Tax notice avalanche hits small businesses

By Jennifer Wentz, October 27, 2017

An onslaught of tax notices hitting some of Pennsylvania’s smallest companies has business owners and tax professionals alike scratching their heads — and, in some cases, digging through massive piles of receipts.

The questions and paperwork are the result of a relatively new state initiative to place more scrutiny on Schedule C documents, the forms that self-employed people and sole proprietors fill out to report their businesses’ profits and losses. The Pennsylvania Department of Revenue has flagged about 46,000 personal income tax returns involving Schedule C forms over the past several months, or roughly 8 percent of such returns filed with the state.

These reviews have caused headaches, and sometimes substantial costs, for one-man and mom-and-pop shops as they struggle to figure out how to substantiate what they say are run-of-the-mill business expenses, according to tax practitioners and small business advocacy groups.

State officials have acknowledged issues with the reviews and say they have changed their procedures to make the process easier for business owners. Some tax professionals, though, remain skeptical.

What’s happening?

It usually starts with a one-page letter.

The document often asks for proof of some kind of item or items on a business owner’s Schedule C tax form. It’s not an audit — audits involve a much more thorough examination of a business’s finances and are subject to different legal requirements — but rather an inquiry into “a line item or two” on a return, according to the Pennsylvania Department of Revenue.

These kinds of inquiries, called desk reviews, only started popping up in mailboxes in significant numbers over the past several months, according to several tax practitioners. The reviews are the result of data analysis software the Pennsylvania Department of Revenue is using to sift through Schedule C forms and flag any reported expenses that seem to fall outside industry norms.

Full-time examiners from the department’s personal income tax division — which has about 100 employees — are conducting the examinations, which state officials say take about an hour each to complete.

The revenue department piloted this process in the 2015 tax year and fully implemented it in 2016. The intention is to help the state meet its legal requirement to “make inquiries, determinations and assessments of all the taxes imposed” under the state’s personal income tax laws, the department said in an emailed statement.

“This project is as much about compliance as it is about collection,” department officials wrote in August in response to questions from the Pennsylvania Society of Tax and Accounting Professionals. “This Schedule is not something that the Department has traditionally looked at because previously we did not have the necessary analytical tools. We now have them available.”

Department officials expect the reviews will bring in additional money for the state but have stopped short of saying they are the direct result of Pennsylvania’s ongoing budget woes, which include a more than $2 billion deficit, persistent revenue shortfalls and a recent credit-rating downgrade.

Officials do not yet have a projection for how much money the state could bring in from the inquiries.

The reviews are not specific to any one industry, nor are they limited to people asking the state for a refund. Of the 46,000 returns flagged for review as of August, about a quarter were returns that sought refunds, another quarter had balances due and the rest neither sought a refund nor had taxes due.

Delays and confused

Tax professionals and the business owners they represent have struggled to understand just how to respond to these requests, with what they say is little guidance from the state.

“There’s really an outcry in the profession right now,” said Sherry DeAgostino, executive director of the Pennsylvania Society for Tax and Accounting Professionals. “The primary thing is people don’t know what is being requested.”

DeAgnostino’s organization has received close to 400 emails from tax practitioners asking for help with these requests. The problem, she said, is that a business owner might list $30,000 in work expenses for a given year. Providing an itemized breakdown of every purchase that makes up that $30,000 can prove near impossible for some small business owners and sole proprietors.

DeAgnostino has heard from tax professionals who say they have had to copy upward of 1,000 receipts to meet the revenue department’s requests. One practitioner was unsure what to do because the client did not own a copier scanner. Several others reported having clients who chose to give up legitimate tax breaks rather than go through the behemoth task of figuring out what information would answer the department’s questions.

That task becomes even more intimidating when you consider the kinds of businesses that typically fill out Schedule C forms, said Warren Hudak, a leader from the National Federation of Independent Business and owner of Hudak & Company, a Cumberland County accounting firm.

“They’re truly small businesses, truly mom-and-pop, very small in size,” Hudak said. “The guy has an idea, and maybe he wants to sell things on Etsy … Or maybe Dad wants to take on some Uber work at night to pay for Christmas presents. Someone who’s doing the work on the side, maybe testing the waters.”

“It’s very easy to target Schedule Cs in terms of getting money. Oftentimes, their records are a mess.”

Officials from the Department of Revenue have since said they do not want businesses to send them actual receipts unless they have no other form of documentation. They would prefer they send general ledgers, schedules, summaries, canceled checks and bank statements — not by certified mail, as many have done, but by fax or email.

DeAgnostino wishes the department had been more clear from the beginning on how exactly it wanted them to respond to these requests. These answers were especially hard to come by in the early months of the review process, when tax professionals struggled to get through clogged phone lines at the department and clients sat in limbo waiting for responses about the status of their reviews.

State officials have acknowledged these issues, saying the data analytics it used to flag returns from the 2016 tax year sparked more reviews than they had anticipated. They have refined the criteria for 2017, in addition to extending the deadline for business owners to respond to a review notice from 15 to 30 days, increasing the amount of time between first and second notices and developing educational material like a planned webinar and a published Schedule C filing tip sheet.

They also met in August with DeAgnostino and other practitioners from the Society for Tax and Accounting Professionals, resulting in a seven-page question-and-answer document published on the trade group’s website.

These steps are a good start, DeAgnostino said, and some things have improved since that meeting in August. She still worries, though, that the department is unfairly denying business owners legitimate tax deductions, and that a sole proprietor would still likely lack the expertise to respond to the department’s request without help from a tax professional.

“We just feel like it’s almost a fishing expedition approach to tax collection,” she said. “It’s inconsistent and unorganized, and they don’t think about the effect that it has on the small business owner.”

 

Tax notice avalanche hits small businesses

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