Many small business owners use Schedule C to report profit or loss from business or profession on their personal income tax returns. Thanks to closer scrutiny and technological advancements from the Pennsylvania Department of Revenue (PA DOR), 46,000 Schedule C returns for tax year 2016 have been flagged for a desk review. The first wave of notices went out earlier this year following the April tax deadline, and another wave is expected after the October filing extension deadline. Read on to find out why this is happening and how recipients of these notices should handle them.
Why is Pennsylvania stepping up Schedule C scrutiny?
Since piloting the program in 2015, PA DOR continues to conduct desk reviews across a variety of tax return and schedule types to ensure compliance and the proper collection of tax revenues for the Commonwealth. New data analysis software allows PA DOR to compare Schedule C filings to average industry standards. Desk reviews are trigged by detection of reported expenses that are unusual or above average compared to similar business types.
PA DOR has approximately 100 full-time tax examiners to carry out the desk review process, in addition to their other job responsibilities, which accounts for the delayed responses to submissions. Once a return is flagged, a tax examiner determines whether a desk review is necessary. If so, a notice is sent to the taxpayer requesting additional information. Responses to the notices are processed in first in, first out order. Once a desk review is completed, PA DOR will issue a final resolution notice.
The number of returns flagged for Schedule C desk reviews earlier this year has caused a significant backlog for PA DOR reviewers. Initial responses returned to PA DOR for notices received took close to six months to obtain a reply from the Department and recent notices are looking at an approximate lag time of close to three months.
How should a small business respond to a desk review notice?
Desk reviews differ from a full audit in that supporting information is only requested for a handful of specific line items. Despite the smaller scope, the desk review notices nonetheless represent a significant undertaking for small business owners, who must comb through past records and assemble the proof needed to verify items claimed on Schedule C. If PA DOR does not accept the additional support provided, the taxpayer may follow the conventional tax appeals process to challenge the determination.
Small business owners are encouraged to submit responses to PA DOR via the department’s fax number (717.772.4193) or resource email account (firstname.lastname@example.org) as these methods will expedite the processing of the information provided. Mailing in the requested information will cause longer delays due to processing along with all other correspondence coming into the Department via U.S. mail. Keep in mind that PA DOR does not want actual receipts, unless that is the only form of support available. Acceptable forms of supporting documentation for line items in question include:
- General ledgers
- Canceled checks
- Bank statements
- Credit card statements
What can small business owners expect moving forward?
Schedule C desk reviews will now be ongoing, with another wave of notices related to 2016 tax year returns expected to be issued by PA DOR now that the October tax extension filing deadline has passed. Business taxpayers of all shapes and sizes should also be prepared for PA DOR to apply desk reviews to other schedules in the future.
Taxpayers subject to a Schedule C desk review that results in no changes or findings are protected from being flagged for the same schedule/line item review for a minimum of two years, as long as the expense items at issue are not significantly larger than the period reviewed. If the notice is ignored, the expense will be denied and the same request for information will be needed for subsequent periods. Keep in mind, however, that this is not a blanket exemption from all desk reviews.
Small business owners should contact their RKL advisor or one of our local offices with any questions about the desk review process generally or for assistance in compiling and transmitting the requested information. RKL’s State and Local Tax Practice Leader Jason Skrinak recently moderated a webinar with PA DOR on this topic, which can be viewed on demand here.