Transcript How Would Your Dealership Hold Up in an IRS Audit?

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 –
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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?
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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
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Audits are Resulting in Large Assessments:
a) Penalties = $25,000 per missed 8300
b) 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)
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Cash Refresher :
a) Cash = currency
b) 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 $10,000
c) Previously unreportable payments that cause total
cash received in 12 month period to exceed $10,000
8300 questions?
email to: [email protected]
Balance Sheet (continued)
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Receivable Issues–
a) Unreported sales
b) Proper year of inclusion
c) Related Party transactions arm’s length?
d) Dealership financing of transactions – note terms
reasonable?
Audit Techniques–
a) Test sales in opening days of subsequent year
b) Confirm tested sales against deal jackets and general
ledger
c) 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 dividend
b) Large, unusual or questionable items
c) Personal items
d) Image Payments – conclusion: taxable
Balance Sheet (continued)
•
Payables and Accrued Expenses–
a) Liability exists
b) 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
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using 100 percent of wholesale valuation
2) Last-in, First-out (LIFO)
- Compliance
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Book and Tax the same
Calculation
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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 Obligor
o Selling price included in income in year sold
o 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 tax
b) Not considered self-employment income
•
Treatment of Driver/Shuttlers
a) 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 deductibility
b) Personal versus business expenses
c) Club Dues
d) Classification of depreciable lives (cost segregation)
e) Passive versus Active Income
f) Deductibility of Reserves and allowances
g) 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
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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 Information
2. Agents allowed to Use Copier without Limits
3. Dealer interviews
4. Negotiating Every Aspect of the Audit
5.Computer-based audits
Tax Deferral Opportunities
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Insurance Premiums
Reconditioning Costs
Floorplan Credits
Advertising in Inventory
Lifo
Cost Segregation
Cash Benefits of Tax Deferrals
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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
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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?
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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 Inventory
3% inflation in base cost
$90,000 deferral
$36,000 in deferred taxes
Cost Segregation
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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
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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 $75,000
Tax rate
40%
Tax Deferral
$30,000
• August 1, 2004 to July 31, 2005 premium year:
Total premiums due under the policy
$75,000
Premiums paid and/or expensed in ’04
31,250
Amount 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
215-881-8882
[email protected]
Tom Earley, CPA, MST
215-881-8883
[email protected]
“The material contained in this presentation
is for general information and should not
be acted upon without prior professional
consultation.”