Tax Planning and the IRS

It is no secret that the Internal Revenue Service (IRS) audits relatively few tax returns. In fact, each year the IRS publishes the figures. The IRS’s own data reveals that slightly more than 1% of all tax returns filed were audited. The audit figures for the almost 10 million business returns filed in fiscal 2009, at least those that included Schedule C’s filed by sole proprietors, were only .58%. Audit percentages ranged between .38% for partnerships and S corporations (.40%) to .85% of small corporations (under $10 million in assets).

Good news? Not really, as the Treasury Inspector General for Tax Administration (TIGTA) recently reported, the agency has improved its ability to target tax returns “posing the greatest compliance risk.” Only 11-15% of all IRS audits reportedly result in “no change,” and the IRS reportedly collected almost $49 million from the relatively few audited. Even worse, the IRS’s enforcement efforts resulted in more than 4.4 million levies, liens and seizures—up 7.6% over last year’s performance.

While how the IRS selects tax returns for audit remains a secret, just how much the IRS knows about the convenience store industry is a matter of public record.

What the IRS Knows
Published last spring, the “Cash Audit Techniques Guide,” provides IRS auditors with background about, and strategies for, examining cash businesses. The recently-released ATG is neither a handbook on how to avoid taxes nor an official pronouncement of the law or the IRS’s position. Rather, the ATG reveals just how much the IRS knows about cash intensive businesses, a category that includes many convenience store operations.

After defining convenience stores, mini marts and bodegas in some depth, the IRS’s Cash Audit Techniques Guide advises auditors to specifically look closely at a convenience store’s unreported income, handling and accounting for cash receipts and cost of goods sold.

As this latest guide points out, many business owners believe cash receipts can go unreported and escape detection by the IRS. Not too surprisingly, convenience business owners who fail to report all income are often detected through a consistent pattern of losses or low profits that seem insufficient to sustain the business or its owners.

Internal Controls
Fast-food drive-through restaurants know that when cash is collected by one employee at the first window and the food is delivered by a different employee at a second window, it is less likely that food will be given away free or that cash will be stolen. A restaurant that offers a free meal if customers do not get a receipt are trying to make sure employees record all sales in the cash register. Both of these are internal controls.

According to the IRS guide, a cash business may have a cash register, but that doesn’t mean that it is used properly. If a convenience store operation has a computerized cash register system, but is unable to provide sales reports, it is a problem easily overcome by IRS auditors. Most systems built within the last decade can produce the essential reports. What’s more, the cash register manufacturer will provide instructions on how to obtain the reports needed.

Money Orders and Other Schemes
The IRS is aware that some businesses that sell money orders or conduct Western Union money transfers will use unrecorded cash to purchase money orders. Taking less space than cash, these can be held in a safe or they can be used to pay the operator’s personal expenses, such as utilities or mortgages.

Sometimes, according to the IRS, business owners will purchase their money orders at a neighboring store and the neighboring store owner will purchase their money orders at the store being audited. Auditors are cautioned to look for the names of other local stores and their owners when sampling money order purchases.

Inventory Management
Many small business owners say they know exactly what is in their store at any time just by looking around. Many also feel that this is why a physical year-end inventory is not necessary. The tax laws, however, require an inventory.

A convenience store, according to industry averages reported by Bizstats.com, a free source of business statistics and financial ratios frequently used by IRS auditors, will have 59 days sales in ending inventory. The inventory ratio is 6.4, which means the entire inventory is sold out 6.4 times during the year. The gross profit percentage is 25.5%. These are the figures IRS examiners use where accurate records have not been maintained.

The IRS’s auditors are also reminded that typical businesses of certain sizes generally have a “normal” range of expenses. Deductions that fall outside of this range or that appear unrealistic may trigger an IRS warning flag. Examiners are advised to try to match an expense item to verify the corresponding income is reported.

IRS auditors are instructed to also check for miscellaneous income from among the following:

• ATM
• Film Developing
• Movie Rentals
• Photocopier/Fax Services
• Vending machines
• Video Games

A Little Help from Friends
What an IRS auditor doesn’t know might not hurt him, but don’t underestimate his ability to find out. IRS auditors examining cash business routinely contact state auditors or sales tax auditors for information on prior examinations and what markup percentages were used.

Markup percentages do not usually change, so this information will be helpful even if the sales tax examination is old. Sales tax examinations are usually performed regularly in most states.

Some small business owners have been known to reduce prices when learning of an IRS, state or sales tax examination in an effort to reduce the eventual adjustment based on a percentage markup calculation. Aware of this strategy, IRS examiners are instructed to record a sample of prices on key items. These can later be compared to cash register tape entries. If the cash register tapes are missing, the taxpayer cannot verify that prices were either higher or lower, allowing the use of the auditor’s figures.

Types of Audits
While IRS audits have been around for many years, there are still a number of misconceptions about what triggers an audit—or how to avoid one. For instance, just because a refund check has been received doesn’t mean that an audit is out of the question. Audit determination is usually made long after the refund check is issued.

The IRS can choose one of two ways in which to audit tax returns: an examination conducted either through the mail or in-person via a personal interview. An IRS audit conducted through the mail is known as a correspondence audit. Its scope is usually less than that required for a field or office audit.

Between 2004 and 2008, the IRS conducted more than 5.1 million correspondence audits, resulting in approximately $35 billion in additional taxes. Each return examined generated about $6,800 in recommended additional taxes, according to TIGTA.

A convenience store operator’s own actions can often reduce the possibility of a more extensive examination by giving the IRS the answer before they ask the question or pointing out “oddball” items on the tax return. For large transactions that may fall into one of the innumerable gray areas of the tax laws, Form 8275, “Disclosure Statement,” may help avoid penalties by disclosing questionable deductions, positions or investments. Few experts think using this form will increase the chance of being audited.

The IRS has developed and published a number of Audit Technique Guides, written so auditors know wh
at to look for when auditing businesses in specific fields or cash intensive businesses. The latest guide should be a warning of how much the IRS knows about convenience stores in general, and a goldmine of information that can help steer every c-store operator away from potential tax pitfalls. The IRS Web site offers a number of industry-specific technique guides along with the complete guide for cash intensive businesses available for download at www.irs.gov.

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