The projected annual gross tax gap for tax year 2022-2024 is approximately $696 billion, representing the difference between taxes owed and those paid voluntarily on time. After accounting for late payments and enforcement actions, the net tax gap is projected to be $606 billion.
This staggering figure is more than a statistic. It represents a significant push by the Internal Revenue Service to increase enforcement and close the divide between what is owed and what is collected. For financial advisors, bookkeepers, and accountants, the period before the filing season officially opens is the most critical time to address discrepancies. A thorough pre-tax season cleanup is not merely an administrative exercise; it is a strategic defense that protects clients from the financial and legal fallout of an audit. By identifying errors in records, payroll, and entity classifications now, practitioners can move from reactive data entry to proactive advisory roles.
The Practical Stakes of a Year-End Cleanup
The primary goal of a year-end tax cleanup is to ensure that the financial data used for tax preparation is accurate, complete, and fully supported by documentation. The Government Accountability Office has noted that errors in tax reporting often stem from a lack of adequate records or a fundamental misunderstanding of complex tax requirements. When a client enters the tax season with unreconciled books, the practitioner is forced to make assumptions that can lead to accuracy-related penalties. These penalties can add a twenty percent surcharge to any underpayment of tax, creating a significant liability for the taxpayer.
Beyond the risk of penalties, a disorganized cleanup leads to missed opportunities for credits and deductions. Many tax benefits require contemporaneous documentation, meaning the records must be created at the time the expense was incurred. If these records are missing, the practitioner may have to disqualify a valid deduction to remain compliant with Circular 230 regulations. A rigorous cleanup process ensures that every eligible dollar is captured and every claim is defensible. This practical memo provides the necessary framework for addressing the most common points of friction before the filing deadline arrives.
Standards for Records and Retention
Establishing a clear protocol for document retention is the first step in any cleanup. The Internal Revenue Service requires all business owners to maintain books and records that are sufficient to establish the amount of gross income, deductions, and credits shown on a return. Generally, these records must be kept for at least three years from the date the return was filed. However, if a return is filed with a substantial understatement of income, the period of limitations for an audit can extend to six years.
Practitioners must ensure that clients are retaining more than just a final bank balance. Documentation should include original receipts, canceled checks, and invoices that describe the nature of the business expense. For businesses that deal in inventory, records must support the cost of goods sold, including all raw materials and supplies purchased throughout the year. For tax documentation retention, the electronic storage of these records is acceptable, provided the system is reliable and the documents are easily retrievable. This is an ideal time to move clients away from physical paper and into organized digital repositories that satisfy the requirements of IRS Revenue Procedure 97-22.
Reconciling Payroll and Employment Taxes
Payroll reconciliation is a high-stakes area because the federal government views withheld payroll taxes as money held in trust. Failure to pay these taxes can lead to the Trust Fund Recovery Penalty, which allows the government to hold individuals personally liable for the unpaid amounts regardless of the business structure. A comprehensive cleanup requires the practitioner to reconcile the quarterly Form 941 filings with the annual Form 940 and the total amounts reported on the W-2 and W-3 statements.
Any discrepancy between these forms can trigger an automated notice from the Social Security Administration or the Internal Revenue Service. Practitioners should verify that all federal tax deposits were made on time according to the client’s specific deposit schedule. Furthermore, it is essential to review the classification of workers. The Department of Labor and the IRS utilize specific tests to determine if a worker is an employee or an independent contractor. If a client has misclassified a worker, they may be liable for unpaid employment taxes, workers’ compensation premiums, and overtime pay. Confirming that every contractor has a Form W-9 on file before January 31 is a critical task that prevents reporting delays.
Financial Statement Reconciliations
The foundation of accurate bookkeeping is the monthly reconciliation of all bank, credit card, and loan accounts. By the end of the year, every balance on the trial balance must match a corresponding statement from a financial institution. Practitioners should pay close attention to outstanding checks or deposits that have not cleared for several months. These items may indicate that a transaction was entered twice or that a payment was lost, requiring a correction to the general ledger.
Merchant account reconciliations are equally important, particularly for businesses that process a high volume of credit card transactions. The IRS receives Form 1099-K from payment processors, which reports the gross amount of all reportable payment transactions. If the gross receipts reported on the tax return do not align with the amounts on the 1099-K, it will likely trigger an inquiry. The cleanup should also include a review of the accounts receivable aging report. Any invoices that are determined to be uncollectible should be addressed according to the client’s accounting method to ensure that income is not artificially inflated.
Entity Classification and Tax Position Review
A business structure that was appropriate at the company’s inception may no longer be the best fit as the business evolves. During the cleanup, practitioners should confirm that the client is operating according to their chosen entity classification. For example, if a client is operating as an S Corporation, they must pay themselves a reasonable salary through payroll before taking profit distributions. Failure to do so can result in the IRS recharacterizing distributions as wages, leading to back taxes and penalties for unpaid payroll taxes.
Additionally, practitioners should verify that any changes in ownership or business activity are reflected in the company’s legal documents. If an LLC has added new members, the operating agreement should be updated to reflect the new allocation of profits and losses. Documentation should also be reviewed for any state-specific requirements, such as annual report filings or changes in state tax nexus. Ensuring that the tax return is consistent with the legal structure of the business prevents the confusion that often leads to processing delays and secondary audits.
Verifying Credits, Deductions, and Retirement Plans
The year-end cleanup is the final opportunity to ensure that a client meets the eligibility requirements for significant tax benefits. For example, the Qualified Business Income deduction allows certain business owners to deduct up to twenty percent of their qualified business income from their federal tax return. This calculation is complex and requires accurate figures for W-2 wages and the unadjusted basis of qualified property. Practitioners must ensure the books clearly distinguish these items to maximize the deduction.
Retirement plan contributions are another area where timing is everything. While some plans allow for contributions up until the filing deadline, the plan must be established by the end of the tax year in many cases. Documentation for specialized credits, such as the Research and Development credit, must also be reviewed for compliance. The IRS often scrutinizes these credits, so the cleanup should focus on gathering the project descriptions and expense logs required to support the claim. Verifying these details in advance prevents the need for rushed calculations during the height of the tax season.
Managing Audit Red Flags and Compliance
Certain financial patterns are more likely to attract the attention of the Internal Revenue Service. Large or recurring business losses, particularly when the business is classified as a hobby, are a frequent target for examination. Practitioners should also be cautious with high-value deductions for travel, meals, and entertainment. Under current rules, entertainment is generally non-deductible, and business meals are subject to specific percentage limitations.
Another major red flag involves the reporting of digital assets. The IRS has increased its focus on cryptocurrency transactions, and every taxpayer must answer whether they received or sold digital assets during the year. A cleanup must include a thorough review of exchange statements and wallet activity to ensure that all capital gains are reported. Finally, business owners who claim one hundred percent business use of a vehicle must be reminded that they are required to keep a contemporaneous mileage log. Without this log, the IRS has the authority to disallow the entire deduction.
Practical Cleanup Checklist
To successfully navigate the pre-tax season window, advisors should focus on three primary priorities for every client.
- Complete a full reconciliation of all balance sheet accounts to ensure that every asset, liability, and equity account is supported by an external statement as of December 31.
- Verify that all payroll filings match the general ledger and that all independent contractors have been properly identified and documented with Form W-9.
- Consolidate all primary source documents, including mileage logs, receipts for major purchases, and retirement plan records, into a secure digital environment for the tax preparer.
Focusing on these three areas will resolve the vast majority of issues that cause delays or errors during the filing process.
Next Steps for Practitioners
The most effective cleanup is one that is documented. As you work through these steps, maintain a record of the adjustments made and the documentation reviewed. This not only creates a better product for the client but also provides a “defense file” in the event of a future inquiry. Preparing a clean trial balance and a folder of source documents now will save dozens of hours of work in March and April. By following these guidelines, you ensure that your practice remains efficient and your clients remain compliant with the evolving standards of the Internal Revenue Service and other regulatory bodies. For a simpler way to organize and deliver client tax packages and cleaned financials, try Magicbooks.
