How to Survive a Dental Tax Audit
While dentists have not yet been specifically targeted by the IRS through the creation of an individualized audit technique guide, dentists nevertheless have certain risk factors that may increase their likelihood to face dentist tax audits. Consider for a moment that in many medical practices payments are processed electronically through third-party payors like insurance companies. While insurance payments exist in the dentistry industry and are fairly common, insurance coverage is less prevalent in this industry compared to other medical practices.
Thus, many dentists may develop annual cash payment plans that entitle a patient to certain services throughout the course of the year. Typically, these services involve a check-up, a cleaning, and a certain number of fillings and other services. While these plans certainly expand a dentist’s market and provide improved access to care for patients, the IRS and other tax agencies may, unfortunately, interpret their cash nature as increasing the potential for and the likelihood of abuse. As such, it is essential that services provided in relation to these plans are tracked accurately and furthermore that the practice’s tax preparer does not solely rely on bank deposits to reconcile gross receipts. Furthermore, in the case of payment by check, payments in the name of the dentist him- or herself may also raise red flags concerning diverted income at the IRS or California Franchise Tax Board (FTB).
Certain Dentists May Have an Increased IRS or State Audit Risk
The simple fact of the matter is that the audit risk for all dental practices is not the same. Certain practices and certain dentists may have a substantially increased risk. For instance, a dentist who owns the building where his or her practice is located can often experience issues when he or she then leases the space back to the practice. Absent involvement in the practice this income should be characterized as passive. However, the failure to consider and account for Treas. Reg. § 1.469-2(f)(6) which states that, under certain circumstance, income must be characterized as non-passive can lead to red flags being raised and the potential for significant penalties and fines.
However, this is far from the only audit risk that dentists can face. The additional risk stems from the electronic nature of certain payments through credit card payments and online payment processing services. These records give rise to what is known as a 1099-K. The 1099-K shows the electronic transactions that have been processed on your company’s behalf by banks, credit card companies, and debit card processors. From this information, the IRS can compare the amount of electronic payments to your overall reported income. For instance, if your 1099-K reports $500,000 in electronic income, but you only claim $510,000 in total income, there is a reasonable likelihood that the IRS may attribute this to an understatement of income or – even worse – diversion or skimming of income and a failure to report it on your taxes.
Other risk factors that can significantly increase the dentist tax audit risk is a high income compared to national averages. This typically means that taxpayers who report greater than $200,000 in gross income face an eight-fold increased likelihood of an audit. Taxpayers who report business income of $1 million or greater, however, face the greatest odds of an audit. According to current statistics, these high-earners face roughly a 12% risk of an audit.
Likewise, the dentists or dental practices form of organization are also additional risk factors. A self-employed medical professional is more likely to face an audit. Likewise, medical practices organized under a corporate form are also more likely to be audited.
Other factors that can increase the risk of an audit include:
- Significant deviations or inconsistencies from the previous year’s income tax filings
- Claims for deductions or tax credits that are out of step with norms and appear overstated
- Misclassification of an employee or other mistakes related to employee compensation
- Implausible claims of expense and gross profit margins for a business in the dentist industry.
The IRS and California FTB rely on statistic methods to identify potential tax mistakes and tax fraud. If your financial information is significantly out of step with similar practices, it is highly likely you will face an audit regardless of your reputation or professional standing.
How Can a Dental Practice Avoid A Tax Audit?
The steps a dental practice can take to minimize the risk of dentist tax audits start with sound record keeping practices and the documentation of all relevant tax considerations. Working with a CPA who understands common issues faced by medical practices, and specifically, dental practices is also a key step to minimizing the chance of an audit that is within a dentist’s or practice manager’s control. Furthermore, preserving all tax records for a minimum of three years from the filing date is necessary, but it is prudent to hold on to these records for at least six years should the IRS allege significant understatements of income or other serious noncompliance. Additionally, the dentist or office manager should also ensure that the records are kept in good condition, they are organized, and that they are accessible. The failure to maintain these records can lead to major headaches and problems for the practice.
It is also important to remember that you cannot eliminate the risk of an audit – you can only minimize it. As the factors discussed above make clear, sometimes characteristics of your practice or income levels alone can trigger an audit. Being prepared so that you can avoid raising additional red flags and inquiry is a key component to managing audit risk.
Targeted Sales and Use Tax Issues can Trigger a California BOE Audit
The California State board of Equalization is responsible for collecting and enforcing sales and use tax laws in the state. Typically, when the dentist’s office makes retail sales of certain products or implements associated with oral care or oral hygiene use and sales tax issues can arise. California state law mandates that the sellers of retail goods obtain a seller’s permit. However, should the retail goods be consumed through the course of practice and not through sale, this requirement is waived. Additionally, sales and use tax reporting obligations can arise through the rendering of professional services typically in the context of nontaxable sales and services. In any case, many dentists’ offices are both consumers and sellers of retail products. This can often lead to a complicated analysis where confusion and improper action is possible. However, even inadvertent failures to comply with use and sales tax obligations can be met with aggressive enforcement action and significant penalties.
What Should a Dentist do if He or She has been Selected for an Audit?
If a dentist or dental practice has been selected or targeted for an IRS or state tax audit, the most important thing the doctor or business can do is to remain calm, but proactive in their approach to the issue. The first thing a professional or dental practice should do is to locate and hire an experienced tax attorney who understands audit practices and procedures and can formulate a strategy to answer these potential eventualities. The tax lawyer understands audit processes and procedures and can work to set ground rules for the audit that can guide the process and protect your from a potential worst-case scenario even if the auditor detects factors that warrant additional scrutiny. Furthermore, and perhaps most importantly, the tax attorney serves as a buffer between you and the auditing agent. This ensures that the dentist does not accidentally make statements that put the auditor on guard or inadvertently make inconsistent statements that are interpreted as a sign of fraud. Furthermore, the tax attorney is likely to protect you from seemingly innocent requests – like a meeting at your office – that can be used to gather additional information that may later be used against you.
If your books and records are a mess, it is especially important that you call a tax lawyer. In situations like these, the auditor will commonly determine that it is impossible for the audit to proceed and he or she will often simply assess your taxes on any and all income deposited into your accounts and disallow all expenses. In short, this will significantly increase your tax liability and furthermore place the burden on you to prove any deductions you wish to claim. This is an unenviable position to find oneself in and taxpayers typically require a reconstructive accounting of their finances to remedy or mitigate the situation.
What are Your Next Steps if Your Dental Practice is Facing an Audit?
If your dental practice is facing an audit and you have concerns about mistakes or underlying criminal issues, it is essential that you do not return to the original preparer and only seek the services of a tax lawyer. Only the attorney-client privilege is sufficient to protect any disclosures you may make should the auditor refer the matter to the IRS Criminal Investigations Division (IRS CID) or for state criminal proceedings.
David Klasing is a former public auditor and dual licensed Tax Attorney and CPA who understands and can anticipate federal and state auditing practices and methodology. He can use this knowledge to develop responsive strategies to the particular issues you face. All of the Tax Lawyers and CPAs of the Tax Law Offices of David W. Klasing are experienced in federal and state tax controversies and can fight for you in an aggressive and strategic manner and most have master’s degree in taxation and have a decade or more of experience.
If you are facing an audit by the IRS, FTB, or BOE securing professional representation is extremely prudent. Working with a tax lawyer can minimize the odds of criminal charges, referral to a corresponding state or federal tax agency, and mitigate the circumstances you face. To schedule a reduced-rate, confidential tax consultation at the Tax Law Offices of David W. Klasing’s Los Angeles or Orange County offices, call 800-681-1295 or contact us online.