No one wants to be audited by the IRS. The time and expense can affect your company's bottom line - not to mention the trauma of having tax agents rummaging through your books with a crowbar.
Knowing ahead of time which issues can trigger an audit -- and what IRS tax examiners look for -- can protect your company and help you audit-proof your tax returns.
When performing an audit, IRS examiners come well armed. Over the past decade, the IRS has developed a library of Audit Techniques Guides to bring examiners up to speed on specific issues in various industries, including construction. The guides are used to train tax examiners.
So if your construction company is hit with an audit, you can expect that the IRS will be well informed and on the lookout for questionable tax stances that are common in the industry.
A Change in Your
An IRS audit challenging your method of accounting can ravage a construction company's finances. You could wind up owing more taxes and be compelled to postpone deductions. On top of that, you could be forced to change your accounting method retroactively over several years, further boosting your tax bill and adding substantial amounts of interest to your liability. And finally, the IRS would probably assess penalties.
Here are four of the top targets described in the IRS Construction Industry guide that you should be aware of:
1. Cash versus accrual accounting has been a hot button for the IRS in recent years. Uncle Sam doesn't like cash-basis accounting both because it delays tax payments and because the timing of income and expenses can be manipulated. Many companies, on the other hand, like cash basis accounting because income isn't taxed until it's received. With the more complex accrual method, a company accounts for transactions when they occur, which is not necessarily when the cash is received.
Construction firms are often frustrated by the IRS stand on these two accounting methods, particularly if the companies incur costs to buy materials but don't technically hold inventory. There have been cases when companies have ordered materials and had them delivered to job sites, and the IRS forced them to change to accrual accounting because the materials were "inventory." Auditors are likely to conclude that materials are income-producing inventory when the cost totals 15 percent of gross receipts or more.
Good news: In a major policy shift, the IRS announced awhile back that it would allow many service businesses that maintain inventory and have annual average gross receipts of $10 million or less to use cash-method accounting.
2. Long-term contracts. Examiners take a close look at the completion dates of jobs, with an eye toward determining whether a company is properly using the completed contract or percentage of completion methods.
A construction company signed a long-term contract on January 1, 2008, and on December 31 of that year, it estimated contract revenue of $10 million and costs of $5 million. The following February, the firm's employees go on strike, forcing the firm to boost estimated costs to $6 million. After the strike, the company gets an order for more work under the same contract. Estimated costs rise to $8 million and revenue to $15 million. Under IRS rules, gross income for 2008 is determined using the December 31, 2008 estimates. The increases in 2009 aren't considered, even though they were known before the company filed its 2008 tax return.
- Adapted from the IRS audit guide on the Construction Industry
Under completed contract accounting, the focus is just what it sounds like -- completion. Auditors are taught to look for signs that the end of a job was deliberately delayed, particularly when 95 percent of a job is completed one year, with the remainder held over to a second year.
Tax examiners also look for changes in a company's contracts to determine if they involve separate projects that should be treated as separate contracts.
For tax purposes, that can make the original order end sooner than you planned. And if a job calls for building identical units, auditors could determine that each unit should be treated as a separate project under a separate contract. That bars you from deferring income until all the units are finished.
3. Independent contractors. In an audit, you can pretty much count on IRS examiners checking your business for independent contractors. And if they decide an employee is improperly classified as a contractor, you can be liable for substantial back payroll taxes, penalties and other costs. The IRS also warns auditors that "smaller contractors ...may report income for only a portion of their work . . . Some contractors have been willing to work for 20 to 25 percent less on the condition that no Form 1099 is issued."
4. Nooks and crannies. Tax auditors look for indications of unreported work and income shifting between related parties. Save all payroll records, correspondence, freight bills, travel expenses and shipping tickets to substantiate your deductions. Auditors also search for -- among other things -- evidence of work done at less than fair market prices for relatives and friends and personal use of company-owned cars.
Before your company is hit with an IRS audit, talk with your adviser to make sure all involved parties have a clear understanding of the practices your company employs. Pay particular attention to cash flow and expansion plans. If you determine your tax reporting method is high risk, you may want to change it voluntarily before you hear from the IRS. This could avoid a retroactive change that covers several years and permit you to spread any tax effects over four years. If an auditor forces a change, taxes and interest are due immediately.
To learn more about this article, please contact the construction professionals at McKonly and Asbury, LLP.