IRS Logo
Print - Click this link to Print this page

Construction Industry Audit Technique Guide (ATG) - Chapter 9

Publication Date - May 2009

NOTE: This document is not an official pronouncement of the law or the position of the Service and can not be used, cited, or relied upon as such. This guide is current through the publication date. Since changes may have occurred after the publication date that would affect the accuracy of this document, no guarantees are made concerning the technical accuracy after the publication date.


Table of Contents
Chapter 8 / Chapter 10


Chapter 9: Income Probes

Introduction

The accounting methods discussed previous chapters control contractor income recognition. Although contractors earn most of their income from building projects including new construction and remodeling, there are other potential sources of income related to construction. These include the following:

  1. Sales of construction equipment
  2. Consulting fees
  3. Forgiveness of debt income
  4. Constructive dividends
  5. Scrap sales
  6. Interest income earned on retainages or deposits
  7. Income from court settlements

Sales may be generated in a variety of ways, including word-of-mouth, Web sites, newspapers, magazines, trade shows, showrooms, or model homes. Typically, a contractor will execute a contract detailing the total job costs and project specifications, as well as the method of payment. The contract may include provisions for retainages, which are usually kept by the general contractor until the project is complete. While the construction contract is an invaluable source of information as to the income from the job, it is also useful in determining the materials consumed, completion dates, job costs, gross profit, and change orders that could result in additional income from the job.

One of the most difficult tasks that an examiner faces is setting the scope of the income probes. This determination must be based upon the risk assessment that is completed during the pre-planning and initial phases of the examination. The initial interview is critical in establishing what type of construction is involved and how the contractor accounts for income, expenses, work in process, and the duties and responsibilities of key personnel. Without an understanding of the business operations, method of accounting, internal controls, and the involvement of the key personnel, the examiner will not be able to properly set the scope of the examination. Internal Revenue Manual (IRM) Section 4.10.3.2 offers guidance in the preparation and documentation of effective interviews. The evaluation of internal controls is discussed in IRM 4.10.3.4.

Understanding the Accounting System

General Techniques

The initial interview is the best time to determine how the accounting system works and what types of internal controls are in place. Gaining an understanding of the business is critical because a contractor could have multiple businesses operating within the same entity. An example of this would be an electrical contractor who also operates a retail sales outlet. In this case, sales could be recorded on the cash basis for the service business, accrual for the retail business, and percentage of completion for the contractor business. Establishing the type of construction involved, the method of accounting for income and expenses, work in process, and the duties and responsibilities of key personnel are all areas to be covered in the interview. See Appendix 6 for sample interview questions specific to a construction company.

The Construction Contract

The construction contract is the keystone for understanding how income is determined. The contract will specify how much the contractor will be paid and when. This information will have an impact on income recognition issues as well as the profit to be recognized from the job. The contract may also provide information about retainage provisions, incentives, awards, penalties, and change orders. Contracts will also specify whether the terms are “cost plus” or based on a bid.

Part of the income probe will be determining if reported income is reasonable with respect to cost of goods sold. Industry standards from Websites such as Bizstats.com can also be used as a benchmark to determine if the reported gross profit is reasonable.

The contract could also be a starting point for comparing materials as specified per the contract to materials actually charged to the job. This might indicate materials being diverted for other use by the contractor or to small jobs that have no contract and were not recorded in sales. Comparing the “budgeted cost” to the “actual cost” in situations where losses or nominal net profits are reported is a good audit technique when reviewing contracts. Some municipalities have computerized building permit records that could be compared with the actual contracts or job costs. Examiners may use the following examples to test income from the contracts:

  1. Compare the board feet of lumber delivered to the square footage of the building. Guides are available that provide this information. Large variances should be investigated.
  2. Compare the cubic feet of concrete purchases to the size of the slab included in the contract.
  3. Compare the square footage of the roof area to the bundles of shingles purchased and delivered to the job site.
  4. Compare the number of major appliances, HVAC units, etc., to the size of the building.
  5. Compare the contractor’s gross profit to the industry standards.
  6. Courthouse research could show properties transferred but not accounted for in the contracts.

Minimum Income Probes

The IRM at 4.10.4.3 discusses the requirement for examiners to consider gross income during the examination of all income tax returns. Certain minimum income probes are to be made regardless of the type of return filed by the taxpayer.

Minimum Income Probes for Non-business Returns

The minimum probes for income outlined in IRM 4.10.4.3.2 include questioning the taxpayer or representative regarding possible sources of income, other than those reported:

  1. Taxable sources
  2. Non-taxable sources
  3. Bartering activities

The responses to these questions concerning possible sources of unreported income should be summarized and referenced to the workpapers that document the interview questions. Internal information, such as the Currency and Banking Retrieval System (CBRS) which is used to track cash transactions over $10,000 and Information Returns Processing (IRP), should also be analyzed to ensure that all business or investment activities are listed on the return. Consideration of possible bartering income is also part of the minimum income probes. Based upon the analysis of income, external sources (third parties) may be used to corroborate the information received or establish an understatement of income. Under IRC Section 7602(c), third party contracts may not be initiated before giving advance notice to the taxpayer that such contracts may be made as part of the examination. See IRM 4.10.4.5.3.6 for a discussion of the procedures to initiate third party contracts.

Minimum Income Probes for Individual Business Returns

IRM Section 4.10.4.3.3 expands the minimum income probes to include an analysis to determine if reported income is sufficient to support the taxpayer’s financial activities. There could be unreported income, overstated expenses, a simple math error, or a combination of these items that could indicate the taxpayers did not have sufficient funds to support their financial activities. Several audit procedures should be utilized:

  1. Prepare a preliminary cash transaction (Cash-T) account based upon the tax return data and updated with new information obtained during the examination. For contractors, the job records showing work in process that may not be reported on the return, but may have a substantial economic impact will modify the preliminary Cash-T. Additional information may be required from the taxpayer if the Cash-T is materially out of balance.
  2. Tour the business sites and record any observations or comments about the business operations in the workpapers.
  3. Evaluate the internal controls to gain an understanding of the taxpayer’s business operations. Conclusions reached by the analysis of internal controls should be documented in the workpapers. See the discussion following this section about the evaluation of internal controls.
  4. Reconcile the taxpayer’s books and records to the tax return. If the taxpayer uses double entry accounting, a book-to-tax reconciliation should be available from the taxpayer.
  5. Analyze the personal bank statements and the business bank records. Normally the minimum analysis would be to compare the total deposits with the reported gross income. Bank statements can also provide information about other accounts, automatic transfers, etc.
  6. Based upon the information gathered, the scope of the examination of income will be expanded or contracted.

Minimum Income Probes for Corporations, Partnerships, S Corporations and Other Business Returns

According to IRM 4.10.4.3.4, the examination of gross income on a business return for corporations or other business entities should include the following steps at a minimum:

  1. Prior to contract, prepare a comparative analysis of the balance sheet and income statement using the assigned year and prior and subsequent years if available. This will assist in the identification of issues to be examined.
  2. Evaluate copies of the tax returns of significant shareholders or partners (greater than 50% direct or indirect ownership) for examination potential, related transactions, or possible diverted funds.
  3. Prepare a comparative analysis of the balance sheet and income statements including prior and subsequent years, if possible.
  4. Reconcile Schedules M-1 and M2 and the trial balance to the return.
  5. Analyze the adjusting journal entries and reconcile the trial balance to the general ledger.
  6. Analyze a significant balance sheet accounts which show substantial increases or decreases, especially those that relate to income, e.g., deferred revenue, reserves, shareholder loans.

The depth of the bank record inspection will depend on the internal controls, the analysis of the primary shareholder/partner’s returns, and the judgment of the examiner. At this point, the examiner should have a solid basis for determining if there is potential for unreported income and if the books and records are reliable. When dealing with construction returns, the method of accounting is always important, because of the impact on income recognition. This could result in a technical adjustment to income.

Internal Controls

The evaluation of internal controls is discussed in the IRM at 4.10.3.4. Examiners are required to evaluate the existence and effectiveness of internal controls for all types of business returns. Even in the small business environment, where the owner-managers control the entire operation, it is essential to evaluate internal control to determine the appropriate audit techniques to be used. The type of business, the records, and the owner’s financial status should be considered as part of the evaluation of internal controls.

What exactly are internal controls in a small business environment? When would they be considered inadequate to the degree of requiring an indirect method? Does the lack of good internal controls mandate the use of an indirect method? Conversely, do good internal controls automatically negate the use of an indirect method?

The answer to these questions is for the most part a judgment call by the examiner. It would be rare that a sole proprietor would be denied unlimited access to the cash resources of the business. While there could be a record keeping system that incorporates a certain level of checks and balances, the credibility reverts back to the owner’s willingness to adhere to the established procedures.

In the absence of legal requirements for contractors, such as bonding or government contracts, for the most part a sole proprietorship with no employees is considered to have very weak or nonexistent internal controls. This conclusion would normally require strong consideration of an indirect method during the course of the examination. The exception would be a result of extenuating circumstances justifying a decision not to pursue an indirect method.

The next level would be “weak” internal controls. This might occur where the owner has occasional or limited access to the cash resources of the business. An example might be a larger Schedule C with an in-house accountant. The staff prepares the majority of the banking transactions. The owner, however, has the opportunity on occasion to skim cash sales and circumvent the control procedures that are in place.

In similar situations, examiners will need to consider the following factors when deciding whether or not to pursue an indirect method:

  1. Type of business involved extensive cash transactions;
  2. The ease of skimming cash such as a large number of unidentifiable customers versus a small number of traceable customers;
  3. Established gross profit ratios such as the fact that the business is operating well below the normal gross profit ratios may indicate skimming practices are present;
  4. The taxpayer’s standard of living, such as a higher standard of living than the amount of income reported may indicate potential skimming;
  5. Cash expenditures not reflected in the taxpayer’s records that are identified by a courthouse records check; or
  6. A high percentage of cash expenditures for business or personal expenses and some or all are not reflected in the taxpayer’s records.

The other end of the scale is a business with strong internal controls. This might be evidenced by an elaborate double entry record keeping system; periodic in-house audits; annual certified financial audits; an outside accountant who provides monthly write-up services; non-related owners with equal involvement in the business operations; or limited cash transactions with easily traceable customers. Under these circumstances, the general rule would be not to pursue an indirect method, and the exception would be where extenuating circumstances dictate otherwise. The key steps to evaluating internal controls are:

  1. Understanding the control environment,
  2. Understanding the accounting system, and
  3. Understanding the control procedures.

First, the control environment is made up of the many factors that affect the policies and procedures of the business. The examiner must understand how the business operates. Interviewing the taxpayer and/or the representative and touring the business are integral steps. Second, gaining knowledge of the accounting system provides information about many of the day-to-day business operations. Finally, the control procedures are the methods established to assure that the business operates as intended. The separation of duties is the primary control procedure because it will reduce the opportunity for any one person to both perpetrate and conceal errors or irregularities. The greater the number of employees, and the more complex the business, the more likely some formal control procedures will exist.

In conclusion, the internal controls of a business must be evaluated and discussed in the workpapers as a mandatory item on every business return examination. The workpapers should include a statement regarding the accessibility to cash by the owner/manager, the quality of internal controls overall, and the effect the internal control environment had on the verification of income.

Audit Techniques for Evaluating Internal Controls

The internal control system should be tested for compliance with the procedures as described in IRM 4.10.3.4.5.3. Observe a transaction through the entire accounting process. Look for consistency in recording similar transactions. At this point, the scope and depth of the examination can be determined. If the books and records are reliable, the examination can include direct testing of transactions, such as tracing specific items to receipts. However, if it is determined that the books and records are not reliable, the examination should include indirect analyses. Because the examination of the books and records will reveal the likelihood of material errors, or that transactions were valid, determining reliability through internal control analysis is a key step.

Use of Indirect Methods

Introduction

Smaller contractors, not faced with bonding or similar requirements for financial statements and performance verification, may improperly report income for only a portion of their work. For example, they might limit income to the amount reported on Forms 1099. Some contractors have been willing to work for 20% to 25% less on the condition that no Form 1099 is issued. This has an adverse affect on the industry as well as on the government.

With the proliferation of check cashing schemes, payment with a check is an insufficient control to validate income via bank deposit records. The auditor should look to some central element of the specialty contractor's business and measure that factor to confirm the reporting of gross income by an indirect method. With a small contractor, the auditor can also look at the owner's return, county record information, and life-style/assets to gain a reasonable assurance as to the economic reality of reported income. As always, the examiner’s judgment will be required to determine if the examination should be expanded to include the use of indirect methods of verifying income.

Indirect Methods - Overview

At some stage of all business return examinations consideration must be given to the use of an indirect method. Equally important is the proper work paper documentation of the decision to pursue (or not to pursue) an indirect method of income reconstruction. With the passage of the Revenue Recognition Act of 1998, the examiner must document the likelihood of unreported income before proceeding with an indirect method. IRC Section 7602(e) provides that the Secretary shall not use financial status or economic reality examination techniques to determine the existence of unreported income of any taxpayer unless the Secretary has a reasonable indication that there is a likelihood of such unreported income.

When the records are incomplete, or there are other indications that the books and records are not reliable, income may be estimated by using other methods such as analyzing building permits, commissions paid to the sales staff, or applying gross profit percentages to jobs. The decision to use other estimates of income or to expand the scope of the income probes should be made after evaluating the results of the initial income probes. The decision making process must be documented in the workpapers, and updated as information is received. The use of an indirect method of reconstructing income should be considered when:

  1. A review of the taxpayer’s prior and subsequent year returns show a significant increase in net worth. In the case of a corporation or partnership, this determination is made on the shareholder's return or the partner's return.
  2. Gross profit percentages change significantly from year to year or are unusually high/low for that business.
  3. The taxpayer’s business and personal expenses exceed the reported income per the return and attempts to reconcile material imbalances have failed.
  4. The taxpayer’s bank accounts have unexplained items of deposit.
  5. The taxpayer does not make regular deposits of income, but uses cash instead.

Types of Indirect Methods

The code and regulations do not define or specifically authorize the use of indirect methods. The authority to challenge a taxpayer’s income determination is under IRC Section 446(b). If the taxpayer has regularly used no method of accounting or if the method used does not clearly reflect income, the computation of taxable income shall be made under such method as in the opinion of the Secretary does clearly reflect income. The application of the various indirect methods is outlined under the IRM at sections 4.10.4.6.3 through 8. These include the following:

  1. Bank Deposit Method;
  2. Cash Transaction and Source and Application of Funds Method;
  3. Net Worth Method;
  4. Percentage of Markup Method;
  5. Unit and Volume Method; and
  6. Potential Defenses to Indirect Method Computations.

In addition to a discussion of the relevant case law and the indirect method computation, the IRM discusses each method in detail. In theory, each method applied properly should yield the same result. However, there are situations that indicate the use of a specific method may be more appropriate. For example, the bank deposit method is recommended in the following situations:

  1. The taxpayer’s books and records are unavailable, withheld, or incomplete.
  2. The taxpayer deposits most income as verified during the examination.
  3. The taxpayer pays most business expenses by check.
  4. The taxpayer used the bank deposit method to report income.
  5. The taxpayer’s records indicate numerous cash expenses.
  6. The assets and liabilities are stable from year to year.
  7. A large volume of unsorted bills, invoices and receipts are submitted in support of items appearing on a return.
  8. The taxpayer’s books and records appear complete and accurate, but a method to probe for unreported income or confirm the accuracy of the books and records is needed.

The Cash Transactions and Source and Applications of Funds methods are recommended in the following situations:

  1. If the review of a taxpayer’s return indicates that the taxpayer’s deductions and other expenditures appear out of proportion to the income reported.
  2. The taxpayer’s cash does not all flow from a bank account that can be analyzed for its source and subsequent disposition.
  3. There is little or no increase in the net worth of the taxpayer, yet, based upon expenditures of the taxpayer, it becomes apparent that the taxpayer has other sources of income.
  4. The taxpayer makes it a common business practice to convert receipts into cash for the purposed of paying claimed business expenditures.
  5. If only one or two years are under examination.
  6. The small amount of time needed to be expended, as compared with using the net worth method.
  7. The taxpayer has many transactions involving assets and liabilities.

The net worth method is recommended in the following situations:

  1. Two or more years are under examination.
  2. Numerous changes to assets and liabilities are made during the period.
  3. No books and records are maintained.
  4. The books and records are inadequate or not available.
  5. The taxpayer withholds the books and records.

The percentage of markup method is recommended in the following situations:

  1. When the inventories are a factor and the taxpayer has nonexistent or inadequate records.
  2. Where a taxpayer’s cost of goods sold or merchandise purchased is from one or two sources and these sources can be ascertained with reasonable certainty. In addition, a reasonable degree of consistency as to sales prices exists.

The unit and volume method is recommended in the following situation:

  1. The examiner can determine the number of units handled by the taxpayer, and also knows the price or profit charged per unit.

Clearly, the examiner’s judgment is a crucial factor in determining the best method to pursue when the examination indicates the use of an indirect method. With the exception of the unit and volume method, any of these methods would apply to construction returns. Construction activity results in the production of tangible personal property so the cost of the materials can usually be determined. Most materials used in construction are not exotic, so pricing is generally not a barrier to determining job costs.

For example a home builder who constructs an average 2,000 square foot home, 13,127 board-feet of framing lumber; 3,100 square feet of roofing material; 3,061 square feet of insulation; 15 windows; 12 interior doors; and 2,085 square feet of flooring material would be required. The average material usage would give the examiner a benchmark to use for determining income based on costs. (National Association of Home Builders, http://www.nahb.org.)

As policy, when an indirect method results in an understatement over $10,000, it is mandatory for the examiner to discuss the case with the group manager. The purpose of the discussion is to consider expanding the scope of the examination and to evaluate any elements of fraud. Fraud potential should always be considered in an examination when unreported income is an issue. The taxpayer’s explanations or lack thereof may help distinguish between civil and criminal fraud. It is important to document the case file for the responses to interview questions, reliability of books and records, or any other indications of fraud.

Miscellaneous Income Sources

Income may also arise from other sources. Some of the more common ones are:

  1. A contractor may have interest income from escrow accounts, retainage accounts, or deposits. Reconciling the IRP transcripts may reveal unreported interest income.
  2. Income from a remote construction project could be omitted. Generally, expenses will be accounted for, so a careful understanding of the books and records is crucial.
  3. It is not unusual for a contract to be involved in some litigation over complicated construction contracts. The income from claims that are subsequently settled by court decisions or arbitration may not be reported.

Conclusion

There are several resources available to the examiner when the taxpayer’s business is construction related. A potential resource is the IRS website (www.irs.gov) which discusses various construction issues. This information is updated with court cases and other documents outlining the government’s position on various construction accounting issues. Because many construction businesses are sole proprietors, issues are found on individual and business returns. An understanding of the industry is vital for examiners to complete a quality examination.

Certain auditing techniques should always be applied when auditing a contractor. Special attention needs to be given to the possibility of unreported income. The contractor should be interviewed and asked to explain the operation of his or her business. The construction contract should be reviewed to see how income is to be received. Income probes should be performed. Other sources of income common to contractors should be investigated. And internal controls should be reviewed. If the results of these reviews indicate the probability of unreported income, indirect methods of determining income should be considered.

No magic formula exists to use in examining contractors’ income tax returns. The examiner must use good judgment as well as innovative techniques when faced with either inadequate or non-existent books or records. Using other resources to estimate income can be sustained when the evidence is supported by increases in net worth or living expenses.

Rate the Small Business and Self-Employed Website

Page Last Reviewed or Updated: 07-Aug-2014