How Would Your Dealership Hold Up in an IRS Audit?
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How Would Your Dealership Hold Up in an IRS Audit?Charles Diegel, CPATom Earley, CPA, MST
Learning ObjectivesUnderstand the key items of interest in the audit guideUnderstand IRS audit techniques for specific areasWhat to do in case of an IRS audit Tax Planning Ideas
Whats the Big Deal?Tax Gap = $300 Billion per year !in 2001
Other Reasons to be ConcernedAccording to the IRS, since 2001..enforcement activities recovered $43 billion of the tax gap in 2004 compared to $33 billion in 2001Audits of high-income taxpayers ($100,000+) topped 195,000 in 2004 double the amount in 2001Total audits topped 1,000,000 in 2004 37% increase from 2001
New Guidance Issued for DealershipsNew Vehicle Dealership Audit Technique Guide Issued on CD-Rom in January 2005Helps isolate areas of focus Allows for understanding of IRS position Indirectly identifies tax planning opportunities
IRS Audit Guide Table of ContentsChapter Titles General FocusBooks and RecordsBalance SheetInventoryLIFOAlternative LIFO for DealersExtended Service Contracts and AftermarketPORCAdvertising AssociationsSales of Dealerships
IRS Audit Guide Table of Contents (continued)Chapter Titles Related Finance CompaniesPassive/ Non-Passive ConsiderationsVoluntary Employees Benefit AssociationsOther Auto Dealership Issues ~ Tool Reimbursement Programs~ Incentive Payments to Salespeople~ Shuttling Services & Drivers ~ Holdback charges~Warranty advances~ Finance Reserves ~ Compensation Issues
General FocusPre-planning:* Review of tax return* Comparative income and deductions* Comparative balance sheet* Review of dealer websiteGood Internal ControlsSales properly booked factory controlsOnce booked, incorrect treatment * shifting income to related entities
Getting Started on the AuditItems always requested Unadjusted Trial BalanceAdjusting Journal EntriesReconciliation to Tax ReturnTax Classification WorkpapersManufacturers Statement
Balance SheetWhat is the agent looking for Material fluctuations 3 year analysisTax classifications proper recording of related party balancesDifferences between book & tax (M-1 & M-2)
Balance SheetCash Issues IRS Form 8300 filed as required?All income reported?Audit Techniques Trace outstanding checks to determine payment of a liabilityAccounting for & questioning all material related company transfersReview AJEs, standard entries & Journal Vouchers
IRS Form 8300Audits are Resulting in Large Assessments:Penalties = $25,000 per missed 8300Many audits on East Coast resulting in six figure settlements no negotiationAsk yourself:Do I have a system in place to file all required forms on a timely basis? Have I trained all front-end and office employees to recognize the need to file?Have I performed a self-audit to ensure that procedures are followed in every case?
IRS Form 8300 (continued)Cash Refresher :Cash = currencyCashiers checks, bank drafts, travelers checks and money orders less than $10,000File 8300 for:One lump sum > $10,000 Installment payments that cause cash received within one year of the initial payment to exceed $10,000Previously unreportable payments that cause total cash received in 12 month period to exceed $10,0008300 questions?email to: 8300QUESTIONS@IRS.GOV
Balance Sheet (continued)Receivable Issues Unreported salesProper year of inclusionRelated Party transactions arms length?Dealership financing of transactions note terms reasonable?Audit Techniques Test sales in opening days of subsequent yearConfirm tested sales against deal jackets and general ledgerScrutinize note transfers for related party or unrecorded transactions
Balance Sheet (continued)Loans to/from Shareholders Arms length transactions (length, rate, etc)?Properly documented?Interest deducted only when paid?Demand loans > $10,000 properly accounted for? Property & Equipment Fair Market Value Rent constructive dividendLarge, unusual or questionable itemsPersonal itemsImage Payments conclusion: taxable
Balance Sheet (continued)Payables and Accrued Expenses Liability existsLiability reasonably determinable?Has economic performance occurred?Is the expense ordinary & necessary?Is the expense directly related to the business?
Capital Stock transfers between family members properly handled (i.e. gift tax returns filed when required)?Flow through entities compared to individual returns and passive/active treatment proper?
INVENTORYWhat is the agent looking for
Inventory account represents everything that should be inventoried Allowable method is being used Any adjustment made is scrutinized
INVENTORYLower of Cost or Market (LCM)Used VehiclesDocumentation, documentation, documentationValuation Guideusing 100 percent of wholesale valuation
Last-in, First-out (LIFO)ComplianceBook and Tax the sameCalculationPooling, agent will look for new models being compared to existing modelsDetermine the index for vehicles in ending inventory and applying it against ending inventory
Extended Service ContractsDealerships RoleAgent; sells product of a third party insurer without assuming legal obligations or insurance riskPrincipal/Obligor; assumes risk in the contractDealer Agent and Dealer Obligor ProgramDealer Agent Commissions must be included in income in the year soldDealer Obligor Selling price included in income in year soldInsurance premium amortized over term of contract
Extended Service Contracts Agent To Request the Following DocumentationListing of all plans soldcopies of actual, executed service contractscopies of promotional materialcopies of any and all agreements and documentations including all endorsements, amendments and schedules between the dealership and other parties to the programwritten samples of accounting entries for all income and expenseswritten statement regarding payments made by party to the program, directly or indirectly, to the dealership owner, and relative of owner, or entity owned or controlled by owner
Producer Owned Reinsurance Company (PORC)Potential Audit Issues:Insurance Company or Notthe issuing of insurance or annuity contracts, or the reinsuring of risks underwritten by insurance companies must be the primary and predominant business activityPricing is at Arms Lengthif not at arms length, additional income would be allocated to the dealershipSham TransactionIf the arrangements are shams in fact or in substance, IRS may disregard the insurance and reinsurance arrangement. Additional portion of premiums would be reclassified as income.
Producer Owned Reinsurance Company (PORC)Know your PORC:Written under IRC 501(c)(15)If net written premiums for the tax year do not exceed $350,000, tax exemption is available.Written under IRC 806If assets are less than $500 million, get to deduct 60 percent of their life insurance taxable income for the year. Phase out limitations apply.Written under IRC 831(b)If premiums are more than $350,000 but not more than $1.2 million, taxed on taxable investment income only.
Sales of DealershipsTypical sale involves hard assets and Blue skySales price needs to be allocated between all assets (may need to file IRS Form 8594)Goodwill & covenant not to compete are amortized over 15 yearsConsulting agreements are deducted as incurred if reasonable and services are actually performedOpportunities available when acquiring assets? * Inventory* Equipment
Compensation IssuesAuto Demonstrator VehiclesRevenue Procedure 2001-56, provides guidance for the taxation of personal use of a Demo Vehicle.Documents Agents will Requestwritten demonstrator policydocumentation of communication to employeespayroll records, including W-2s and payroll journalswithholding and income accounted for on a monthly basislist of employees given demo vehiclevaluation of the demo vehicle
Compensation IssuesReasonable vs. Unreasonable CompensationFollowing factors are consideredAre salary and bonuses in excess of industry practice without a valid business reason.Who is the primary person responsible for the level of growth, productivity, and financial success of the dealership.If a large year-end bonuses were paid, any evidence of a pre-determined formula or other industry accepted method of determining the amount paid.Years of experience compared to the franchisers guidelines.
Tool Reimbursement ProgramsCompensation broken into two partsNormal Hourly wages taxable as usualReimbursement for Use of Tools - not wages or subject to payroll taxesvalue of rental not based on actual expenses paid or incurred by the technicians must be a logical connection to the expenses incurredbusiness connection test met only if the expenses are actually incurred during current employment (tools typically a condition of employment) Substantiation of expenses must be timely (30 to 120 days)Substantiation must be detailed and completeExcess reimbursements must be returnedRe-characterization issue (i.e. vacation, meetings, etc)
Tool Reimbursement ProgramsIRS Audit Guide conclusion: Generally, amounts paid to motor vehicle service technicians as tool reimbursements do not meet the accountable plan requirements. Amounts paid under an unaccountable plan are included in the employees gross income, must be reported to the employee on Form W-2 and are subject to the withholding and payment of federal employment taxesIf you still want to do it-seek a private letter ruling from the IRS-seek indemnification from the administrator-seek a good tax attorney
Miscellaneous ProvisionsManufacturers incentives paid to salespeople not subject to withholding taxNot considered self-employme