Retail Industry ATG - Chapter 3: Examination Techniques for Specific Industries (Electronic Business, Online Retail)
NOTE: 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.
Chapter 3: Examination Techniques for Specific Industries
(Electronic Business, Online Retail)
Electronic business (E-Business) encompasses a wide range of emerging and evolving concepts and technologies. Generally, e-business consists of business transactions conducted over open computer networks.
To most people, e-business implies online shopping, but web shopping is only a small part of the e-business picture. E-Business also refers to other business transactions including online stock and bond transactions, Business-to-business purchases (EDI), and electronic telemarketing. In retail businesses the examiner is likely to find that retailers make a substantial percentage of their purchases of goods and supplies online
Retail e-business sales for 2003 were $55 billion, according to the U.S. Department of Commerce. 2004 has again seen a dramatic increase in online retail sales increasing to nearly $69 billion. There are a significant number of Small Business/Self-Employed taxpayers involved in online retail, including Catalog and Mail Order Sales of Automobiles & Parts, Specialty Items, Music, Videos, Books & Magazines, Electronics & Appliances, Computer Hardware & Software, and Clothing.
With the increased awareness and popularity of the Internet, individuals and businesses, both large and small can participate in e-business. The Internet is changing the way that many retailers conduct their business. Retailers are now involved in multi-channeling to a greater extent; whereby a portion of the business is still conducted at the traditional “brick and mortar” establishment and also business is conducted on the Internet becoming “click and mortar” businesses. Many retail and service businesses use the Internet for advertising for their traditional businesses in which the sales transaction of the product or service cannot be or is not consummated online.
As the influence of the Internet grows, conducting business-to-business commerce on the Internet will expand greatly, and become more of a routine part of commerce than it is today. Even small businesses are increasingly utilizing the Internet to conduct business transactions. This increase in rate of electronic business promises to be faster than any other technological innovation to date and its implications far more profound.
Online Retail Sales have shown a significant growth of 243 percent for the period 2000 through 2004, with sales of $28.3 billion in 2000, rising to $68.9 billion through 2004. (Source: U.S. Department of Commerce Census Bureau.)
Internet Investigative Tools
How does the examiner know if the taxpayer is involved in e-business or has a web site? There is no definitive means of determining whether or not a taxpayer is involved in e-business. Here are some suggested audit techniques to help make that determination:
Ask the taxpayer if he/she has a web site. Use a search engine.
Most businesses want high visibility to reach customers and will register their site with the major search engines.
Look in the yellow pages to see if the taxpayer advertises a website.
Business cards will often have the name of a website on it or an e-mail address. If the domain name included in the e-mail address is similar to the taxpayer's business name, then it is very likely the taxpayer has a business web site.
Look for deductions that are common for e-business:
Website development costs paid for software used to create a website or to an application service provider.
Larger than normal depreciation deductions for web servers, networking equipment, and payments to Internet access providers.
The examiner of a retail business should always consult the Internet for possible websites or links to the business under examination or to unknown businesses belonging to the taxpayer. Inspection of the taxpayer’s website is every bit as important as the inspection of the place of business. Internet Investigative Tools are available to assist examiners in their examinations. What can these tools do for the Revenue Agent? After the agent has determined an Internet presence for the business or promotion the agent will be able to identify possible third-party contacts to be made and related websites and other possible businesses and relationships.
Ask the taxpayer. This question must be asked during the Initial Interview.
Perform Google searches for the Domain Name based on the business and individual names.
Save the current website content using Internet Explorer. Saving the website content before the taxpayer closes it down or places security on it such as “members only” registration is important to the development of an unreported income case involving online retail sales.
Perform a LinkPopularity search to determine linked websites, related websites and other websites under the control of the taxpayer to determine other possible sources of income for summons action.
Use Whois to locate the Registrar and summons records.
Use Whois to locate the Responsible Party and summons records
(*The Internet Archive is a database of archived webpages dating back to 1996. The search interface for the Internet Archive is the Wayback Machine. Using the Wayback Machine, it is possible to search for the taxpayer’s website. The results displayed will show all archived copies of the website available. This search will allow the examiner to determine what the website contained during the year of examination as well as historical information. Did the online business really start in 2004 or was there activity prior to that year? What were the product lines that were being sold online during the year of audit? Are those product sales included in income?)
Audit Techniques & Interview Questions
Do you have an Internet presence? (web site, web page, e-mail, banner for business purposes)
Do you conduct business transactions over the Internet? (Accept orders and/or payments over the Internet?) (What types of records are maintained for these transactions? All electronic? Paper documents?)
What products, services or memberships may be purchased on your web site or through the use of email?
When was the web site "opened" for business? Did the business exist prior to creation of the web site? Is the business conducted over the Internet separate or distinct from the taxpayer's historic line of business?
What domain names have been registered either by you or on your behalf? What domain names do you have control over? Please include the date of registration and the name of the registrant.
How is the fee for Internet connection services determined?
How was your Internet web site developed, i.e. outside consultant, internal staff, web site design software? Details regarding all consulting fees, employee salaries, design software, etc. should be requested.
How many employees are engaged in the Internet-based business activity? Secure a list of the employees, job titles, compensation, etc., responsible for web site design and web site hosting.
How much has the taxpayer paid to outside vendors including non-employee compensation, for web site development and web site hosting?
What type of credit cards does your financial institution(s) accommodate?
What is the name of the financial institution(s) that clears your credit card receipts? Was an application or merchant services sign-up form completed for the credit card clearing services?
Does your ISP or the entity that is providing you server space process your credit card transactions?
Have you used any other financial institutions in conjunction with your web site?
Does your financial institution(s) provide:
Prepaid card issuance and acceptance?
What type of purchase payment enabling software do you use? Make note of the vendor name and address. If the taxpayer does not know the name of the software, ask if the ISP hosting the web site is providing the software.
How are credit sales handled and how are they recorded in gross receipts?
How are non-credit sales handled and how are they recorded in gross receipts?
How is information for approved or authorized credit card product purchases processed?
What is the sequence from order entry to shipment?
How are products shipped and which shippers are used?
Who are your major suppliers and vendors?
From where are shipments made?
Do you have any paid referral or advertising contracts with other Internet web sites? If the answer is yes, obtain copies of the contracts.
Do you swap (barter) links, banner space and server space with any other businesses?
Do you have any foreign operations?
Do you have direct or indirect control over any foreign corporations, foreign partnerships, foreign trusts or any other foreign business enterprises?
Do you have any direct or indirect control over foreign bank or other offshore accounts?
Identification of E-Business Cases:
When you are first assigned a return for examination, you may not immediately know a taxpayer has an e-business. The return, however, may have some E-Business indicators. The most obvious indicator on a tax return may be the business name. If one of the gTLDs (e.g. .com, .net, etc.) is a part of the name or if the name is preceded by www, the business is likely to be in e-business. Another indicator may be found in the explanation of the Business Activity (Product or Service). Internet businesses may use words such as Internet Service Provider, web host, web design, web master, or online in the descriptions.
Review the instructions for the preparation of Forms 1040 Schedule C, 1120-S, 1065, and 1120 with respect to the “Business Code” line item for each form. This code is referred to as “Codes for Principal Business Activity and Principal Product or Service” and is indicated to be based on the North American Industry Classification System (NAICS). E-Business returns may be identified using NAICS.
|Forms||NAIC Code||Explanation of Business or Products|
|1120, 1065, 1120S, 1040/C||425110||B2B Electronic Markets|
|454110||Electronic Shopping & Mail Order Houses|
|516110||Internet Publishing & Broadcasting|
|518111||Internet Service Providers|
|518112||Web Search Portals|
|518210||Data Processing, Hosting & Related Svcs|
|541511||Custom Computer Programming Services|
|541512||Computer Systems Design Services|
|541513||Computer Facilities Management Svcs|
|541519||Other Computer Related Services|
|1040/C-Only||519100||Other Information Svcs (News, Synd, Lib)|
Expenses contained in the Other Deductions line item may provide indicators of Internet activity. Below is a list of expenses that a business witha website might deduct:
|Web site design costs||Domain name registration fees|
|Web maintenance costs||Internet service provider fees|
|Cable modem access||Web page hosting fees|
|Web consulting fees||Domain name cost|
|Network service fees|
Many tax returns contain a supplemental depreciation schedule. Assets included on the depreciation schedule may also indicate that the business is involved in the Internet. These assets may include the following:
|Servers||Significant computer purchases|
|Phone Lines||Domain name|
|Web site design costs||Switches|
An unusually large amount deducted for Rental/Leasing Expense and/or Utilities may also be indicators that the company is involved in Internet activity. Many taxpayers do not have the capital necessary to fund the initial investment for equipment and peripherals needed for Internet activity. These taxpayers rent or lease the equipment and peripherals as an alternative.
More and more traditional brick & mortar” businesses in the retail and services trade are turning to the Internet as another market and becoming what is referred to as “click and mortar” businesses, combining their traditional business activities with the virtual world of the Internet. This may not be obvious to the examiner upon review of the return during the pre-planning stages.
If there are no indicators on the return or if the indicators are not conclusive, other references may also indicate that the taxpayer is involved in e-business. A Yellow Pages ad, for example, may list a web address. A company with a web site will usually include the address in their advertising, brochures or pamphlets, signs on the building, business cards, company letterhead, vehicles, and receipts or invoices. A Google search for the business is also an excellent pre-planning tool to determine whether the taxpayer is involved in online sales or services. More advanced searches are recommended to identify all websites used by the taxpayer and business.
Once the audit has started, the most obvious way to find out if the taxpayer is involved in e-business is to ask. It is important to ask even if there are no indicators of an online presence for the taxpayer. See the recommended Interview Questionnaire and the Explanation for the questions in the chapter Appendix.
The potential for omitted income is greater in E-Business, due to the borderless and paperless feature of the organization. Another large segment of E-business transactions is internet bartering.
The examiner should question the taxpayer for the procedure when a sale of a product is conducted on the taxpayer's website, for example, can the order be placed on-line and payment submitted on-line? What type of payment is the taxpayer accepting if sales are occurring on the Internet? How can the examiner verify that all sales are being reported? The examiner must determine if the business offers its clients the opportunity to purchase directly from a web-based catalog. “Walk me through various types of transactions.”
It is important for the examiner to review the taxpayer’s web-pages for E-payment sources such as PayPal, Visa and MasterCard, then tie those sources to the Books and Records and then on to the Tax Return. This is an important audit technique for online retail. Look for those items of income that should be there but are missing. Evidence of an unreported online business can also be found by tracing credit card payments or following up on invoices providers.
Any business that operates a website will receive advertising income for banner ads and pop-up ads that appear on their website. Additionally, each time a site visitor clicks onto the ad, another fee is paid to the site owner. Be sure to ask how this income is accounted for. Many times there is a counter on the site that indicates the number of visitors to the site that would give the examiner an idea of the amount of traffic the web site receives. If the examiner can determine the “click-through” rate charged, a good estimate of this income can be made. (Often this rate is between 5 and 10 cents per click.)
With online retail, the reconciliation of shipment costs with both COGS and Income is another quality audit technique. The examiner should consider the average mark-up based on purchases reported and not reported to identify any unreported income. The Percentage Mark-up Technique for the determination of Income based on Cost of Goods Sold Purchases should be considered and employed when appropriate.
Point-of-Sale software issues (ZAPPER) and the fact that taxpayers have the ability to edit tax and accounting records in most versions of commercially available software are discussed elsewhere in this guide. Needless to say, examiners must be vigilant for any indications of income or expense record manipulation by the taxpayer.
Cost of Goods Sold
Cost of goods sold will not differ significantly for businesses involved in e-business. Since there is no fixed location, shipping costs will be evident and the examiner should question the taxpayer regarding the method (FedEx, USPS, UPS, etc.). Another clue to business-to-business internet purchasing is when the ‘ship to’ address is different from the ‘purchaser address’. This is indicative of a more complex business structure that could involve a possible Offshore aspect to the examination. Any Offshore issues involving Online Retail should be referred to the E-Business & Emerging Issues staff for assistance.
Some expenses of an online retail business will be different, but the same tax laws apply as those for a traditional retail establishment.
Online Purchases and Expenses present a challenge as usually there is no evidence other than the electronic document, which can be easily manipulated. Electronic records should be tested for accuracy and any adjusting entries scrutinized. If the books and records appear questionable and Internal Control is lacking, the examiner should consider third-party contact for significant and/or reoccurring expense items.
Potential Tax Issues
- Not a trade or business – When a taxpayer has claimed losses over several years from online retail activity which was used to shelter ordinary income from other sources, a determination should be made whether this activity is a business or a hobby. These losses often stem from abusive deductions for expenses such as auto expenses, travel, and in home office allocations. Allowance of these items is questionable under several IRC Code sections including sections 162, 183, and 262. (Home-based business)
- Tax Shelter – Similar to the above scenario, except that we have identified a systematic scheme to obtain losses and credits that are not allowable under IRC sections 162 and 44. (ADA Credit for Website Improvements)
- Cost of Goods Sold - Revenue Procedure 2000-22 excepts qualifying taxpayers with average annual gross receipts of $1,000,000 or less from the requirements to account for inventories. However, if a taxpayer decides not to account for inventories, the taxpayer is required to treat what would have been treated as inventory as a material or supply that is not incidental under Treasury Regulation section 1.162-3. The result is that the deduction is deferred until the material or supply is consumed or sold. This is a potential issue for online retail.
- Failure to Report or Failure to File – Information available indicates that the taxpayer has an online retail site, but the examiner cannot ascertain how the proceeds were reported. There is no Schedule C, Partnership, or Corporate filing that has been identified or the taxpayer is a nonfiler. An examination must be conducted to determine tax liability using Indirect Methods and Third-party Contacts and Summonses.
- Omitted Online Retail Sales for an established “brick & mortar” business. One easy way to understate income is to not recognize an entire income stream such as the online retail segment of an established traditional retail business. Segregated income streams are easily concealed by diversion. This is an example of the importance of using Internet Investigative Tools to determine whether a traditional retail business has expanded into an Internet presence. Techniques discussed earlier in this chapter will be required to develop the case.
- Use of Limited Liability Companies and Trusts structures and no 1040 returns filed. This scheme has been identified in the field involving online retail and online services businesses. An LLC is formed as the business entity for the online retail business, with Grantor Trust Partners creating a TEFRA partnership at the LLC level. The individuals involved in the business do not file 1040 returns.
- The tax treatment of the following items may result in potential tax issues. Many of these potential issues boil down to capitalization versus expensing and timing of deductions. The tax treatment of these items is still under consideration by Counsel and issues involving the tax treatment of these items and online retail should be referred to the E-Business & Emerging Issues staff for assistance.
- Business Start-up Costs (Internet Business)
- Acquisition of Domain Name(s) and Website Development Costs
- Acquisition of Hardware
- Acquisition of Intangibles, including Costs of Production of Literary Content, Graphics, Sound or Video
- Acquisition of Software and Software Development Costs
- Lease Expense
- Catalog Costs
- Research & Experimental Expenditures and Credit
Summons Resources for Online Retail Case Development
During the course of an examination of an online retail taxpayer, it may be necessary to issue summonses to third parties. Suggested summons language
for Responsible Parties, Registrars, Internet Service Providers, Internet Access Providers, Credit Card Companies, PayPal and Other E-Payment Providers is available on the E-Business & Emerging Issues website.
ARIN American Registry for Internet Numbers
B2B Business to business transactions, such as making online purchases from supplier.
B2C Business to consumer transactions, such as when a consumer makes an online purchase from a business website.
Bridge A device linking Local Area Networks (LAN) together or two segments of the same LAN.
Broadband A type of transmission where a single medium (typically fiber optic) can carry several channels at once.
FTP File Transfer Protocol.
Gateway A device linking LANs that may be using different networking protocols to communicate
HTML HyperText Markup Language
ICANN Internet Corporation for Assigned Names and Numbers
IP Internet protocol
Terminal Server A point of access to a network. Also called remote access servers.
WWW World wide web.
EXHIBIT 1: E-Business
Explanation for E-Business Online Retail & Services Interview Questions
- Do you have an Internet presence? (web site, web page, e-mail, banner for business purposes)
Explanation – It is important to determine the extent of the taxpayer’s involvement with the Internet. Keep in mind that a web presence does not necessarily mean that the taxpayer is involved in e-business. A business may have a web site that is purely for advertising purposes with nothing sold online. For example, a national restaurant chain might have a web site that contains their menu and a listing of their locations.
- Do you conduct business transactions over the Internet? (Accept orders and/or payments over the Internet?) (What types of records are maintained for these transactions? All electronic? Paper documents?)
Explanation – The examiner will need to determine the nature of business transacted as well as the volume and types of records maintained for examination.
- What products, services or memberships may be purchased on your web site or through the use of email?
Explanation - The interview process often provides leads that are very valuable to checking and verifying reported income later when you are examining the actual books and records. For example the taxpayer may describe a list of products a, b, c, d & e. Yet when you are looking through inventory records you may only see a, b, & c on hand. Maybe you are auditing the 2003 tax year and the taxpayer did not start selling d & e until 2004, or maybe they omitted the sales of these particular items from their tax return.
- When was the web site "opened" for business? Did the business exist prior to creation of the web site? Is the business conducted over the Internet separate or distinct from the taxpayer's historic line of business?
Explanation – How you audit a business depends in significant part on what was the driving force behind the expansion of the business. Is the Internet-based business an extension of an existing business or does it represent a completely new endeavor?
An important first step in this regard is to establish the date that the web site became operational. The date the taxpayer obtained their domain name may coincide with the date the web site opened for business. Invoices from paid consultants or purchases of software, and service dates on bills from the taxpayer’s Internet Service Provider (ISP) are all indicators as to when a web site became operational or there was a significant upgrade in the capabilities of the web site to offer interactive business services.
- What domain names have been registered either by you or on your behalf? What domain names do you have control over? Please include the date of registration and the name of the registrant.
Explanation - The domain name is the web site address used to find the site on the Internet. As a revenue agent, you already know the importance of conducting a tour of a business. If you were auditing the XYZ chain of bookstores, you would look to see the addresses of the separate bookstores, how many cash registers each had, etc. Each web site is just like a separate bookstore in the physical world with a separate cash register. In the world of electronic business, each domain name gives the taxpayer a storefront with its own unique cash register. Identifying the number of web sites a taxpayer has is no different than trying to identify all the possible business sites or cash generators on your tour of a more earthbound business.
Domain name information can be obtained from InterNic. InterNic is the directory service under contract with U.S. Government to register and track domain names. InterNic’s registry includes the name, address and phone for the registrant, the billing and technical contact points, the host site name and its Internet Protocol (IP) address. Domain names may be acquired from domain name brokers. Third party domain name brokers gang register domain names with InterNic for a nominal fee on the speculation that the name may appreciate in value. The resale value may exceed several hundred or even several thousand dollars. These names are tentatively believed to be capital in nature with the cost being amortizable.
- How is the fee for Internet connection services determined?
Explanation - The stock reply from the taxpayer is "From the bill." However, the answer we are looking for is not so obvious. The fee charged by the ISP might be either connection or volume based. A connection-based fee is based on the simple fact that the taxpayer is paying for basic point of presence (POP) on the Internet.
A volume-based fee is based upon what is known as bandwidth and storage volume. You can have either or both together. Bandwidth refers to the ability of a site to handle access volume. For example a million simultaneous hits might be more then most servers could sustain without crashing. As access to a site grows, the host must expand its ability to service multiple users. This is accomplished by expanding bandwidth. Therefore, a large bandwidth implies a high volume web site.
Storage volume is associated with the sophistication of the web site. The web site is resident on the host company’s computer as a sub directory. The sub directory consists of separate text, graphic, video, and sound files. The larger and more graphics-heavy the web site, the more storage space is required when someone accesses the web site.
In addition to bandwidth and storage, volume-based billing may also include charges for other ancillary services. These may involve special routines such computer graphics interchange (CGI) routines, Perl Scripts and server side applications. The billing for these extras is not necessarily volume based, but is generally associated with high volume sites. In summary, the higher cost of a relatively more sophisticated web site implies a higher volume of business.
- How was your Internet web site developed, i.e. outside consultant, internal staff, web site design software? Details regarding all consulting fees, employee salaries, design software, etc. should be requested.
Explanation - The proper tax treatment of web site development costs is the subject of controversy. Should web site development costs be expensed or capitalized? Should the costs be aggregated into one intangible asset and amortized over a period of time? Alternatively, should pre-Internet precedents be applied that would permit expensing some of the web site costs like software, and capitalizing others such as logo and trademark expenditures? It is important to quantify the various categories of web site design costs. See Questions 8 & 9 for additional discussion.
- How many employees are engaged in the Internet-based business activity? Secure a list of the employees, job titles, compensation, etc., responsible for web site design and web site hosting.
Explanation - Many Internet based businesses, especially start up companies are “sweat equity” or “bootstrap” operations. The taxpayer may do much or most of their own web site design and hosting activity rather than paying an outside party. The purpose of this question is to quantify how much of those internal costs might be associated with web development. Be alert for equity interests given in lieu of compensation for web design services.
- How much has the taxpayer paid to outside vendors including non-employee compensation, for web site development and web site hosting?
Explanation - As with question 8, we are seeking to identify and quantify the costs of web design versus hosting. Be alert in this area to issues associated with Form 1099 compliance and employment tax.
- What type of credit cards does your financial institution(s) accommodate?
Explanation - An Internet business can accept various credit cards from various sources and have them processed through multiple financial intermediaries. We cannot emphasize enough the need to examine this area in detail. Our experience to date indicates that the diversion of credit card receipts is the primary vehicle for underreporting income on the Internet. A flow chart of the transactions through the system, especially the interface between the web site and the accounting records is a useful tool in identifying “leakage” of receipts from the system.
- What is the name of the financial institution(s) that clears your credit card receipts? Was an application or merchant services sign-up form completed for the credit card clearing services?
Explanation - There is a wealth of information on the sign-up form. Ask to see copies of all the form(s). In addition to the names of the financial institution, make note of the following: a) the account numbers, b) dates opened and closed, c) changes in financial institutions.
In most businesses, the merchant receives approval as a credit card vendor from a commercial bank. Usually, a small business, such as your neighborhood hardware store, will utilize the services of a local bank. The typical flow of transactions is as follows: the merchant deposits the credit card slips to its account, the bank posts the deposit to the credit card processing account, and then as a transfer deposit to the merchant’s checking account.
There are no geographic limits on the Internet and the connection with the local financial community may be minimal for an Internet-based business. Banking and credit card relationships may be fractionalized on the Internet. For example, company A in New York may be using a credit card processor to verify account number validity, a second financial institution to provide credit card merchant (clearing) services, and a third financial institution to serve as a depository for the proceeds of the transactions. This last financial institution may be a local bank or could be located anywhere in the world. One typical scenario is to have domestic bank serve as the depository for the credit card receipts. The domestic bank’s private banking department then facilitates transfer of funds to an offshore subsidiary. The offshore subsidiary then issues the taxpayer a credit card, which is funded by the offshore account. The lesson here is that on the Internet someone different can handle each separate step of processing a credit card sale, sales slips exist only as an account number, and the final deposit can go anywhere.
- Does your ISP or the entity that is providing you server space process your credit card transactions?
Explanation - There are a number of web site hosting services that will provide a free web site in exchange for the exclusive right to process the credit card transactions originating with that web site.
- Have you used any other financial institutions in conjunction with your web site? If yes, secure the same information discussed under question # 11.
- Does your financial institution(s) provide:
- charge authorization
- transaction capture
- charge-back handling
- reporting, or
- prepaid card issuance and acceptance
Explanation - This shopping list refers to various features that a particular financial institution may provide to a typical merchant. Charge authorization establishes that a hold is placed on a customer account at the time of order to minimize sales in excess of the credit limit. Transaction capture refers to the process of recording the actual sales transaction for the merchant. Settlement refers to the actual transfer of funds to the merchant’s account in settlement of the customer charge. Charge-back handling refers to the situation where a customer objects to a particular billing. This amount is then "charged back" or offset against the merchants other settlements. Reconciliation involves the process of clearly establishing the sources and payment of sales to the actual settlement remittances provided to the merchant. Reporting is the provision of statements detailing sales activity. Prepaid card issuance and acceptance refers to what is sometimes known as a debit or prepaid card in which the customer prepays an amount. It is good until exhausted and may be replenished by the customer by additional payments. Phone cards, toll cards and some debit cards are examples of prepaid cards.
What type of purchase payment enabling software do you use? Make note of the vendor name and address. If the taxpayer does not know the name of the software, ask if the ISP hosting the web site is providing the software.
Explanation - This is an area that is changing on an almost daily basis. In order to process a payment from an Internet web site a special type of software must be in place. It utilizes the security aspects of Secure Socket Layer (SSL) type technology to make sure that credit card data can not be intercepted by anyone on the Internet. There are a number of retail software packages that enable a site to conduct business. Many of the newer ones use a turnkey, “load the software and you're in business” type approach. For a minimal fee, the software vendor will handle the actual sales activity.
- How are credit sales handled and how are they recorded in gross receipts?
Explanation- This is merely what you would do in any physical business audit. However, with an Internet based sales operation the various pieces can be very far flung and can change several times as the merchant experiments with alternative sources and institutions.
- How are non-credit sales handled and how are they recorded in gross receipts
Explanation - Are transactions that are paid for using check, e-check, money order, or even cash handled differently than credit card sales?
- How is information for approved or authorized credit card product purchases processed?
Explanation -This question is designed to address the actual steps utilized in approving and authorizing a customer credit card number for a purchase from a commercial web site. In a typical (non-Internet based) business you go into the store present your card and the merchant runs it through a machine that reads it or prepares a document. A deposit is then automatically made to his previously approved bank account. An Internet based company only needs the card number and the expiration date to process your purchase. A personal name may not be required to process the transaction online.
An Internet based company can perform the credit card approval and authorization process using various online vendors who never even see the customer. A flow chart should be used to document the steps in the purchase process just like you would for any business. The monthly processing cycles, deposit periods, and holdbacks may affect the proper reporting of income depending on the taxpayer’s method of accounting.
- What is the sequence from order entry to shipment?
Explanation - This question is a follow-on to question number 18. The answer to this question will tell such things as to when income should be accrued, inventory is relieved, and items are actually shipped. It will allow you to establish the cutoff periods that should be used in the books. The purpose of flowcharting (a.k.a. system walkthrough) and documenting (verifying audit trail) all the steps in the process is to ascertain the degree of correspondence between the physical flow of goods and services, and the taxpayer’s method of accounting. In addition to determining whether the taxpayer is using a proper method of accounting, the walkthrough may identify weaknesses in internal control that would warrant an adjustment to the scope of the audit plan for sales and cost of goods.
- How are products shipped and which shippers are used?
Explanation - This question is meant to address purchases of the taxpayer’s product by the ultimate consumer. Companies use many different shippers and common carriers. Some of the ones that are frequently utilized by Internet based companies include the U.S. Postal Service, FedEx, UPS, etc.
Several useful pieces of information may be garnered from shipping records. First, the total cost of “freight out” is indicative of the total volume of sales. Second, the information on shipping can assist with inventory related questions such as:
- relief or reduction of inventory at year end
- timing of inventory reductions
- when title passes, and
- reimbursement for insurance, shipping and handling costs.
- Finally, the shipment records can be used as an “independent third party” for internal control and verifying income reported.
- Who are your major suppliers and vendors?
Explanation - It is suggested that you document a list of product vendors from whom the business buys as a means to check sales and inventory. Look for vendors that are selling items that do not fit the profile of the taxpayer’s type of business.
- From where are shipments made?
Explanation – Unlike traditional businesses, Internet-based companies may not ship out of a warehouse that is co-located with the rest of the business. In fact, the items sold over the Internet are frequently “dropped shipped.” This term refers to the process whereby goods are shipped directly from the manufacturer to the ultimate purchaser. There is no intervening warehousing by the seller, except to consolidate items from multiple sources into one shipment to a particular customer. The use of “just in time” or “virtual” inventories may affect the allowable method of accounting, the timing of inventory reductions, recordation of consignments, and the efficacy of inventory write-downs. Additionally, the identification of items “dropped shipped” from foreign sources to foreign destinations may indicate the existence of unreported foreign source income.
- Do you have any paid referral or advertising contracts with other Internet web sites? If the answer is yes, obtain copies of the contracts.
Explanation - A business may pay other web site operators a fee for referring visitors to its site. This referral fee may be based upon activity such as the number of hits originating from the referring web site. Alternatively, it may be based upon a certain percentage of the sales resulting from customers referred from the originating web sites.
Ideally, the referral or advertising contract will describe the relationship and payment terms. However, do not be surprised if the “contract” does not contain all the signatures and legal niceties that are the hallmarks of a valid contract. Many contracts on the Internet are relatively informal affairs. It may be something as simple as a copy of a web page offering terms and prices for setting up a banner ad on another page with the deal being consummated by an exchange of e-mails between businesses hundreds of miles apart.
There are audit techniques that may be utilized to ascertain how many “click throughs” may have originated from a particular source site during a given period of time. These methods require access to the ISP’s server log, the ISP’s periodic operational data backups, as well as the taxpayer’s “statistics directory”. The latter may be found among the web site files on the host server. These techniques do not yield conclusive findings, but would only serve as an indicator. They may yield potential third parties that could be contacted for information on the volume of referrals.
Two additional limitations regarding this technique merit comment. First, web sites can change frequently and current information available on line may have absolutely no relevance to the year under audit. ISPs usually do not retain these types of records for long periods.
Second, since this information is largely circumstantial, except for the identification of the number of web site hits, it is the revenue agent’s responsibility to evaluate the merits of pursuing this line of inquiry in light of RRA ’98’s prohibitions against excessively intrusive audits and economic reality-type income probes.
While “advertising contracts” may or may not exist, payment will. Payment may be in the form of check, electronic funds transfer, or online bank check. The old collection axiom of “follow the money” is probably most appropriate. If we have a payment for advertising, we have a payee. If we have a payee, we have a payer with one or more of the following obligations: 1) to identify the payee as a party not subject to backup withholding, 2) to obtain the taxpayer identification number of the payee and 3) to issue Forms 1099. If the payer is remiss in his reporting responsibilities, the back-up withholding may be assessed. The current back-up withholding rate is 31 percent.
- Do you swap (barter) links, banner space and server space with any other businesses?
Explanation – This is a follow-on to question number 21. A link is simply a highlighted spot on a web page. When you click on the link it brings you to another web site. A link may be a highlighted name or a picture. In designing a page the webmaster chooses whether the link will be text or a picture.
A banner is similar in function to a link. Its purpose is to bring you to the web site of the advertiser. In general, banners are larger than simple text links. They frequently occupy the top fifth of the page, or extend down the side. A banner is designed to function as a kind of interactive electronic billboard. It is designed to attract attention. The most common form of bartering on the Internet involves the swap of banner space. Two businesses will place banners on each other’s web site in order to develop some synergy between the two web sites.
Recall our earlier discussion regarding the role of a host computer in supporting a web site. In general, a taxpayer’s web site is not resident on the taxpayer’s computer, but it is electronically (physically) located on a host computer owned by an ISP. The only exception is a taxpayer that owns its own host computer. The web site’s host computer is called the server.
The issue in the instant case is whether something or some service is being swapped for server space. For example, a company may provide server space in exchange for banner space on the web site, the right to process credit card transactions originating from the web site, or product.
What are the tax implications of all of these transactions? It is entirely likely that your taxpayer may tell you that they received this link, banner or server space for free. This is becoming more commonplace as costs have dropped dramatically. The reason for the practice is that it is done to increase site visitors, hits and page views. The Internet is a linked community. It is helpful to consider the fair market value of what is being bartered when considering the potential tax effect of these transactions. Fair market value is what someone else would pay for that space on your taxpayer’s web site in an arm’s-length transaction.
Storage space can be purchased in the open market for less then a penny per megabyte using hard drive storage cartridges that contain up to 2.6 gigabytes of information that sell for $35 each. File size of a graphical banner ad with animation could take up almost a megabyte of space itself on a host’s server. Is the cost of the server space the FMV? Not necessarily, cost is usually equivalent to fair market value. What really determines fair market value of a banner ad is the popularity of the web site it is on. If you are selling auto insurance, your banner will be worth a lot more if it is located on a web site hosted by large auto dealership in comparison with the web site operated by XYZ’s Junk Yard.
- Do you have any foreign operations?
Explanation – We are not restricting our concept of foreign operations to activities that require a physical presence in a foreign country. The Internet and electronic commerce transcend the limits of geography. It has created an era of micro-multinational corporations. If your taxpayer has extensive foreign sales or investments, you should consider requesting the assistance of an International Examiner. Form 2962 may be used to request the assistance of an International Examiner.
- Do you have direct or indirect control over any foreign corporations, foreign partnerships, foreign trusts or any other foreign business enterprises
Explanation – Sometimes to facilitate operations and financial activity a business here may set up foreign corporations, foreign trusts etc. If you can identify any of these foreign entities as existing then you can possibly obtain or request the foreign return documents filed by the taxpayer for these entities. Again, the involvement of an International Examiner should be considered.
- Do you have any direct or indirect control over foreign bank or other offshore accounts?
Explanation - If there are any indications of foreign bank accounts the taxpayer may be liable for filing Treasury Form 90-22.1 (FBAR) (this is not an IRS form). Failure to file the form may subject the person to a penalty under Title 31. These forms apply to situations where there is more than $10,000 on deposit at ANYTIME during the course of the year. The income tax return contains a check off block in which the taxpayer must affirmatively attest to the presence or existence of foreign bank accounts. Past experience has shown that failure to disclose the existence of foreign bank accounts can in appropriate circumstances be held to constitute the filing of a false income tax return when combined with other factors.