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Thursday, September 22, 2011

IRS Beefs Up Staff - Audits on the Rise

In an aggressive move to close the tax gap — the difference between tax owed and what is actually paid to the federal government — the IRS has increased its ranks significantly, hiring 1,500 additional new revenue officers who are busy auditing and collecting taxes it believes it is owed from businesses. In the following article, Armanino partners and tax experts Dan Jones and John Brychel give details and best practices to help your company minimize the time and cost of the dreaded IRS audit.

Over the past 18 months, the frequency of business audits by the IRS has risen rapidly. We’re not surprised because legislative and economic drivers are clearly motivating The Service to pull out all the stops to collect what it believes it is owed. The IRS claims there is up to $500 billion on the table that it can pick up through enforcement. When you consider that the IRS gets $4 in revenue for every dollar it spends on auditing, you can understand why The Service has stepped up its assessment efforts.

The areas being targeted by the IRS include incentive credits such as R&D credit, and deductions such as those allowed under Section 199 of the Internal Revenue Code. Another big area of focus is transfer pricing, particularly that which goes on between American companies and their affiliates overseas, but also transfer pricing between related companies in the U.S. Here is a brief list of the areas that are current IRS hot spots:

Research & Development Credit – This is a “Tier 1” issue for the IRS, meaning it is very intent on examining companies that claim this credit, a federal incentive intended to help U.S. manufacturers and technology companies to be more competitive globally.

For companies that claim this credit, the IRS will ask:

  • Does your claim qualify as research as defined by the IRS?
  • Can the taxpayer link research expenses to qualified research activities?
  • Does the taxpayer keep appropriate (rigorous) records of its qualified research activities?

IRS guidelines mandate that detailed accounting records must be maintained on R&D activity or claims could be denied. Jones and Brychel advise taxpayers who claim this credit or seek to claim it to utilize detailed timekeeping.

One client told us that they can’t get their engineers to wear shoes, let alone fill out a timecard. But if you can get internal compliance with these admittedly distracting tasks, you can achieve a level of recordkeeping that will serve you well in defending your company in an audit. If you have employees working partly on R&D and partly on other activity, detailed timekeeping is crucial to gaining the credit and defending it in an audit.

Section 199 Deduction – This tax benefit is a fairly new incentive initiated in 2005 and aims to reduce the tax rates for manufacturing, contractors, engineering companies and architectural firms by up to 3 percent. It was instituted to encourage manufacturers to make products and finished goods in the United States. A business claiming this deduction must meet two tests: first, it must prove that it did produce most or all of the goods and second, it must demonstrate that the product was manufactured in the United States. The deduction’s “safe harbor” formula is that if your direct costs comprise at least 20 percent of your total cost of goods, then your business will qualify for the deduction. In addition, you can also justify this deduction on a “facts and circumstances” basis. Here’s an example:

If you imported a finished product and just slapped your label onto it, you’ll be assessed for that if you attempted to claim the deduction. However, if you imported raw diamonds, then cut them and set them here, you are likely to be able to claim this deduction based on facts and circumstances even if you didn’t make the safe harbor threshold.

A related issue is that of Section 263A of the code which stipulates uniform capitalization and which is tied to Section 199. To get to the “safe harbor” level for Section 199, you need to allocate overhead costs. Uniform capitalization is a method whereby overhead is allocated uniformly for inventory items. Deductions are allowable as you sell these items, but not before.

Here, consistency of allocation is the key. Some manufacturers change how they allocate costs frequently for a variety of reasons, but the IRS is more comfortable with a consistent approach. If you have to change your allocation method, you should have an underlying, fundamental operational reason for doing so.

Transfer Pricing – The pricing of transactions between related companies or companies operating under one corporate parent is a carefully watched area. Basically, the IRS insists that transactions between related companies should yield the same results as if two unrelated taxpayers conducted the same transaction on the open market. This is known as keeping a transaction “at arm’s length.”

The greatest focus by the IRS is on international transfer pricing, where a U.S.-based company conducts transactions with related entities overseas. The IRS is concerned that U.S. companies are gaming this system to strip away profits, and thus, tax revenue, due to the U.S. by not meeting the “arm’s length” standard.
The IRS has established a special unit with transfer pricing “economists” who focus on the issue and thus taxpayers can expect more examination of their transfer pricing techniques. Here are steps taxpayers can take to defend in this area:

  • Review current transfer pricing policies and documentation. If you don’t have any, create them now.
  • Create a defense file that contains the policies, intercompany contracts, and rationale for why the structure your company uses is best for your company as well as the formulas you are using to come up with your prices.
  • If you are audited for this, anticipate the auditor’s questions and have everything covered.

Penalties for assessments for non-compliance on transfer pricing are significant: up to 40 percent of the amount in dispute.

Transaction Costs – With mergers, acquisitions and other liquidity events, some of the costs associated with these transactions are deductible and some must be expensed. Keeping those straight is important when you are audited. The general rule here is you must capitalize all costs to investigate or facilitate a transaction up to the signing of a letter of intent. Due diligence costs before a letter of intent is signed are generally okay to deduct as an ordinary expense. One important rule to remember is to get as much detail as possible on invoices from your professional services vendors so that you can justify deductions. Vague bills are difficult to prove in an audit.

Accruals – The main issue here is the timing of deductions for which the IRS has three tests:

  • All events that determine the fact of a liability must have occurred.
  • Economic performance has occurred.
  • The amount of liability can be determined with reasonable accuracy.

Other Issues – There are other areas the IRS will examine in audits such as payment of year-end bonuses, the accumulated earnings tax, repairs and maintenance expenses, large expenses and other areas. For companies that wish to reduce their chances of an audit or keep the audit process as short as possible, we recommend the following general rules:

  • Be thorough and detailed about documentation.
  • Make sure your vendors provide detailed invoices.
  • Be consistent: don’t make a lot of changes every year; for example, switching methods of accounting. Whenever you do make changes, be sure you have a strong supporting narrative and documentation.
  • Be sure your board minutes reflect detailed accounts of how and why changes to business practices are implemented.


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