The basics:
- New Jersey CPAs say aggressive tax positions can increase IRS audit risk
- Cannabis, real estate and small business cases highlight the dangers
- Experts stress documentation, legal opinions and reasonable support
- New tax law benefits create opportunities — and new gray areas
Walking the line between smart tax planning and waving a red flag in front of the Internal Revenue Service involves careful consideration, proper documentation and, sometimes, a professional legal opinion, say New Jersey CPAs. The wrong moves can trigger an audit or worse.
That’s what happened when a New Jersey cannabis dispensary wanted to take an unusually aggressive tax position, according to Seth Kamens, managing member of the CPA and advisory firm Kamens & Associates.
“At the time, federal law allowed cannabis businesses to deduct their cost of goods sold, but –unlike New Jersey – prohibited deductions for SG&A [sales, general, administrative], ordinary business expenses like salaries,” he explained. “The dispensary had $5 million in sales and $3 million in cost of goods sold and wanted to deduct an additional $1 million in other expenses.”
The stance taken by the company, which is no longer a client of his firm, was that federal law denying the additional deductions was not valid, Kamens added [a recent executive order signed by President Donald Trump that directs federal agencies to move to favorably reschedule cannabis under the Controlled Substances Act may change that]. “We couldn’t write a legal opinion ourselves, since we are not attorneys, so the client hired an attorney who researched the matter and wrote an opinion, which was submitted with the return, backing up the company’s position.”
He warned the then-client about potential penalties and interest if the IRS disallowed the position. “When you take a position contrary to IRS regulations, you need to disclose it,” he said.
Kamens identified several other warning signs that increase audit risk. “Usually it can be a red flag if expenses don’t correlate with revenue,” he said. “As an example, say you’re a sole proprietor who files a Schedule C tax return. If you have, say, $200,000 in revenue and $185,000 in expenses, that can be a red flag. If you have adequate documentation, like material or rent receipts, you may survive an audit unscathed, but the fact is you are running a higher risk of an audit because the net profit percentage is so low. In a case like that, we discuss expenses with clients to make sure they make sense and explain if they are deductible.”
Audits remain rare
Still, he said, audits remain relatively rare. “IRS typically doesn’t go after a return that reflects under $1 million in revenue,” Kamens noted. “Business owners should know, however, that tax authorities share information. I recently handled a case where a client was due a $72,000 New Jersey refund, but owed the IRS $32,000. He ended up getting a net $40,000 check after the agencies coordinated.”
And while recent reports indicate the IRS has lost about one-third of its auditors, Kamens cautioned against using this as justification for taking an overly aggressive position. “There are clients that are very conservative and will forgo legitimate expenses because they are terrified of being audited and believe that this will make them safer,” he said. “The idea is the lower the expenses, the return may have less chance of being audited.
Then there are clients who are aggressive and want to maximize every potential deduction. “When you have significant expenses like labor, rent or materials, your net profit percentage will be less, and that may lead to an audit. But as long as you have the documentation for these deductions, you should be fine.”
Ultimately, Kamens advised that individual risk tolerance is one of the elements in tax planning. “If you’re risk averse, then be aware that home office deductions, for example, will likely carry more audit risk.”
Walking the line
There’s a critical difference between legitimate tax planning and tax positions that could land a company in hot water with the IRS, according to Phillip Goldstein, CEO of the CPA firm Goldstein Lieberman & Co. Understanding that distinction proved essential for his clients’ financial health and legal security, Goldstein said.
“We have taken aggressive stances, as long as we had research and tax law to support our clients’ position,” he explained. “The key is having solid tax law supporting the client’s position, which may require consultation with tax attorneys before proceeding with uncertain interpretations of the tax code.”
He said this approach paid off dramatically in a notable case involving a complex real estate tax issue for a client who owned triple net lease properties, with tenants that include fast food and other franchises.
Under a triple net lease, property taxes, building insurance, common area maintenance and other costs are paid by the commercial tenant, making the lease a hands-off, low-risk income stream for landlords while giving tenants more control and, often, lower base rents.
“We took a tax law position on triple net leases that offered our clients favorable tax benefits,” Goldstein explained. “The interpretation was not a clear-cut one, although it was well supported, and ultimately saved the client more than $30 million to date, while continuing today to offer tax benefits. The case exemplified our firm’s philosophy of helping our clients: Using the tax law to their advantage, but only when the client’s position can be defended.”
Asked if there’s a bright line between defensible and indefensible tax positions, he replied: “If we couldn’t support it, we wouldn’t take it.”
“It’s bad for the client and bad for the firm. We have occasionally turned down clients whose desired tax positions lacked reasonable support, recognizing that penalties, interest charges and professional liability risks simply weren’t worth the potential benefits.”
Fair warning
Goldstein added that business owners need to carefully consider their CPA firm’s professionalism and experience. “An inexperienced or less scrupulous firm might encourage positions that appear appealing on paper but collapse under scrutiny,” Goldstein warned, “potentially leaving the clients facing substantial penalties and interest, and possible jail time.”
And even though the IRS has been losing agents and not replacing them because of budget cuts, which potentially reduces the risk of an audit, Goldstein counsels against playing “IRS roulette,” or taking aggressive positions that cannot be defended, in the hopes of evading scrutiny.
“Hoping to slip questionable positions past authorities isn’t tax planning,” he said. “It is gambling with potential criminal consequences.”
The federal One Big Beautiful Bill Act (OBBBA) provides businesses with some “very favorable provisions,” including accelerated expensing of big-ticket asset purchases, bonus depreciation, and expensing research or experimental costs under Internal Revenue Code Section 174A, to name a few, according to SKC & Co. CPAs LLC Director of Tax Nicole DeRosa.
But these opportunities also created new challenges for small and medium-sized businesses navigating the fine line between smart tax planning and raising IRS red flags.
“Taking an ‘aggressive tax stance’ has not been at the forefront of many taxpayers with positive cash flow,” DeRosa explained. While IRS audit rates had been declining in recent years due to workforce reductions, she cautioned that targeted audit rate increases remain in place for specific taxpayers, including large corporations, large partnerships and high-net-worth individuals.
Further, “As a CPA, it is always important to act with integrity and exhibit professional competence at all times, and I personally only like to take tax positions that demonstrate a reasonable basis and can be substantiated by valid tax authorities if challenged by the IRS,” she said. “The passing of the One Big Beautiful Bill Act, although very favorable in many ways, unfortunately will create more gray areas, as many of the newer provisions are not crystal clear and we have already seen a lot of questions surrounding them.”
Expert advice
DeRosa offers straightforward advice about distinguishing between strategic tax planning and overly aggressive positions: “If it sounds too good to be true, it likely is too good to be true.”
She stressed that documentation and valid tax authorities are the foundation for substantiating tax positions during an audit. “This includes receipts, cancelled checks, logs, invoices, legal documents, Internal Revenue Code sections, Revenue Rulings, and Treasury Regulations,” she said.
DeRosa also noted that the general statute of limitations for IRS audits is usually three years from the later of the original due date or the filing date. “But it is important to note that there are exceptions to the general rule in the case of fraud, tax collection and failure to file,” when the statute of limitations may be extended.
DeRosa also issued a strong warning against playing IRS roulette. “It is not ethical and it is not worth it,” she stated firmly. “There is no statute of limitations when it comes to fraud, and the risk will not outweigh the reward if they were to get caught.”
