company — the tenant, in this case — is paying the highest possible market rate for rent. That, in turn, allows for a rental-loss tax deduction.
The owner — the landlord — in turn receives the highest possible rate of rental income, which is now sheltered from taxability in future years that resulted from rental losses disallowed in previous years. This allows the tenant to take a deduction and the landlord is sheltered from tax on rental income, creating a win-win for the owner, both in his capacity as owner of the business and owner of the property.
Since the restructuring in 2013, the company has paid off its $200,000 tax bill. With BPM’s help, safeguards are now in place to prevent future audits and six-figure tax bills. Today, this closely held professional service firm is flourishing, with a bright future ahead of it
This case study illustrates how important it is to make sure your business is properly structured and that you are not taking actions that create unnecessary tax burdens.