The Pros, Cons of IRS’ Move to Specialize

As if the Y2K problem weren’t enough for small businesses to deal with, there’s another millennium problem on the horizon: increased and more expert scrutiny of small firms by the Internal Revenue Service in the year 2000.

Under the IRS Restructuring and Reform Act of 1998, the agency is being reorganized into four separate operations, divided not by its own internal functions but instead by service to taxpayer groups. Small business is one of the groups. That means that auditors serving small business will be more expert about the tax problems facing sole proprietors and small corporations.

The reorganization was prompted by the public outcry over tales of taxpayer abuse revealed in U.S. Senate hearings last year. The horror stories--many from small-business owners hounded by IRS auditors--pulled tax reform from the legislative backwaters and made it a bipartisan rallying point last year.

But the changes come at a time when the IRS also is creating auditing teams specializing in certain industries. Called MSSPs, short for market segment specialization programs, the special teams began in Los Angeles, focusing on the entertainment industry. They have been expanded nationwide over the last five years to include 40 industries, such as auto body and repair, car washes, commercial printing, manufacturing, pizza restaurants and used-car dealers. Ten of the MSSPs were created last year alone and 70 more are in the works.

Though all this reorganization and specialization is intended to meet the new IRS mission to be more customer-oriented, the expertise “can be good and it can be bad,” said Laura Kauls, a certified public accountant who owns Kauls & Co. in Redondo Beach.

“If and when you get audited, you’re getting a better person, a more efficient auditor, who knows what they’re looking at and knows what the problem areas are and can zero in on them,” she said. Such an auditor won’t waste time on a fishing expedition, poring over returns, but that same auditor could know immediately when something is amiss, Kauls added.

Because management for the new small-business operating unit won’t be named until late 1999, small businesses have time this year to get their books in order, say tax advisors.

“A lot of small businesses go by the seat of their pants and wait to react, instead of being proactive,” Kauls said. She suggests business owners do their budgeting and planning in the first months of the year and their tax planning in the middle of the year, when equipment should be bought or assets sold.

For small-business owners seeking to be tax-compliant, here are some tips to keep in mind when planning or preparing:

* For the 1998 return, self-employed business owners might still be able to reduce their tax burden with retirement plan contributions made through April 15, 1999. For Keogh contributions, the plan must be in place from last year or before, but self-employed pensions, known as SEPs, can still be created and contributions made now for 1998, said Mark Luscombe, a principal analyst with CCH Inc., a Chicago-based tax- and business-law information publisher.

* Also for the 1998 return, certain employees whose hours are federally regulated, such as airline pilots and truckers, can claim 55% of their entertainment expenses as a deduction. For all others, the 50% deduction remains in place.

* Health insurance deductions for the self-employed in 1999 rise to 60% of the total cost, compared with 45% previously. It’s part of a phased-in change to 100% deductibility in five years. But a federal bill could make the 100% deductibility immediate if Congress approves it this year.

* The home office deduction in 1999 for the first time will extend to business owners who perform only administrative and bookkeeping functions in their home offices. Previously, to qualify for the deduction, business owners had to do the majority of their work in the home and meet customers there, so consultants and artisans who worked off-site were excluded.

But Luscombe cautions that small-business owners should be careful about taking this deduction if they plan to sell their homes soon. Another recent tax change allows homeowners to exclude as capital gains up to $250,000 from the sale of the primary residence ($500,000 for married couples). If home-based business owners claim a home office deduction the same year as the sale, the same percentage of home maintenance costs must be deducted from the sale costs and claimed as business income, Luscombe said.

“If you anticipate you might be selling your home within the next couple of years, you might want to forgo the home office deduction and treat the entire home as a principal residence at least two years before the sale, so you can exclude the entire gain,” Luscombe said. “Of course, most people don’t have those crystal balls to know those things.”

* With all the changes in other areas, small businesses and individuals have increasingly run afoul of the alternative minimum tax. Originally designed to catch wealthy industrialists who, through various deductions, managed to pay no income taxes at all, the AMT is now catching unawares some small businesses that pay state taxes ahead of time in an effort to lighten their federal tax burden, said Gregg Wind, CPA and owner of Gregg R. Wind & Associates in Marina del Rey. Small-business owners who have high medical costs can also become ensnared by the AMT, which can increase taxes owed by up to $5,000, consultants warn.

“The layperson may not even think of it,” Wind says, advising small-business owners to do the AMT calculations when they prepare their returns. Savvy businesses can also shift deductions under Schedule A (itemized deductions) to Schedule C (profit and loss on a business), because Schedule C deductions are less likely to kick off the AMT.

* Another area that can be overlooked is the fee for LLCs, or limited liability companies, an increasingly popular business structure. An LLC allows a small firm to create a partnership-like structure yet take advantage of the liability protection afforded corporations, under which partners are not automatically liable for corporate debts. For this privilege, though, a fee of anywhere from $500 to $4,500 must be paid, based on gross receipts, typically $5 million or more.

* Tax credits for welfare-to-work, research and work opportunity have been extended to June 30. These tax credits are aimed at encouraging employers to hire certain categories of workers, such as ex-felons, welfare recipients and the inner-city unemployed. But CPA Dick Lavine, whose Los Angeles company provides help to professional tax preparers, said few small businesses take advantage of these credits because of the restrictions and red tape involved and because few CPAs are familiar with the programs.

“The problem with small businesses dealing with this is the compliance costs overwhelm them,” Lavine said. “It costs them more than they could save.”

Small-business owners interested in these programs should check with their local welfare departments and social service agencies, which often can help with the paperwork, Lavine said.

* Some miscellaneous small changes for 1999 include an increase in the large-equipment deduction, which rises to $19,000 from $18,500, and a decrease in the auto mileage deduction, beginning April 1, down a penny to 31.5 cents per mile.

For more information on what IRS tax auditors identify as key issues and are likely to examine in 26 types of businesses, go to https://www.latimes.com/atissue. For other tax help, go to https://www.irs.ustreas.gov or https://www.toolkit.cch.com.

Times staff writer Vicki Torres can be reached by phone at (213) 237-6553 or be e-mail at vicki.torres@latimes.com.