A Tale Of Tax Audits For Two Businesses

© 2000 by Michael C. Gray

January 26, 2000


I recently had experiences with two tax audits from which I believe you can learn some important lessons.

Tax Audit 1 – The inattentive businessman

The first tax audit started in March 1999 and wasn’t concluded until January 2000.

The primary focus of the audit was a Schedule C – Trade or Business income for a small family business. "John" operated the business and "Susan" kept the records for the business. Both John and Susan are senior citizens in declining health. Susan suffered a stroke a couple of years ago. I didn’t prepare the income tax returns for the taxpayers, but knew them personally and had represented them for a tax audit before.

Taxpayers who report a trade or business on their individual income tax returns are audited more often than most other taxpayers. The IRS has found that there is often unreported income or overstated deductions for these businesses.

The cost of sales on the tax return at issue exceeded the sales. This was probably the reason the tax return was selected for audit. John explained that he had suffered large theft losses because of poor security for his inventory.

One of the tests performed by the IRS auditor was to add the total receipts according to John and Susan’s bank statements and compare the total to the amounts reported on the income tax returns. Less receipts were reported on the income tax returns, so Susan and I went back through the bank statements and listed the breakdown for each deposit. It turned out that John had made some deposits from the business to a bank account and didn’t tell Susan. Susan did not keep bank reconciliations for that account for the year at issue.

The IRS auditor also questioned amounts claimed as deductions for insurance expense for the business. When Susan and I listed the payments that made up the insurance expense deduction, it turned out that there were payments for personal life insurance and health insurance for other family members included, which weren’t deductible.

John and Susan had experienced a loss relating to a note received from a development project during the year under audit. No deduction was claimed for the loss, but I hoped I could reduce the tax bite of the audit by using it as an offset for the adjustments proposed by the auditor. The documentation for the series of transactions was very poor, so I couldn’t substantiate what happened very well. John also said he was contemplating litigation relating to the note, so the auditor decided the transaction wasn’t completed for the year at issue.

There were other items, including cash received from personal loans, that I was successful in documenting, but this was a very difficult case because of the poor records kept by the taxpayers.

If John and Susan had kept a good set of double-entry accounting records, including monthly bank reconciliations, and had used legal counsel to write the contracts relating to their loss from their note, they could have avoided a lot of pain of suffering.

Tax Audit 2 – What a difference good records make!

The second audit was for a corporation, "Goodco."

Goodco has a well-organized accounting department and an excellent computerized accounting system.

The agent assigned to the Goodco audit interviewed the owner, "Joe Good" to understand the business. Then he came to my office for two days to look at selected corporate accounting records, including payroll tax returns and large deposits. I answered his questions about special accounting issues for Goodco’s industry. Then the agent left, saying he will probably issue a "no change" report.

Just having a good set of records had gone a long way to giving the agent confidence that the tax returns were in order, so he decided not to burn a lot of time sifting through the details.

Conclusion

Establishing good accounting procedures and practices can help smooth the tax audit process. It’s also important to get good legal assistance to properly document important transactions. "An ounce of prevention is worth a pound of cure."

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Michael Gray, CPA
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