How Would Your Dealership Hold Up in an IRS Audit?

Charles Diegel, CPA

Tom Earley, CPA, MST

Learning Objectives

• Understand the key items of interest in the audit guide• Understand IRS audit techniques

for specific areas• What to do in case of an IRS audit • Tax Planning Ideas

What’s the Big Deal?

Tax Gap = $300 Billion per year !

in 2001

Other Reasons to be Concerned…

• According to the IRS, since 2001..– enforcement activities recovered $43 billion of the tax gap in

2004 compared to $33 billion in 2001– Audits of high-income taxpayers ($100,000+) topped 195,000

in 2004 – double the amount in 2001– Total audits topped 1,000,000 in 2004 – 37% increase from

2001

New Guidance Issued for Dealerships

• New Vehicle Dealership Audit Technique Guide Issued on CD-Rom in January 2005– Helps isolate areas of focus– Allows for understanding of IRS position– Indirectly identifies tax planning opportunities

IRS Audit Guide Table of Contents

Chapter Titles • General Focus• Books and Records• Balance Sheet• Inventory• LIFO• Alternative LIFO for Dealers• Extended Service Contracts and Aftermarket• PORC• Advertising Associations• Sales of Dealerships

IRS Audit Guide Table of Contents (continued)

Chapter Titles • Related Finance Companies• Passive/ Non-Passive Considerations• Voluntary Employees’ Benefit Associations• Other Auto Dealership Issues

~ Tool Reimbursement Programs~ Incentive Payments to Salespeople~ Shuttling Services & Drivers~ Holdback charges~Warranty advances~ Finance Reserves ~ Compensation Issues

General Focus

• Pre-planning:* Review of tax return* Comparative income and deductions* Comparative balance sheet* Review of dealer website

• Good Internal Controls• Sales properly booked – factory controls• Once booked, incorrect treatment…

* shifting income to related entities

Getting Started on the Audit…

• Items always requested –– Unadjusted Trial Balance– Adjusting Journal Entries– Reconciliation to Tax Return– Tax Classification Workpapers– Manufacturer’s Statement

Lessons Here?

Balance Sheet

• What is the agent looking for –

– Material fluctuations – 3 year analysis– Tax classifications – proper recording of related party balances– Differences between book & tax (M-1 & M-2)

Balance Sheet

• Cash Issues–

a) IRS Form 8300 filed as required?b) All income reported?

Audit Techniques–

a) Trace outstanding checks to determine payment of a liability

b) Accounting for & questioning all material related company transfers

c) Review AJE’s, standard entries & Journal Vouchers

IRS Form 8300

• Audits are Resulting in Large Assessments:a) Penalties = $25,000 per missed 8300b) Many audits on East Coast resulting in six figure

settlements – no negotiation• Ask yourself:

a) Do I have a system in place to file all required forms on a timely basis?

b) Have I trained all front-end and office employees to recognize the need to file?

c) Have I performed a self-audit to ensure that procedures are followed in every case?

IRS Form 8300 (continued)

• Cash Refresher :a) Cash = currencyb) Cashiers checks, bank drafts, traveler’s checks and

money orders less than $10,000• File 8300 for:

a) One lump sum > $10,000 b) Installment payments that cause cash received within

one year of the initial payment to exceed $10,000c) Previously 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– a) Unreported salesb) Proper year of inclusionc) Related Party transactions arm’s length?d) Dealership financing of transactions – note terms

reasonable?• Audit Techniques–

a) Test sales in opening days of subsequent yearb) Confirm tested sales against deal jackets and general

ledgerc) Scrutinize note transfers for related party or

unrecorded transactions

Balance Sheet (continued)

• Loans to/from Shareholders– a) Arms length transactions (length, rate, etc)?b) Properly documented?c) Interest deducted only when paid?d) Demand loans > $10,000 properly accounted for?

• Property & Equipment– a) Fair Market Value Rent – constructive dividendb) Large, unusual or questionable itemsc) Personal itemsd) Image Payments – conclusion: taxable

Balance Sheet (continued)

• Payables and Accrued Expenses– a) Liability existsb) Liability reasonably determinable?c) Has economic performance occurred?d) Is the expense ordinary & necessary?e) Is the expense directly related to the business?

• Capital Stock– a) transfers between family members properly handled

(i.e. gift tax returns filed when required)?b) Flow through entities compared to individual returns

and passive/active treatment proper?

INVENTORY

• What is the agent looking for –

– Inventory account represents everything that should be inventoried

– Allowable method is being used– Any adjustment made is scrutinized

INVENTORY

1) Lower of Cost or Market (LCM)- Used Vehicles- Documentation, documentation, documentation- Valuation Guide

- using 100 percent of wholesale valuation

2) Last-in, First-out (LIFO)- Compliance

- Book and Tax the same

- Calculation- Pooling, agent will look for new models being compared to

existing models- Determine the index for vehicles in ending inventory and applying

it against ending inventory

Extended Service Contracts

• Dealerships Role– Agent; sells product of a third party insurer without

assuming legal obligations or insurance risk– Principal/Obligor; assumes risk in the contract

• Dealer Agent and Dealer Obligor Program– Dealer Agent

o Commissions must be included in income in the year sold

– Dealer Obligoro Selling price included in income in year soldo Insurance premium amortized over term of contract

Extended Service Contracts

• Agent To Request the Following Documentation– Listing of all plans sold

• copies of actual, executed service contracts• copies of promotional material• copies of any and all agreements and documentations

including all endorsements, amendments and schedules between the dealership and other parties to the program

• written samples of accounting entries for all income and expenses

• written 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 Not

• the issuing of insurance or annuity contracts, or the reinsuring of risks underwritten by insurance companies must be the primary and predominant business activity

– Pricing is at Arms Length• if not at arm’s length, additional income would be allocated

to the dealership

– Sham Transaction• If 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 §806• If 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 Dealerships

• Typical sale involves hard assets and “Blue sky”• Sales price needs to be allocated between all assets (may

need to file IRS Form 8594)• Goodwill & covenant not to compete are amortized over 15

years• Consulting agreements are deducted as incurred if

reasonable and services are actually performed• Opportunities available when acquiring assets?

* Inventory* Equipment

Compensation Issues

• Auto Demonstrator Vehicles– Revenue Procedure 2001-56, provides guidance for the

taxation of personal use of a Demo Vehicle.– Documents Agents will Request

• written demonstrator policy• documentation of communication to employees

• payroll records, including W-2’s and payroll journals• withholding and income accounted for on a monthly

basis

• list of employees given demo vehicle• valuation of the demo vehicle

Compensation Issues

• Reasonable vs. Unreasonable Compensation– Following factors are considered

• Are 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 franchiser’s guidelines.

Tool Reimbursement Programs

• Compensation broken into two parts– Normal Hourly wages – taxable as usual– Reimbursement for Use of Tools - not wages or subject to

payroll taxes• value of rental not based on actual expenses paid or incurred by

the technicians – must be a logical connection to the expenses incurred

• business 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 complete• Excess reimbursements must be returned• Re-characterization issue (i.e. vacation, meetings, etc)

Tool Reimbursement Programs

• IRS 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 employee’s gross income, must be reported to the employee on Form W-2 and are subject to the withholding and payment of federal employment taxes”

• If 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 Provisions

• Manufacturer’s incentives paid to salespeople– a) not subject to withholding taxb) Not considered self-employment income

• Treatment of Driver/Shuttlersa) Treated as employees or independent contractors?b) Tests include: means & method; results of work; control

over drivers; written instructions; mandatory meetings, etc.

Items Not in the Guide

• Items Frequently Addressed in an IRS audit of a Dealership a) Travel and entertainment deductibilityb) Personal versus business expensesc) Club Duesd) Classification of depreciable lives (cost segregation)e) Passive versus Active Incomef) Deductibility of Reserves and allowancesg) Proper deferral of income

Non-Qualified Deferred Compensation

• New, restrictive rules effective October 3, 2004• Includes nearly all types of deferred compensation

agreements (phantom stock, etc.) • Failure to meet these requirements result in recognition of

taxable income for all years unless subject to substantial risk of forfeiture.

• 20% penalty on all deferred amounts included in income• Beware of amending plans• Action Plan:

• Identify each plan• Determine if new rules apply• Evaluate alternatives & develop plan

IRS Audit - Preparing

Decide who will work with the agent - Controller or CPA Designate Employee for Agent contact Audit Site - Dealership or Offsite Prefer Not at the Dealership - Reasons

Conducting an IRS Audit

Procedures Requests for Information Providing Gratuitous Information Request Agents Plan Computerized Records Request Agent Relations Resolving the Issues

Top 5 Audit Mistakes

1. Allowing Unrestricted access to Information2. Agents allowed to Use Copier without Limits3. Dealer interviews4. Negotiating Every Aspect of the Audit5.Computer-based audits

Tax Deferral Opportunities

• Insurance Premiums• Reconditioning Costs• Floorplan Credits• Advertising in Inventory• Lifo• Cost Segregation

Cash Benefits of Tax Deferrals

Option #1 - Pay no tax Option #2 - Defer Paying as Long as Possible Example of Deferral: IRA’s Time Value of Cash Savings Example: $10,000 @ 9.5% Pay back in 10 years = $4,234 Pay Back in 20 years = $1,643

Internal Gross Profit/Reconditioning

Recondition Used Vehicles Recognize Profit in Service or Body Shop Vehicles Still in Inventory @ YE? Why Pay Tax on Profit not Realized? Example:

100 vehicles @ $500 ea. recon. 50% back end gross

$25,000 *45%=$11,250

Floorplan Credits

Floorplan Credits: Interest Income or Purchase Discount Receive Regardless of Expense Receive Regardless of Days Vehicle is Actually in Inventory Considered Discount? Recognize Discounts When Vehicle is Sold Defer Discounts Until Vehicle is Sold Financial Statement Issues

Advertising Expense

Included on Invoice Paid to Association When to Expense?

* When Vehicle is Sold?* When Invoiced by Mfg?

TAM 9243010 Deduct When Invoiced Example: Inventory= $2 million 1.5% = $30,000*45% = $13,500

To LIFO or Not to LIFO?

Last-in, First-Out Don’t Pay Tax on Inflation Dealers Afraid to Utilize? New - Yes; Used - ?; Parts - No! Used - write-offs vs. Lifo vs. inflation

Example: $3,000,000 New Inventory3% inflation in base cost

$90,000 deferral$36,000 in deferred taxes

Cost Segregation

Depreciation for Buildings = 39 years Lots of new facilities & remodeling Manufacturer Initiatives Building - many components Need to Identify & Separately Depreciate Requires Engineering Expert! Can Utilize on Property Acquired in Prior Tax Years Can Utilize on “Used” Facilities

Cost Segregation Example

Building Addition = $2.3 million Reclassified Amount = $864,000 PV of Tax Savings @ 7% = $122,000 Tax Savings - first 2 years = $70,000 Cumulative benefits if Placed in Service in a Prior Year Bonus depreciation available for 2004

Prepaid Expenses – 12-Month Rule

• Allows a current deduction for certain expenses that do not extend beyond the earlier of:– 12 months after the first date on which the taxpayer

realizes the benefit, or– The end of the taxable year following the year in which

payment is made.• Possible opportunities:

– Insurance– Taxes and Licensing Fees to governmental authority– Liabilities arising under workers’ compensation act– Prepaid rent does not qualify because the payment is for

use of the property which has not been provided

Insurance Deductibility

• Prepaid expense rule change appears to allow the accrual of 2005 insurance premiums– Amount must be fixed and determinable– Recurring Item Exception– Can elect for tax purposes only– Need to pay premium with 8 & ½ months before year

end– Need Change in Accounting election (IRS Form 3115)– Must extend tax return until paid in full

Insurance Deductibility - Example

• Determine premium year and unpaid balance• December 31 to December 30th premium year:

Annual premium – WC and/or P & C $75,000Tax rate 40%Tax Deferral

$30,000

• August 1, 2004 to July 31, 2005 premium year:Total premiums due under the policy $75,000Premiums paid and/or expensed in ’04 31,250Amount available to be accrued $43,750

Tax rate 40% Tax Deferral

$17,500

Learning Objectives

• Understand the key items of interest in the audit guide• Understand IRS audit techniques

for specific areas• What to do in case of an IRS audit • Tax Planning Ideas

Summary

• Questions?

• Thank you!

Charles Diegel, CPA Tom Earley, CPA, MST215-881-8882 215-881-8883cdiegel@amper.com tearley@amper.com

“The material contained in this presentation is for general information and should not be

acted upon without prior professional consultation.”