How to Survive a Dental Tax Audit
Just after 8:00 A.M., on the morning of June 16, 1970, a group of four Special Agents of the Internal Revenue Service (IRS) arrived at the office of Dr. Donn VonderAhe, a dentist practicing in Fremont, California. Simultaneously, a second group of three agents arrived at the home of the doctor and his wife, Barbara, in Newark, California. Each group was armed with a search warrant issued by a United States Commissioner. The Agents then proceeded to search or, more accurately, to ransack both office and home and to seize practically every piece of paper they could lay their hands on.
Although the chances of anything similar happening to you are slim, it is best to be prepared at all times for all eventualities. In the current climate, it is very likely that a dental practice will be audited. Statistically speaking, most dental practices that are contracted with dental plans are audited at least once during their practice. Our Tax Lawyers are here to tell you all the essential information you need to know in dealing with the IRS, the California Franchise Tax Board (FTB), the California Department of Tax and Fee Administration (CDTFA), or the California Employment Development Department (EDD).
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.
Misclassification of Dental Practice Employees
The classification of a particular worker as an employee or an independent contractor has significant tax consequences for a dental practice. Essentially, the determination will define your obligations for the payment and/or withholding of various federal taxes, including federal income tax, social security taxes arising under the Federal Insurance Contributions Act (FICA), and Federal Unemployment Tax Act (FUTA) taxes. A dentist has various legal responsibilities with respect to these taxes for its employees that it does not have for independent contractors. As a result, the cost and legal implications of using independent contractors can be attractive. That said, however, the legal and financial costs of misclassifying an employee as an independent contractor can be staggering. Therefore, classification determinations need to be made carefully.
Misclassification of an employee or other mistakes related to employee compensation could also increase the likelihood of you getting audited. Because unemployment taxes exist to aid a class of people that society has chosen to protect, an employer’s claim of exemption is closely scrutinized. Exemptions from taxation statutes are strictly construed in favor of applying the tax, with the burden of proof on the party who seeks the exemption. If it is suspected that you are not paying unemployment insurance taxes, the IRS or EDD can audit your dental practice to determine whether the dental practice had to pay back taxes, penalties, and interest.
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. Such documentation can include but is not limited to (1) combined cash-receipts-cash-disbursements journal; (2) bank statements and canceled checks; (3) savings account passbooks; (4) daily patient appointments book with amounts charged and amounts collected; (5) patient cards containing dental information together with charges and collections; and (6) cash receipts books. Do not be among dentists whose recordkeeping practices are poor. Those who do not keep a general ledger for their dental practice and do not keep receipts for cash expenditures. Those who fail to keep separate bank accounts for their business and personal affairs. Those who delegate their responsibility to identify business expenses to their office manager, who holds no accounting or bookkeeping experience.
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.
As a dentist operating your own dental laboratory, you might be confused about the applicability of the sales tax to your purchases of dental supplies. Let us clear the confusion through the use of some examples.
Suppose you are a local dentist and have a laboratory in your suite capable of producing inlays and other dental appliances. You contemplate the employment of a competent dental laboratory technician to produce such appliances for the use of your patients. In this situation, sales tax will be paid on all purchased material. There will be no additional sales or use tax payable on the finished products you use in your practice. You will be considered to be a consumer of your purchases.
Let’s change the situation a bit. You now contemplate employing the same technician to also produce appliances for two other practicing dentists. The two other dentists will reimburse you for the cost, without profit, of the technician’s services. In this case, you are making taxable sales to the other dentists. The measure of tax is the gross receipts from the sales of the finished products without deduction for the part of the cost attributable to the technician’s services. You are now a dentist-seller and must apply for a seller’s permit. You may buy the materials which make up the sold, finished products under a resale certificate, or, in the alternative, may take a taxpaid purchases resold deduction for the cost of the materials in the products sold to your customers.
Now imagine you and the other two dentists employ the technician in your own behalf, paying a salary directly to him as well as paying federal and state payroll taxes. Whether the technician will be considered an employee of each of you and the other two dentists or be considered an independent contractor, i.e., a dental laboratory, depends on all the circumstances of the case. If, in fact, he acts as an independent dental laboratory, then his charges are taxable. If the technician is an employee, not an independent contractor, working on the separate property of each dentist, then each dentist will only pay sales tax reimbursement to the dental supply house from which he buys his materials. The fact that the dentists pay payroll taxes does not control the determination that the technician is acting in the capacity of an employee for sales tax purposes.
To summarise, as a dentist, you are the consumer of materials used in performing your services, and tax applies to the sale of such property to you. No additional tax is due when you operate, alone or with the aid of a technician, your own dental laboratory, producing articles, such as inlays or plates, used in your own practice. If, however, you employ a technician to produce appliances for one or more other dentists, you are making taxable sales, the tax being measured by the gross receipts from the sales of the finished products without deduction for the part of the cost attributable to the technician’s services. As a dentist-seller, you must apply for a seller’s permit. You may buy the materials under a resale certificate or take a tax-paid purchases resold deduction for the cost of the materials in the products sold to your customers. If a group of dentists engages a technician who conducts an independent dental laboratory (independent contractor), his charges are taxable. If considered an employee working on the separate property of each dentist, each dentist will only pay sales tax reimbursement to the dental supply house from which he buys his materials.
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.
Generally, IRS is required to assess a tax within three years after the filing of a return. However, when a taxpayer has filed a false or fraudulent return with the intent to evade tax, there is no period of limitations, and the tax may be assessed at any time. Circumstances that may indicate fraudulent intent, often referred to as badges of fraud, include but are not limited to:(1) understating income (2) keeping inadequate records (3) giving implausible or inconsistent explanations of behavior (4) concealing income or assets (5) failing to cooperate with tax authorities (6) engaging in illegal activities (7) supplying incomplete or misleading information to a tax return preparer (8) providing testimony that lacks credibility (9) filing false documents (including false tax returns) (10) failing to file tax returns, and (11) dealing in cash.
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.Suppose you own a dental clinic and contract with three dentists for the performance of the dental services offered by the clinic. Although you regard several office workers, hygienists, and dental assistants as employees, you have consistently treated the dentists as independent contractors for tax purposes. You may be at the risk of having a declaration issued that there was an employer-employee relationship between you and the three dentists with whom you had contracts.
In case that happens, we are trained to handle such situations. We will make it apparent to the auditing agency that your opportunity to control the manner and means of the three dentists whose status is in question is extremely limited, even if the right of control had been reserved. We will explain that you did not reserve to yourself the right to control the manner in which the dentists practiced their profession. The dentists set their own schedules, decide the type of treatment to be provided to each patient, and sometimes refer patients to dentists who are not associated with the clinic. We will make it clear that although the dentists are paid monthly, their compensation is based on a percentage of the billings attributable to the services each renders rather than a fixed salary. Although you provide office space and the fixtures and major items of equipment used in the clinic, each dentist provides his or her own hand instruments and pays his or her own malpractice insurance premiums and continuing dental education fees. In short, we know exactly what to do to save your skin in case you ever find yourself in such an unfortunate position.One of the worst things that can happen is if it is found that you acted with fraudulent intent. In our experience, the badges of fraud that have shown a dentist’s fraudulent intent in the past were:
- Understating income. The dentist admitted he understated income, and it was found that he deliberately concealed the payments that his patients made by cash, check, or credit card. These facts provided very strong evidence of fraudulent intent.
- Maintaining inadequate records. The dentist admitted that his recordkeeping was poor. It was found that this rose to the level of fraud when he told the IRS that he did not have a computer in the office, but he did take a deduction for computer expenses.
- Failing to cooperate with IRS. It was found that the dentist’s behavior with the IRS was obstructive and a clear badge of fraud.
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.
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More Commonly Asked Tax Audit Questions
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California Sales Tax Questions and Answers
- Common issues encountered during sales tax audit
- What is a sales tax audit?
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- What should Petition for Redetermination contain?
- Is the appeals conference formal or informal?
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- Problems with the mark up audit
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- Business being audited for sales tax. Should I be worried?
- Audit determined fraud to avoid sales and use tax
- Definition of “sale” for California Sales Tax
- What do California sellers need to know about sales tax?
- How do I apply for a sellers permit?
- What are my obligations as a permit holder?
- What is sales tax?
- What is tangible personal property?
- What is a sale?
- What are total gross receipts?
- What is use tax?
- Who is responsible for paying the use tax?
- Who is a retailer engaged in business in California?
- Who is a qualified purchaser?
- Do I need a Certificate of Registration Use tax?
- Do I need a Use Tax Direct Payment Permit?
- What types of sales are exempt from sales tax?
- How are Internet Transactions Taxed?
- How is California sales or use tax determined?
- What is the statewide sales and use tax rate?
- Are there other local and district sales and use taxes?
- Total sales and use tax rate calculation
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- Waiting Until Audited to Take Action on Tax Matters
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- What are California’s sales and use taxes?
- Why does the State of California audit businesses to ensure compliance with sales and use taxes? How does the State determine whether to audit my business?
- The BOE reviews the purchase invoices of my business
Questions and Answers for Criminal Tax Representation
- When tax defense counsel parallels tax crime investigation
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- How the government proves deficiency in a tax evasion case
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- Requesting conference before investigative report is done
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- Failure to keep records or supply information
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- How government proves a taxpayer attempted tax fraud
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Questions about delinquent payroll taxes and trust fund recovery penalty
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