HIDDEN RESOURCES: IRS Audit Techniques Guides
Historically, IRS examiners were assigned to audit taxpayers in many different industries. On one day, an examiner audited a grocery store and on the following day the examiner may have audited a computer retailer or a medical doctor. As a result, experience gained in one audit did not significantly enhance the examiner’s experience for purposes of conducting other audits.
More recently, the IRS has been attempting to identify and reduce non-compliance through efficiency, tax form simplification, education, and enforcement. In addition, the IRS has significantly modified its examination process in a manner designed to increase the available resources and experience of its examiners.
The IRS Audit Techniques Guides (ATGs) focus on developing highly trained examiners for a particular market segment or issue. A market segment may be an industry such as construction or entertainment, a profession like attorneys or real estate agents or an issue like passive activity losses, hobby losses, litigation settlements or executive compensation – fringe benefits. These guides contain examination techniques, common and unique industry issues, business practices, industry terminology, interview questions and procedures and other information to assist examiners in performing examinations.
IMPROVED IRS AUDIT EFFICIENCY. The ATGs significantly improve IRS audit efficiency and compliance by focusing on taxpayers as members of particular groups or industries. These groups have been defined by type of business (artists, attorneys, auto body shops, bail bond industry, beauty shops, child care providers, gas stations, grocery stores, entertainers, liquor stores, pizza restaurants, taxicabs, tour bus industry, etc.), technical issues (passive activity losses, alternative minimum tax), and types of taxpayer or method of operation (i.e. cash intensive businesses). As examiners focus on the tax compliance of a particular industry, they have gained experience on specific issues to be examined for a particular type of business, whether or not the issues are set forth on a tax return. Examiners often spend the majority of their time auditing taxpayers in the particular market segment for which the examiner has become a specialist. Some may specialize in examining the construction industry while others may specialize in examining restaurants.
IRS examiners are routinely advised about industry changes through trade publications, trade seminars and information sharing with other examiners. As such, there is an increased understanding of the market segment, its practices and procedures, and the appropriate audit techniques required to identify issues unique to the market segment under examination. Utilizing an ATG, examiners attempt to reconcile discrepancies when income and/or expenses set forth on a taxpayer’s return are inconsistent with a typical market segment profile or where the reported net income seems inconsistent with the standard of living prevalent in a geographical area where the taxpayer resides. As a result, information and experience gained through the examination of returns for other taxpayers becomes the barometer for judging the accuracy of a particular return under examination.
Issues are continually being identified by their unique features requiring specialized audit techniques, technical or accounting knowledge, or the need to comprehend the specific business practices, terminology and procedures. The IRS has published numerous ATGs, including attorneys, auto body/repair shops, bail bondsmen, beauty/barber shops, car washes, child care providers, check cashing establishments, childcare businesses, construction contractors, farmers, restaurants and bars, various segments of the entertainment industry (motion picture/television, athletes and entertainers, music), garment industry, gasoline distributors, grocery stores, insurance agencies, jewelry dealers, liquor stores, mobile food vendors, parking lot operators, pizza parlors, real estate agents/brokers, real estate developers, recycling businesses, scrap metal businesses, taxicabs, the trucking industry, direct sellers and auto dealers.
DEVELOPMENT OF AN ATG. Once the IRS identifies a particular market segment project, an audit group may develop an ATG based upon the market segment’s unique business activities. Information developed during IRS examinations of similar issues or taxpayers is coordinated into what eventually become an ATG for such issues or type of taxpayer activity. The audit guides are then used by examiners throughout the country to develop a pre-audit planning strategy. As such, utilization of the ATG allows the examiner to streamline their examination resulting in more efficient examinations often targeting sensitive issues or issues involving industry non-compliance.
The ATGs explain the nature of each respective market segment or industry, the type of documentation that should generally be available, and the nature and type of information to search for during a tour of the business premises. They identify potential sources of additional income not otherwise readily apparent from the type of business activity being examined. As an example, the “Attorney ATG” identifies potential sources of revenue other than from the attorneys general practice, litigation, tax, and probate fees. The ATG indicates that the attorney “may also receive revenue from performing services as board directors for clients and non-clients, speaker’s honoraria, and other outside professional activities. Inquiries about these types of revenue should be made during the initial interview.”
ATG INTERVIEW QUESTIONS. The ATGs identify issues to be raised during an audit interview with the business owner/operator, including the need for a detailed discussion about internal controls (weak internal controls in a small business environment does not preclude the necessity of determining the reliability of the books and records since every taxpayer has a method of conducting business and safeguarding business operations), source of funds utilized to start the business, a complete list of suppliers, identification or business records that might be available and the individual that maintains the business records. The examiner will also explore the manner of business operations, including the hours and days it is open, the number of employees, the responsibilities of each employee, identification of the individual that maintains control over inventory (beer, wine, etc.), cash and credit card receipts, and the cash register tapes. Examiners are advised to search out payments of non-business or personal living expenses by the owner/operator from the business operations.
ATGs are designed to focus IRS examiners on the typical methods of operation for businesses operating within a particular market segment. For example, with respect to cash intensive businesses, the audit guides identify the potential for skimming in liquor stores, pizza restaurants, gas stations, retail gift stores, auto repair shops, restaurants and bars. However, the ATGs acknowledge that “chain” or “franchise” businesses may not participate in skimming to the same extent due to the somewhat intensive internal controls typically required in their operations. Internal controls are often stronger in franchises due to independent audits and verifications performed by the franchisor. Typically, the franchise fee is based on the gross revenue of the business. The franchisee usually must buy products from the franchisor to maintain the franchise. The franchisor also requires maintenance of certain books and records in a format determined by the franchisor and may conduct audits of the franchise operations.
The “Cash Intensive Business” ATG sets forth various ideas for the initial interview of the taxpayer, including:
- Principal Products?
- How long in business?
- Who are your principal customers?
- Ask if the taxpayer has any other source of income.
- How are sales handled?
- Method: cash or accrual?
- Basis for recording?
- If accrual, does he/she have a list of accounts payable and receivable?
- How are prices set?
- What is your markup percentage? (Ask for markup % on each major product)
- How often is inventory taken, by whom?
- Who keeps the books?
- How did they learn recordkeeping?
- What bank accounts maintained?
- Do they deposit everything? Who deposits?
- How do they get cash to spend?
- Check to cash?
- Personal withdrawals – how handled?
- Safe deposit box?
- How do they record expenses?
- How were the return figures arrived at?
- How are the expenses paid?
- How much?
- Where located?
- Non-taxable income.
- Pensions, loans, gifts, inheritances?
- Real Estate?
- Major personal property?
- Major Expenses:
- Loan repayments?
- Asset acquisitions? When? How?
SPECIFIC INDUSTRY APPLICATIONS OF AUDIT TECHNIQUES. IRS examiners are advised to make specific inquiries based on the type of taxpayers under examination. For example, in the retail liquor industry, examiners are advised to search for off-book inventory including purchases outside of the liquor distributor, i.e. local wholesaler, bottle redemption and check cashing as well as contacting for check with local/state beverage department for pending or completed investigations involving taxpayer and/or known suppliers of the taxpayer. For pizza restaurants, examiners are cautioned to reconcile the difference of the number of boxes sold verses the number of boxes used (less some account for spoilage boxes) as possible additional unreported sales. For gasoline service stations, examiners are advised use the indirect mark-up method of determining income (gallons purchased multiplied by the average selling price as representing total sales) and inquire about imaging reimbursements, incentive agreements, accommodations, blending and rebates.
For restaurants and bars, examiners are advised to inquire about rebates to franchisees from suppliers, compare restaurant averages (sales v. cost), reported net profits as compared to the industry average, spillage, whether “point of sales” machines, using bar averages (pour) to calculate income, etc. With respect to grocery stores, examiners are advised to search for potential sources of unreported income that might include coupon processing rebate fees, cash discounts from vendors, rebates from vendors, receipt of high dollar promotional items from vendors, use of vending machines (i.e. newspaper), pinball machines/arcade games, bottle/can redeeming, money orders, credit card sales, food stamp sales and prepaid telephone cards.
PUBLIC ACCESS TO THE ATG. While ATGs are designed to provide guidance for IRS employees, they’re also useful to small business owners and tax professionals who prepare returns and are also quite helpful for business and tax planning purposes. Tax professionals should consider consulting the appropriate ATG before preparing returns or commencement of an IRS examination involving a type of taxpayer or issue covered in an ATG. Knowing what issues are important to the IRS is, quite simply, important.
Many of the IRS ATGs are publically available at irs.gov. See https://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Audit-Techniques-Guides-ATGs