Over the last year, the IRS released revised comprehensive Audit Technique Guides (ATG) for auditors to use in conducting exams of individuals in professional service industries. While the new ATGs were specifically directed to attorneys, architects, and business consultants, these same guidelines will apply to a wide variety of our clients. The guides are used to pinpoint areas that the IRS agents are instructed to explore, explains how the audits should be conducted, and list the types of documents that should be requested and examined.
Following are some key areas that the auditors will examine when an attorney’s return comes under review:
- Unreported income – The auditors are instructed to determine if fees were included in income at the proper time. Additionally, the auditors are told to pay special attention to checks that are deposited to accounts other than the general operating account.
- Deferral of Income – The auditors will review trust accounts to ensure that once a settlement is received (and is both determinable and available), that the income is reported in the current year and not held in the trust until the next year.
- Noncash payments instead of fees for services rendered – The auditors are told to looks for instances of bartering by reviewing the attorney’s work schedule as compared to fees received, assessing ledger cards, and verify basis in newer assets such as partnership interests or stock.
- Constructive receipt – Income is constructively received when it is subject to the demand of the taxpayer and there are no substantial limitations on the rights to receive it. Therefore, even a cash basis taxpayer might be required to include income in the current year under the constructive receipt doctrine.
- Advanced client costs – The courts have determined that litigation costs paid on behalf a client, especially for those cases taken on a contingency basis, are loans for tax purposes and are not deductible as a current cost of conducting business. The costs are expensed in the same year the income is received, or a bad debt deduction is taken in the year the costs are determined to be uncollectible.
- Other issues – Many other issues may be reviewed, including the misclassification of employees as independent contractors, ensuring that Form 1099 has been properly issued, and that Form 8300 has been properly filed when more than $10,000 of cash is received in one transaction or in two or more related transactions.
Following are some key areas that the auditors will examine when an architect’s return comes under review:
- Personal Service Corporations (PSCs) – Auditors are instructed to ensure that substantially all activities involve the rendering of architectural services, that substantially all stock is owned by current or retired employees, and that the 35% flat tax rate is being used.
- Domestic Production Activities Deduction (DPAD) – Auditors are instructed to review whether post construction services or gross receipts from landscape architecture services are included in the DPAD calculation. Neither of these are allowed.
- Proper accounting method – Generally, architects are allowed to use the cash or accrual method of accounting. They are not permitted to use the completed contract or percentage-of-completion method.
- Tax year – PSCs, partnerships and S corporations are generally required to be on a calendar year unless they can establish a business purpose and obtain IRS approval for a different period.
- Other issues – Other items the auditors will review include ratios of income and expenses to industry norms, legal fees to ensure payments are for current services and not possible future litigation, contractor versus employee classifications, and educational expense used to maintain skills and meet the requirements of the employer. Auditors might ask for additional documents including a breakdown of reported sales, copies of contracts and bonding information.
Following are some key areas that the auditors will examine when a business consultant’s return comes under review:
- Shifting or the assignment of income / substance versus form – Auditors are instructed to review closely held or one-person personal services corporations for the shifting of income earned by the individual to another entity in order to reduce their income and / or self employment taxes. The auditors will look for taxpayers who might shift income earned in one entity to another entity to offset net operating losses, or even to circumvent limitations like those related to Roth IRAs. The examiners will review consulting agreements and contracts to look for certain information related to income shifting.
- Tax years – The auditor will ensure that the taxpayer has not improperly selected a fiscal year instead of a calendar year to defer income.
- Travel – The ATG notes that there is extensive travel both inside and outside the US by business consultants. The auditors will look for spousal / family travel and personal travel that might be incorrectly included in expenses.
- Independent contractor versus employee – The ATG is especially interested in former employees who return to a place of employment as a contractor with very little break in service. Due to the downsizing that has been taking place, the auditors are well aware of this shifting of social tax responsibilities and payroll costs. Another issue might arise when a consultant creates a strategic alliance to serve a client that he or she alone does not have the resources for. This can lead to an employee / employer relationship.
- Meals and entertainment – Auditors are instructed to review the meals and entertainment for the proper application of the applicable percentage limitation, the point that travel status meals and entertainment should be limited if not reimbursed, and expenses being claimed during non-travel status. They will also review the expenses for proper documentation and support as to whom the meal was with and the business purpose
- Personal Service Corporations (PSCs) – As described above, the auditor will review whether a C corporation meets the qualifications of a PSC.
The items noted above are some of the new areas of emphasis that the IRS will look at when auditing a tax return. The list is not all inclusive and many areas of concern including inclusion of income, proper documentation of expenses, and proper application of tax law will also continue to be reviewed in the audit process.
Under U.S. Treasury Department guidelines, we hereby inform you that any tax advice contained in this communication is not intended or written to be used, and cannot be used by you for the purpose of avoiding penalties that may be imposed on you by the Internal Revenue Service, or for the purpose of promoting, marketing or recommending to another party any transaction or matter addressed within this tax advice. Further, RubinBrown LLP imposes no limitation on any recipient of this tax advice on the disclosure of the tax treatment or tax strategies or tax structuring described herein.
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