Areas to watch to avoid an IRS audit.

• Author: Williams, Joseph
• Position: Private companies - Internal Revenue Service

It's that time of the year again to begin filing tax returns for private companies using a calendar tax year. For the Internal Revenue Service (IRS), it's time to ramp up its audit workforce to reduce the tax gap, and it's recruiting nationwide for its Large and Mid-Size Business (LMSB) Division. The LMSB Division serves corporations, subchapter S corporations and partnerships with assets greater than $10 million. The Small Business/Self Employed (SB/SE) Division serves businesses with assets of less than $10 million.

On Jan. 9, the Taxpayer Advocate (TA) Nina Olson delivered her annual report to Congress. The TA is an independent organization within the IRS that helps taxpayers and businesses resolve IRS tax problems. The annual report focused attention on late changes to the tax code and the need to combat the cash economy portion of the tax gap.

The strategic initiatives identified by the LMSB Division for 2007 also identified principal compliance objectives a private company can use to avoid an IRS audit. These compliance objectives include: gross income (cash and noncash transactions), discharge of indebtedness, abusive tax avoidance transactions (ATAT), global compliance risks, amendments to the alternative minimum tax (AMT) and "flow-through" transactions of LLCs, LLPs and S corporations. These are explained more fully below.

* Gross income (cash and non-cash transactions) will receive priority consideration by the LMSB and SB/SE. Gross income remains an area of considerable confusion and contention between taxpayers and the IRS because the characterization of gross income has become increasingly complex and unclear.

Moreover, there is an entrenched IRS belief that tax noncompliance in the cash economy accounts for the largest portion of the tax gap. Regardless of IRS initiatives to reduce the tax gap without undue compliance burdens or undermining taxpayer rights, in practice, compliance related to gross income will continue.

* Discharge of indebtedness is a priority IRS concern because the tax consequences of awards and settlements are particularly litigious issues. Typically, awards for injuries received on account of physical injuries or physical sickness are excludable from income. Punitive damages are not. For the foreseeable future, tax audits and litigation are expected to increase significantly due to the discharge of indebtedness related to subprime mortgage losses.

* ATATs are combated by abusive tax avoidance transactions...