House Small Business Committee chairman Sam Graves, R-Mo., has written a letter to the Internal Revenue Service expressing his concerns about the thousands of notices that the IRS is sending to small businesses telling them they may have underreported their income.

The IRS has reportedly sent Notifications of Possible Income Underreporting to approximately 20,000 employers based on the information reports it has received on their debit and credit card transactions.

“We have heard from tax practitioners whose clients are small business owners who have received letters from the IRS titled Notification of Possible Income Underreporting,” he wrote to Faris Fink, the commissioner of the IRS’s Small Business/Self-Employed Division, in a letter last Friday. “First, although my staff met with you and your team, you assured us that the IRS is merely seeking additional information, the initial sentence of the notification letter begins, ‘Your gross receipts may have been underreported.’ This gives the impression that the IRS is looking for more than just additional information. To the contrary, the letter implies that this is a serious matter that could lead to assessments of additional tax, penalties and interest.”

In addition, Graves argued that small business owners are told by the IRS that their receipts are off from an average, but the notice gives them no idea how much or the source of the information so they can verify the claim and confirm that it is a valid comparison.

“Next, the small business owner is, within 30 days, required to furnish a complete and accurate response, but is not told exactly what he or she is expected to prove,” said Graves. “One tax advisor to small businesses said it will be like trying to prove a negative.”

Graves acknowledged that the worksheets provided by the IRS address some of the more common reasons why a small business taxpayer’s may not sync with the IRS’s averages. But if the taxpayer’s situation is not addressed, the small business owner is asked to provide documentation to prove why their numbers did not fall within the IRS’s standard, even though the taxpayer does not know what the IRS’s standard is.

The instructions for step 5 on page 2 of the IRS notification form imply that the taxpayer’s gross receipts are less than expected, Graves pointed out. “Practitioners have told us that what will be true in most cases is that merchant card receipts are higher than expected but the total receipts and tax paid will be correct,” he added. “I understand that the instructions with this notice may appear to track what you have assured us during our discussions, that these letters do not require small businesses to maintain additional records and that the notice should not alarm the business owner. However, a small business owner who receives one of these notices is very likely to feel alarmed and threatened.”

Graves asked Fink to respond to his request by September 3 and explain how the IRS intends to modify its notices and procedures to reflect the concerns of small business owners.

In a hearing last month before his committee, he asked IRS principal deputy commissioner Daniel Werfel to testify about IRS audits of small businesses, which have reportedly been on the rise. Werfel said that in fiscal year 2012, the IRS audited approximately 1.65 million returns, of which 21 percent were small business returns. For fiscal year 2011 the percentage was 22 percent, and for fiscal 2010, 21 percent. This group includes filers of Schedule C and Schedule F, along with small corporations, S corporations and partnerships. The 2012 small business audit rate equates to only 0.2 percent of all returns filed, and 1.3 percent of small business returns filed, Werfel pointed out.

He noted that in conducting its examination program, the IRS uses a variety of techniques to focus exam resources on the areas of greatest compliance risk. As returns are processed, a majority of them are scored by a computer program for compliance risk, with a higher score indicating a higher probability that a change will be recommended during an examination. While the computer score is the most frequent reason for selecting a return for examination, there are other reasons a return may be selected. These include the need to reconcile what is reported on a taxpayer’s return with third-party information provided on forms such as W-2s or 1099s.  Graves’s letter referred to the information collected by the IRS from the recent 1099-K third-party reporting requirements under Section 6050W of the Tax Code, which compare information from credit and debit card transactions against the information reported by the business.

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