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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.

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How Would Your Dealership Hold Up in an IRS Audit?

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  1. How Would Your Dealership Hold Up in an IRS Audit? Charles Diegel, CPA Tom Earley, CPA, MST

  2. Learning Objectives Understand the key items of interest in the audit guide Understand IRS audit techniquesfor specific areas What to do in case of an IRS audit Tax Planning Ideas

  3. What’s the Big Deal? Tax Gap = $300 Billion per year ! in 2001

  4. 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

  5. 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

  6. 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

  7. 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

  8. 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

  9. 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?

  10. 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)

  11. Balance Sheet • Cash Issues– • IRS Form 8300 filed as required? • All income reported? • Audit Techniques– • Trace outstanding checks to determine payment of a liability • Accounting for & questioning all material related company transfers • Review AJE’s, standard entries & Journal Vouchers

  12. IRS Form 8300 • Audits are Resulting in Large Assessments: • Penalties = $25,000 per missed 8300 • Many audits on East Coast resulting in six figure settlements – no negotiation • Ask 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?

  13. IRS Form 8300 (continued) • Cash Refresher : • Cash = currency • Cashiers checks, bank drafts, traveler’s checks and money orders less than $10,000 • File 8300 for: • One lump sum > $10,000 • Installment payments that cause cash received within one year of the initial payment to exceed $10,000 • Previously unreportable payments that cause total cash received in 12 month period to exceed $10,000 8300 questions? email to: 8300QUESTIONS@IRS.GOV

  14. Balance Sheet (continued) • Receivable Issues– • Unreported sales • Proper year of inclusion • Related Party transactions arm’s length? • Dealership financing of transactions – note terms reasonable? • Audit Techniques– • Test sales in opening days of subsequent year • Confirm tested sales against deal jackets and general ledger • Scrutinize note transfers for related party or unrecorded transactions

  15. 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 dividend • Large, unusual or questionable items • Personal items • Image Payments – conclusion: taxable

  16. Balance Sheet (continued) • Payables and Accrued Expenses– • Liability exists • Liability 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?

  17. 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

  18. INVENTORY • Lower of Cost or Market (LCM) • Used Vehicles • Documentation, documentation, documentation • Valuation Guide • using 100 percent of wholesale valuation • 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

  19. 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 • Commissions must be included in income in the year sold • Dealer Obligor • Selling price included in income in year sold • Insurance premium amortized over term of contract

  20. 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

  21. 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.

  22. 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.

  23. 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

  24. 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

  25. 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.

  26. 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)

  27. 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

  28. Miscellaneous Provisions • Manufacturer’s incentives paid to salespeople– • not subject to withholding tax • Not considered self-employment income • Treatment of Driver/Shuttlers • Treated as employees or independent contractors? • Tests include: means & method; results of work; control over drivers; written instructions; mandatory meetings, etc.

  29. Items Not in the Guide • Items Frequently Addressed in an IRS audit of a Dealership • Travel and entertainment deductibility • Personal versus business expenses • Club Dues • Classification of depreciable lives (cost segregation) • Passive versus Active Income • Deductibility of Reserves and allowances • Proper deferral of income

  30. 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

  31. 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

  32. Conducting an IRS Audit • Procedures • Requests for Information • Providing Gratuitous Information • Request Agents Plan • Computerized Records Request • Agent Relations • Resolving the Issues

  33. 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

  34. Tax Deferral Opportunities Insurance Premiums Reconditioning Costs Floorplan Credits Advertising in Inventory Lifo Cost Segregation

  35. 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

  36. 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

  37. 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

  38. 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

  39. 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 Inventory 3% inflation in base cost$90,000 deferral $36,000 in deferred taxes

  40. 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

  41. 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

  42. 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

  43. 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

  44. 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

  45. Learning Objectives Understand the key items of interest in the audit guide Understand IRS audit techniquesfor specific areas What to do in case of an IRS audit Tax Planning Ideas

  46. Summary “The material contained in this presentation is for general information and should not be acted upon without prior professional consultation.” Questions? Thank you! Charles Diegel, CPA Tom Earley, CPA, MST 215-881-8882 215-881-8883 cdiegel@amper.comtearley@amper.com

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