Are you ready for IRS audits?

Are you ready for IRS audits?
Tags: Business Strategy and Profitability, Operations Management
July 27, 2010

By Richard Yelton

Over the past several years, the IRS examination of small businesses, which it defines as those with assets less than $10 million, has significantly increased. In fact, a recent report by Syracuse University’s Transactional Records Access Clearinghouse (“TRAC”) shows that IRS audits of small businesses has increased by 30% over the last five years. Surprisingly, that same report showed that the audit of large businesses, defined as those with assets greater than $250 million, have actually decreased by 33% over the last five years. With this increase in IRS scrutiny, small businesses must be ever mindful of maintaining internal controls and excellent books and records to support their tax filings.

In its review of total revenues, the IRS will often begin by comparing daily POS system information and the related bank deposits. This procedure should provide the examiner adequate comfort that revenues have been properly recorded. However, if the examiner has difficulty using this procedure to tie out total revenues, other indirect methods may be used to estimate food sales.

Those techniques may include, for instance, ingredient mark-up calculation: The IRS agent may test the restaurant’s reported pizza sales, for example, by reference to the amount of ingredients, such as flour, cheese and sauce, purchased during the year. The agent would also need specific pizza recipe information, such as the amount of ounces of flour, cheese and sauce that are used in making a large cheese pizza. Based on this information, the examiner may attempt to approximate the number of pizzas sold during the year, and estimate the total revenues from pizza sales accordingly.

As you can imagine, each of these methods can result in an unreliable estimation of total revenues by the IRS examiner. For example, factors such as food spoilage are often not considered within these calculations. As a result, such indirect methods of estimating revenues could lead to a proposed adjustment by the IRS examiner, and additional income taxes assessed. Unfortunately, such an assessment could have possibly been avoided if the restaurant owner had maintained a more reliable set of records to support its sales activities.

For larger restaurants that tend to have more internal controls in place, an IRS agent may be able to verify total revenues without having to use any indirect methods in the process. In that situation, the agent may focus more on the deductions and income tax incentives claimed, including:

Costs of intangible items: There are many intangible costs unique to the restaurant industry, such as franchise costs and liquor license costs, which must be spread over 15 years, even though the useful period of such costs may be considerably less. Restaurants that either immediately deduct such costs or amortize them over shorter periods may find themselves with disallowed tax deductions upon examination.

Employment related tax credits: Restaurants are eligible for several tax incentives related to its workforce, most commonly including the Work Opportunity Tax Credit (WOTC) and the FICA Tip Tax Credit. Since recent legislation has made these credits even more beneficial for restaurant owners, IRS agents approach these credits with even greater scrutiny. Accordingly, restaurants should be certain to properly maintain the related documentation, including certified employment forms, that are often required to claim such credits.

The overall IRS examination rate for small and mid-size businesses is still relatively low, even considering the recent increases. However, restaurant owners should remain focused on maintaining proper internal controls and reliable books and records. Doing so will not only make an IRS examination less painful, but will allow the restaurant to maximize its long-term profitability and growth.