Newland's Business Notes

Is the IRS Targeting Latino Businesses?

Volume 12 Issue 5 -- September/October 2008

In Northern Virginia (and perhaps elsewhere) it appears the IRS may be singling out small unincorporated Latino companies with mostly Hispanic workers for audit. Some of these businesses may have Hispanic workers lacking valid Social Security Numbers (“SSNs”) or Individual Taxpayer Identification Numbers (“ITINs”).

Recently we have seen five different cases of IRS audits in Northern Virginia that share a common pattern. To illustrate this, let’s use the hypothetical case of Haz Panico, owner of Haz Drywall, that has approximately 12 independent contractor workers (“IKs) to install drywall. All of the IKs receive gross amounts of compensation as IKs which is reported on 1099’s.  Suppose only three of the 12 have valid SSNs or ITINs. The IRS audited Haz and disallowed all of his labor, insurance, and vehicle expenses.

Haz Drywall’s annual gross receipts were about $400,000. As a result of disallowing all labor, insurance, and vehicle expenses, the IRS sought to impose tax on roughly 88% of gross receipts for one year. That produced a tax bill of nearly $500,000 for a three-year period.  Clearly Haz could not produce $400,000 of gross receipts without help.

In each of the five cases we have seen, the IRS took essentially the same approach, although the stated reasons varied. Because these five cases involved five different IRS Auditors working under five different IRS Supervisors, arguing that this phenomenon is due to one “rogue agent” seems implausible.

In two of these cases the IRS Auditor stated that their Supervisor had informed them to disallow all labor expenses if the Hispanic workers did not have valid SSNs or ITINs. Surprisingly in one case, the Agent said that she (on her own) had contacted the IRS’s own attorneys and had been informed that such blanket disallowances of labor cost were not consistent with the law.

In one of the cases, the Auditor stated in her Revenue Agent’s Report that “Taxpayer failed to establish business purpose (invalid Social Security Numbers)” and disallowed all labor costs for the entire year. The taxpayer had been in the construction framing business for years. It is hard to conceive that he had no “business purpose.”

The Internal Revenue Code broadly defines income and allows reasonable deductions for business expenses.  If, for example, a business owner has limited records, it is sometimes permissible for the courts to allow expenses based on the testimony of the business owner, as happened in a well known case involving the entertainer George M. Cohan. Despite this rule, in the recent Latino cases the IRS gives no consideration to the fact that those workers must be paid regardless of their status. 

While some state laws have been changed recently to deny deductions against state income taxes for compensation paid to undocumented workers, federal tax law has no such provision. In many years of tax practice, prior to the recent Latino cases, I have never seen an IRS auditor totally disallow all contract labor costs.

Many fail to appreciate the cause and effect of adjustments in an unchallenged Auditor’s Revenue Agent Report.  Far too often, an inappropriate IRS Notice of Deficiency will be issued. If the taxpayer fails to file a petition to the US Tax Court within 90 days, the tax bill will become final, even if it is wrong.

The widespread failure to understand and respond to IRS notices is compounded by the fact that many Latinos speak English as a second language. It appears that the IRS (at least in Northern Virginia ) may be attempting to take advantage of this fact to impose this unwarranted and exceptional treatment of labor expenses. This should not be permitted.

Even if labor expenses paid to IKs with invalid SSNs or ITINs are deductible, there are other avenues open to the IRS. One approach which is becoming more common in Northern Virginia is for the IRS to issue a “No- Match” letter, Form CP-2100A, informing the business that the IRS has determined that payees shown on an enclosed list of 1099 recipients may have provided incorrect SSNs, ITINs, or names. The last newsletter (“Hernando’s Horrors”) discussed what the business must do upon receiving such a “No- Match” letter. 

In the next issue, we will cover some of the practical implications that businesses in this situation face.

If you have questions or have these issues, you can contact Newland & Associates for assistance.  

Copyright 2008

Published by the law firm of Newland & Associates, PLC
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