4.35.2  Audit Techniques for Business Returns

4.35.2.1  (05-05-2006)
Overview

  1. This chapter discusses audit techniques for business returns.

4.35.2.2  (05-05-2006)
Preliminary Work at Taxpayer's Office

  1. The examination at the taxpayer's office may begin with miscellaneous records other than the actual ledgers and journals. Frequently, these records indicate items that the examiner should be alert for as the examination progresses.

  2. The records and the type of information to be obtained are as follows.

    1. Minute book -- This corporate record should contain information on officer's salaries, real estate leases and sales, construction contracts, lawsuits, patent applications, the issuance of new stock, the purchase of Treasury stock, and information relating to restricted stock options. As the examiner skims through the minute book, appropriate notes for future consideration should be made. The review of the minute book should not be confined to the taxable year under examination. It is advisable to cover at least some of the period immediately before and after, if necessary, the minute books should be obtained that go all the way back to the inception of the business. The correct name of the corporation should appear on the company charter that is usually kept in the minute book. This name is important when it becomes necessary to prepare a waiver to extend the statutory period of limitations. Large corporations maintain minutes of the executive committee in addition to the minute book.

    2. Original partnership agreement (or an operating agreement, if a partnership election is made by a Limited Liability Company) and all subsequent amendments and changes -- The provisions of this document should be noted. The distribution of income including partner's salaries and interest on capital and other allowances, which it may establish, should be checked against the partnership return. These allocations need to be analyzed to determine if they are proper under IRC section 704/752 rules.

    3. S corporation election -- The election should be reviewed to verify that (1) all shareholders at the date of the election signed the election and that the number of shareholders at the date of the election did not exceed the maximum number of shareholders, (2) all shareholders were individuals who were U.S. citizens or residents, estates, certain types of trusts, IRC section 501(c)(3) organizations or employee stock ownership plan (ESOP), (3) the corporation has only one class of stock and (4) the corporation is not an ineligible corporation as defined in IRC section 1361(b)(2).

    4. Audit report of independent auditors -- This report should be read. Where two reports were issued, one in detail for management and the other a condensed one for investors, the former should be secured. Income and net worth per this report may differ from income and net worth per books due to the auditor's adjusting entries not reflected on the books. Where this difference exists, these adjusting entries will be reconciling items between the books and the return. The auditor's workpapers usually explain these entries. They should be checked closely. Any qualifications or unusual comments in the auditor's report or certificates, such as expressions of opinion as to taxpayer's depreciation policy, adequacy of reserves, status of collectibility of receivables and the like, should be noted for consideration later when the items of income and expense are audited.

    5. Auditor's workpapers -- Audits, particularly of larger companies -- may frequently be simplified if the examiner is given access to the auditor's workpapers. Judicious use of such records helps to reduce the time in examining the taxpayer's books. Examples of the types of analyses often found in such workpapers which may prove useful to the examiner are accounts receivable aging schedules, or repair analyses in which each expenditure over a certain amount is described. Guidelines for Requesting Accountants' Workpapers are contained in IRM 4.10.3.

    6. Retained copy file of income tax returns -- Preceding and succeeding years' tax returns should be inspected. Items to observe are: significant ratio variations between other years and the current year; such as gross profit ratios or selling expenses to sales. Where they vary widely from the current year the examiner should make a note to determine the cause as the taxpayer's records are being examined. Balance sheet ratios or trends should also be observed. Continuation in the year of examination of prior elections concerning bad debts, inventory valuation methods, depreciation rates and methods, etc. should be verified.. Prior or subsequent year entries in the reconciliation schedules of retained earnings and the accumulated adjustments account and other adjustments account on a corporate return or of partners' capital accounts on a partnership return which affect the year under examination should also be reviewed. Retained copies of other prior year returns may be useful in certain cases, such as those requiring determination of the status of the retained earnings account, the basis of assets and depreciation allowed or allowable and the shareholder's stock basis or the partner's partnership basis.

    7. Stock transfer book -- This book contains the names of present and past stockholders with the number of shares owned and the dates issued or cancelled.

    8. Statements and schedules filed with regulatory bodies -- Companies in the public utility field are required to file certain data with regulatory agencies, such as the Interstate Commerce Commission, Civil Aeronautics Board, and State and local utility commissions. These schedules are detailed and can at times save the examiner considerable analytical work. Rules of accounting which public utility enterprises are required to adopt by regulatory commissions are not controlling for Federal income tax purposes.

    9. Financial statement for credit purposes -- Financial statements furnished grantors of dealer franchises -- Comparison of such statements with the tax return balance sheet and income statement schedule may reveal significant variations. For instance the reserve for bad debts on a balance sheet furnished a bank or a credit agency may be smaller than the reserve shown on the return balance sheet. This may indicate the reserve on the return is too high.

    10. Appraisals -- Engineers' and real estate dealers' appraisals are important in many cases, particularly in allocating real estate costs between land and building. In addition, art dealer appraisals may be useful in valuing works of art.

4.35.2.3  (05-05-2006)
General Ledger, Examination Approach

  1. The accounts contained in the general ledger will provide the examiner with an insight into the operations of the business. The chart of accounts should be requested from the taxpayer. If a private ledger is maintained, it should also be requested.

  2. The examiner should obtain an adjusted trial balance. An adjusted trial balance is a list of all general ledger accounts and the year end balance. The adjusted trial balance should be reviewed for unusual account balances. Also, it is a quick indication of the amount of accrued liabilities the taxpayer has claimed. Examination of the liability accounts is addressed in section test 2.5.2 of this manual. The examiner should be aware of all account balances with a credit balance. Even though they may be classified as an asset, a credit balance in an asset account is an indication it is in reality a liability account. An example is the bad debt reserve. It is normally recorded as a contra asset account, which is the same as a liability account.

  3. As the examiner goes through the ledger unusual or nonrecurring items should be noted. Such items fall roughly into three classes.

    1. Unusual in amount -- The examiner should be alert for month-end entries of like amounts which represent large expense items which have been debited to a deferred account and spread over several months to avoid attracting attention. The total amount of an account may be unusual in amount because it appears to be too small. For example, where there is a small repair account total in a year under examination and the taxpayer had substantial fixed assets, the small repair total may be indicative of the practice of charging repairs to other accounts less likely to be checked. The manufacturing expense account is one potential alternative for such repair charges.

    2. Unusual by source -- Source as used here means the journals from which the account was posted, as indicated in the folio column. There is a normal source pattern for most postings. Repairs or advertising expenses are generally posted from the cash disbursement journal or the purchase journal; if the folio column indicates a cash receipts journal or general journal source it may warrant a further check. Entertainment expense items from the general journal more often than not represent officers' expense. Fixed asset credits from the cash book are unusual, if the assets were sold, a general journal entry is the normal way to eliminate the cost of the asset from the books. A cash book source suggests that the total selling price instead of the cost was credited to the account. These are a few of the possible source variations. The examiner should be alert for the many more items that may be encountered.

    3. Unusual by nature -- An entry in a ledger account may be unusual by nature as well as by an account itself. Some examples of unusual entries and accounts are: Credit entries in accounts that usually contain only debits or vice versa. As an example a debit to a sales account could possibly be a bad debt write- off. Accounts that exist at the beginning of the year but do not exist at the end. For instance, the existence of a supplies inventory at the beginning of the year and no inventory at the end may indicate that the taxpayer had made an unauthorized change in the method of accounting. Conversely, the existence of an account at the end of the year, where none existed at the beginning, such as accrued wages, may indicate a similar unauthorized change. A general ledger in which the nominal accounts are not closed out to the income summary account at the end of the year. Where this situation exists, and the necessary information is not available from the auditor's workpapers, the examiner should trace the account to the tax return. This audit approach is advisable so that the examiner will uncover adjustments to the accounts that are not reflected by entries on the books.

4.35.2.4  (05-05-2006)
Net Worth Section

  1. Consider the following information when examining net worth.

4.35.2.4.1  (05-05-2006)
Purpose and Scope of Examiner's Analysis

  1. The principal purpose of an income tax examination is the verification of the taxable income shown on a particular tax return. That taxable income is the end product of the various items of income and expense on the return. Any one of these items may be an accumulation of from one to thousands of individual transactions. These individual transactions do not appear on the tax return. Accordingly, it becomes necessary to examine them in the place where they do appear and that is in the books.

  2. Since the transactions are recorded on the books according to accounting principles rather than tax law, it is likely that there will be some differences between the net income on the books and the net income on the tax return. The examiner must isolate and reconcile these differences.

  3. If a questionable item is noted in the taxpayer's books during the examination of an income or expense account, the examiner should analyze the reconciliation from net book income to net income per return to determine if the item was eliminated from the amount deducted on the tax return.

  4. The net worth section is the starting point in determining the relationship of the books and the return. There are three elements in this section at the end of any given tax year. They are:

    1. the net worth at the beginning of the year;

    2. the operating income or loss of the current year;

    3. the non-operating transactions of the current year.

  5. The examiner is primarily concerned with the second element. However, since the books and the returns may vary, the examination should not be confined only to the second element. Items, which fall in the second element on the books, may belong in either of the other two insofar as the tax return is concerned, and vice versa. The examiner must therefore check all three elements.

  6. Having defined the scope and purpose of the net worth analysis and the income reconciliation, the manner in which they are to be accomplished is the next step. In some respects the manner varies depending on the entity involved. The corporate taxpayer will be considered first.

4.35.2.4.2  (05-05-2006)
S Corporations

  1. Like a C corporation balance sheet, the net worth of an S corporation is composed of the capital account and retained earnings account. The difference is there is no reconciliation of the retained earnings account on an S corporation return. The Schedule M-2 on a C corporation is the reconciliation of the retained earnings account while the Schedule M-2 on an S corporation return is the analysis of the Accumulated Adjustments Account (AAA), Other Adjustments Account (OAA) and Shareholder's Undistributed Taxable Income Previously Taxed (PTI). The OAA will only be used if the S corporation has tax exempt income and or expenses related to tax exempt income. The PTI account will only be used if the S corporation was in existence prior to 1983 and has income that has been taxed on the shareholder's return, but has not been distributed to the shareholder or S corporation losses accumulated prior to 1983.

  2. The purpose of Schedule M-2 is to track the income, losses and separately stated items that should have been reported on the shareholder's tax returns.

  3. The examiner should remember that the retained earnings account on the S corporation balance sheet is a book number and more than likely will not tie to the amounts in the AAA, OAA and PTI, which are tax numbers. The main difference will be timing differences between book and tax. For example, if the book depreciation is less than the tax depreciation, the retained earnings account on the balance sheet will be larger than the AAA balance.

  4. Since there is no reconciliation of the book retained earnings account shown on an S corporation return, as there is on a C corporation return, the following reconciliation should be made:

    Beginning Ending Retained Earnings xxx

    Book Income/Loss (Schedule M-1, Line 1) xxx

    Less: Distributions xxx

    Subtotal xxx

    Ending Retained Earnings xxx

    Difference 000

  5. If the difference amount is not zero, a reconciliation should be obtained. There are two possible reasons for a difference, (1) The amounts on the balance sheet are wrong so the balance sheet cannot be relied on, or (2) There was an entry made directly to the retained earnings account. This would be known as an M-2 adjustment on a C corporation. As with a C corporation, any amount entered directly into the retained earnings account has by-passed the income statement and taxable income. All entries made directly to the retained earnings account should be examined to determine if taxable income is being avoided.

  6. Sometimes the distribution section of the Schedule K and the AAA are not completed or are completed incorrectly. Using the above formulas will detect the potentially incorrect entries on the Schedule K and AAA. If it is assumed that no entries were made directly to the retained earnings other than actual distributions, the amount of the distribution can be determined using the above formulas. The preparer should always be asked to reconcile any differences brought out with the use of the above formulas.

4.35.2.4.3  (05-05-2006)
Partnerships

  1. There is no great difference in principle between the net worth analysis of a corporation and a partnership. The same technique applies to both. However, relative to partnerships, the examiner must first ascertain the method of accounting used to complete the 1065 Balance Sheet. In many instances, the balance sheet of Form 1065 is prepared based on Fair Market Value to coincide with Partnership Allocation Rules. The examiner can make this determination by reviewing Part II, Block N of schedule K-1. In such instances where the balance sheet of Form 1065 was prepared based on Fair Market Value, the examiner should solicit a tax basis balance sheet from the taxpayer prior to conducting a net worth analysis.

  2. Schedule M. Reconciliation of Partners' Capital Accounts. Form 1065, is a rough equivalent of Schedule M-1. Reconciliation of Income(Loss) per Books with Income per return, and Schedule M-1 Analysis of Unappropriated Retained Earnings per Books on the corporate return, Form 1120. with Income per Return, and Schedule M-2. Analysis of Unappropriated Retained Earnings and Undivided Profits per Books, on the corporate return, Form 1120As stated in (1) above, the examiner must first identify the method of accounting used to complete the 1065 Balance Sheet.

  3. Schedule K shows total distributive partnership items. Schedule K-1 reflects each partner's share of income, deductions, or credits that are required to be set out separately by the partnership. The schedule provides for the segregation of IRC section 1231 transactions. The examiner should remember that the decision on whether gain or loss on such assets is ordinary or capital should be deferred until transferred into the partners' individual returns. For each at risk activity, Schedule K-I requires the entry of the partner's share of partnership liabilities for which the partner is personally liable. Examiners should be aware of at- risk limitations of losses on certain tax shelter partnership investment. Examiners should be alert for situations where taxpayers have claimed deductions for accrued interest on existing liabilities and foreclosure proceedings have subsequently occurred. Verify that the taxpayer has included the difference between the liability per books and the liability that was relieved by the foreclosure as income or gain (depending on the nature of the debt and if the underlining asset was disposed of).

  4. Since Schedule M on the partnership return is condensed, the examiner should first secure the taxpayer's workpapers showing how various items were grouped for the schedule. Once this breakdown is secured the examiner can reconcile the books with the return. The per return column can be prepared solely from Schedule M as allocated in the workpapers; and from Schedule D Sale or Exchange of Property, Form 4797, Supplemental Schedule of Gains and Losses; and Schedule K of the return. The per books column detail should be secured from the taxpayer and then checked against the books to see that they agree.

  5. After the reconciliation has been made; the examiner should continue with the examination bearing in mind the effect the above reconciling items have on the transactions appearing in the books. For instance, if there is a $ 1,000.00 charge to charitable contributions, the examiner should remember that the $ 1,000.00 was not claimed on the tax return. If the examiner sees an additional $ 200.00 contribution to another organization the examiner would know that it was claimed on the return and should be adjusted.

  6. The regulations under IRC section 6050K require partnerships to file Form 8308 (Report of a Sale or Exchange of Certain Partnership Interests) when a portion of any money or other property given to a selling partner in exchange for all or part of the partner's interest in the partnership is attributable to unrealized receivables or substantially appreciated inventory items (IRC section 751(a)) IRC section 6050K is effective for sales or exchanges occurring after 12/31/84. During their examination of partnerships, examiners will verify that all required Form 8308's have been filed. If they have not been filed, the appropriate penalties for failure to file these forms will be imposed, unless reasonable cause is found to exist. Examiners will also give consideration to securing within the district affected partners' returns to determine if examination is warranted, and preparing information reports on out- of- area partners.

4.35.2.5  (05-05-2006)
Balance Sheet Approach to Examinations

  1. See the following sections that explain the balance sheet approach to examinations.

4.35.2.5.1  (05-05-2006)
Examination of Asset Accounts

  1. See the following sections that explain the examination of the asset accounts.

4.35.2.5.1.1  (05-05-2006)
Introduction

  1. Thus far, this chapter has presented a series of suggestions on the technique of commencing the examination of a set of books and records. The initial phase includes a verification that the net income per books with appropriate reconciling adjustments, is actually reflected in the tax return under examination, whether it be a corporation, a partnership or a sole proprietorship.

  2. Once this verification is completed, the examiner should turn attention primarily to the books and records, bearing in mind that there are some reconciling items that affect the net income per books.

  3. The following subsections offer guides to the technique of examining the asset, liability, income, and expense accounts normally found in the general ledgers.

4.35.2.5.1.2  (05-05-2006)
Cash on Hand and in Bank

  1. Review the cash disbursements journal for a representative period. Note any missing check numbers, checks drawn to order of cash, bearer, etc.; large or unusual items, and determine propriety thereof through a comparison with vouchers, journal entries, etc.

    1. In the case of a cash basis taxpayer, ascertain if checks were written and recorded which were issued after the close of the year under examination.

    2. Give special consideration to checks issued for cashier's checks, sight drafts, etc., where the payee and nature are not clearly shown.

  2. Obtain bank statements and cancelled checks for each bank account for one or more months, including the last month of the period under examination.

    1. Compare deposits shown on the by bank statement against entries in cash receipt book.

    2. Note year-end bank overdrafts in case of cash basis taxpayer. This may indicate expenses that are unallowable since funds were not available for payment.

    3. Determine if any checks have remained outstanding for an unreasonable time. This may indicate improper or duplication of disbursements. Old outstanding checks possibly could be restored to income.

    4. Determine whether voided checks have been properly handled.

    5. For a test period, check endorsements to see if they are the same as payee, noting any endorsements by owner, or questionable endorsements.

  3. Review the cash receipts journal for items not identified with ordinary business sales, being alert to such items as sales of assets, prepaid income, income received under claim of right, etc.

  4. If records appear unreliable or have not been subjected to a competent independent audit, tests of footings and postings should be made for a representative period.

  5. Investigate entries in the general ledger cash account. Look for unusual items that do not originate from cash receipts or disbursements journals. These entries may indicate unauthorized withdrawals or expenditures, sales of capital assets, omitted sales, undisclosed bank accounts, etc.

  6. Test check some cash sales with the cash book to ascertain if they have been correctly recorded. Also check cash sales made at the beginning and end of the period under examination to determine if year-end sales have been recorded in the proper accounting period.

  7. Test check disbursements from petty cash to determine if there are any unallowable items included.

  8. Scrutinize cash overages and shortages, being alert to irregularities which may have cleared through accounts.

  9. Review the cash on hand account to determine if there are any credit balances during the period under examination. This may indicate unrecorded receipts.

4.35.2.5.1.3  (05-05-2006)
Notes and Accounts Receivable

  1. Check entries in the general ledger control accounts. Look for unusual items, especially those that do not originate from the sales or cash receipts journals.

  2. Determine if subsidiary ledgers are in agreement with control accounts, and, if not, ascertain the reasons for any differences.

  3. Note any credit balances in the general ledger or subsidiary accounts. This may indicate deposits or overpayments that could be considered as additional income or unrecorded sales.

  4. Some credit sales invoices and postings should be test checked from the sales journal to the subsidiary and control account.

  5. Determine whether accrued income on interest bearing notes or accounts has been included in income.

  6. Where the taxpayer reflects an accrual method by subtracting beginning receivables and adding ending receivables to cash collected, consider checking the detailed listing of receivables at the beginning of the period to the cash receipts book. This may disclose diversion diverting of funds, etc. Determine if beginning receivables used in the computation are the same as the ending receivables of the preceding year.

  7. Insure that the return conforms to the books in terms of its method of accounting.

4.35.2.5.1.4  (05-05-2006)
Investments

  1. Analyze sales and other credit entries with regard to the following:

    1. gains or losses (basis, wash sales, interest included in sales price, etc.);

    2. other (exchanges, write downs, write-offs, transactions with related taxpayers, or controlled foreign entities, etc.).

  2. Review debit entries. Consider such items as:

    1. Nontaxable securities acquired with borrowed funds.

    2. Other acquisitions (transactions with related taxpayers, noncash acquisitions, creation, organization or reorganization of a foreign corporation, etc.).

  3. Become familiar with the nature of investments, utilizing any records maintained by the taxpayer. Make necessary test checks to determine if related income has been properly reported (dividends, interest, etc.).

  4. If shares of stock are held in a foreign corporation, determine whether it is a foreign personal holding company.

  5. If the investment account is a negative amount, then the partnership or S corporation has most likely invested in another flow-through entity. The negative amount represents the excess of deductions over the capital contributed.

4.35.2.5.1.5  (05-05-2006)
Depreciable Assets

  1. Determine whether assets shown on the depreciation schedule, which have a prior year acquisition date, are the same as shown on the tax return for the immediate preceding period. If not, this would indicate point up depreciation being taken on assets that have previously been expensed or fully depreciated, etc.

  2. Review additions during the period. Test additions by reference to invoices, contracts, etc., giving consideration to the following.

    1. Note items that appear to have originated from unusual sources such as appraisal increases, transfers, exchanges, etc., and determine propriety thereof. Ascertain if prior earnings were adequate to cover acquisitions.

    2. Determine if costs relating to the acquisition and installation of assets, leasehold improvements, etc., have been capitalized.

    3. Ascertain if assets include items of a personal nature.

    4. Where construction or any other work of a capital nature is performed with the taxpayer's own equipment, labor, etc., for its own use, be certain that the basis of such asset includes the proper elements of material, labor and overhead, including depreciation.

    5. With regard to the basis of assets, consider such items as trade-ins, acquisitions from related taxpayers, allocations of cost between land and building, etc. Also consider whether the basis has been reduced by the appropriate amount of investment credit for periods after December 31, 1982. Is a comment on ITC really important anymore?

  3. Decreases in the asset accounts during the year should be noted. Gains or losses resulting therefrom should be verified.

    1. Ascertain if the taxpayer has transferred assets to a controlled domestic or foreign corporation for less than fair consideration.

  4. Examiners should be alert for situations where deductions are being claimed by entities leasing property to tax-exempt entities. As a result of the Deficit Reduction Act of 1984, certain tax benefits otherwise available (depreciation, investment credit), have been greatly reduced for owners of property that is leased to tax-exempt entities. Again, do we really care about a 1984 Tax Act?

4.35.2.5.1.6  (03-02-2006)
Valuation Reserves

  1. Review nature and source of all accounts and ascertain whether they are being used as a means of diverting or understating income, or claiming unallowable deductions.

  2. Depreciation, Amortization, and Depletion Reserves -- Determine whether any of these are contingent reserves. Check for reasonableness of any additions.

4.35.2.5.1.7  (05-05-2006)
Intangible Assets

  1. Verify correctness of deductions claimed, such as amortization, write downs, write-offs, royalties, etc.

  2. Test check current additions to determine if the basis includes the proper elements of cost, such as legal fees, application fees, etc.

  3. Determine if there have been any transactions with related taxpayers, or controlled foreign entities; if so, consider arms-length features.

  4. Determine if income applicable to intangibles has been included in income. In this regard connection be aware that it is not necessary for an intangible to have a basis or to appear on the records (e.g. subleases, overriding royalties, franchises, etc.).

  5. Analyze any transaction involving transfer of foreign rights to any foreign entity for an equity interest, or for nominal consideration.

  6. Be alert to any situation or transaction which logically could have given rise to an intangible which may have been expensed through inventories, fixed assets, expenses, etc. (e.g. purchase of a going business -- which could involve good will, covenant not to compete, etc.).

4.35.2.5.1.8  (05-05-2006)
Prepaid Expenses and Deferred Charges

  1. Determine Make check as to the nature and source of these assets, and the manner in which they are charged off to expense. Prepaid expenses are generally present in all businesses. The absence of such items should be considered, since a distortion of income may be involved.

4.35.2.5.1.9  (05-05-2006)
Other Assets

  1. The nature and classification of other asset accounts should be considered to determine if they have a bearing on tax liability.

4.35.2.5.1.10  (05-05-2006)
Exchange, Clearing or Suspense Account

  1. Determine the nature and purpose of the account. Test check debit and credit entries, being aware of the possibility that such an account may be used as a means for diverting sales, padding expenses, etc.

4.35.2.5.2  (05-05-2006)
Examination of Liability Accounts

  1. See the following sections that explain the examination of the liability accounts.

4.35.2.5.2.1  (05-05-2006)
Current and Accrued Liability, Including Notes Payable

  1. Review computation of year-end accruals with respect to their allowability as expenses or purchases. Verify that the economic performance requirement of IRC section 461(h) has been met along with the all events test. See that accruals set up at the end of the preceding year were either reversed in the current year or that the actual expenses were charged against them when paid. Be alert to large year-end items that have been shifted between years for the taxpayer's advantage.

  2. Note any debit balances in the general ledger or subsidiary accounts. This may indicate diversion of funds, etc. Also note accounts that have long overdue balances. This may indicate contested liabilities and liabilities which no longer exist such as unclaimed wages, Unclaimed deposits, items set up twice, etc.

  3. Determine if subsidiary ledgers are in agreement with controls, and if not, ascertain the reasons for any differences.

  4. Determine if accrued items payable to related taxpayers were paid within the time limit prescribed. Under IRC section 267, an accrual of an expense is not allowable if it is to a related taxpayer and that taxpayer is on the cash basis.

    1. If the accrual is for compensation, even subcontractors, verify that it was actually paid within the first 2 1/2 months of the next year. See IRC section 404(a).

  5. Investigate entries in the general ledger control accounts. Look for unusual items, especially those that do not originate from the voucher register or cash disbursements journals. This may disclose unreported income, improper or overstated expense.

  6. Examiners should be alert for situations where taxpayers have claimed deductions for accrued interest on existing liabilities and foreclosure proceedings have subsequently occurred. Verify the taxpayer has included the difference between the liability per the books and the liability that was relieved by the foreclosure as income.

  7. Analyze any newly established liability to a controlled foreign corporation as it may represent a constructive dividend.

4.35.2.5.2.2  (05-05-2006)
Officer's Salaries

  1. Determine total compensation paid or accrued to principal officers, taking into consideration any compensation claimed under headings other than officers' salaries, such as manufacturing salaries, supervisory salaries, labor, etc., contributions to pension plans for the officers, payments of personal expenses, year-end or other bonuses, etc.

  2. Determine if and to what extent each principal officer's compensation is unreasonable.

  3. ) The examiner should take into account such factors as: nature of duties, background and experience, knowledge of the business, size of the business, individual's contribution to profit making, time devoted, economic conditions in general, and locally, character and amount of responsibility, time of year compensation is determined, whether alleged compensation compensate is in reality, in whole or in part, payment for a business or assets acquired, the amount paid by similar size businesses in the same area to equally qualified employees for similar services, etc.

  4. Be alert to closely held multiple corporation situations in which compensation may be split between two or more related corporations, and which, in the aggregate, may be considered excessive to the officer-stockholder.

  5. ) In closely held corporations, determine that accruals payable to controlling stockholders are paid within the prescribed time limit. Under IRC section 267(e), no deduction is allowed for accrued compensation to an S corporation shareholder.

  6. Determine if executives have received substantial bonuses under the guise that the proceeds would be used by the recipient to make significant political contributions.

  7. Be aware of excessive compensation to S corporation officer/shareholders for the purpose of avoiding the built-in gains tax of IRC section 1374., avoiding taxable dividend distributions or shifting income amongst shareholders.

  8. Be aware of inadequate salaries paid to officer/shareholders who receive substantial nontaxable distributions. S corporation earnings are not subject to the self-employment tax, so officer/shareholders often receive minimal small or no wages salary income to avoided employment taxes.

4.35.2.5.2.3  (05-05-2006)
Fixed Liabilities

  1. ) Financing arrangements such as mortgages, certificates of indebtedness, etc. are areas in which substantial adjustments are quite often found. The examiner should become acquainted with pertinent details with regard to such financing arrangements and consider possible adjustment areas as follows:

    1. legal, professional and other expenses of issuance;

    2. refunding of debt;

    3. transactions with related taxpayers and controlled foreign entities;

    4. related expense accounts (interest and amortization).

  2. Scrutinize any long term outstanding liability to a controlled foreign corporation as it may represent an equity interest rather than a creditor interest.

4.35.2.5.2.4  (05-05-2006)
Other Liabilities

  1. The nature and classification of other liability accounts should be considered to determine if they have any bearing on tax liability. The accounts are often used to improperly defer revenue to a future period. The examiner should review and analyze the composition of the other liabilities account in conjunction with IRC section 451, IRC section 61 and the regulations thereunder to make a proper determination as to whether or not the amount reported as other liabilities should in whole or in part be a component of current revenue."

4.35.2.5.2.5  (05-05-2006)
Capital Stock

  1. Review all capital stock accounts -- give adequate consideration to the following.

4.35.2.5.2.5.1  (05-05-2006)
No Changes

  1. No changes during period -- Even though no changes in the total outstanding stock appear on the balance sheet or in the general ledger control accounts, consideration should be given to such features as:

    1. Subchapter S Corporations. Is there a valid election, number and changes in stockholders, limitation on losses, etc.

    2. Dealings in stock between shareholders. Check gains or losses to the individuals concerned where the corporation ultimately becomes involved in such transactions and consider the possibility of distributions being essentially equivalent to a taxable dividend.

    3. Closely held companies should receive special consideration throughout the examination for such items as arms-length features, disguised dividends, etc.

4.35.2.5.2.5.2  (05-05-2006)
New Issues of Capital Stock

  1. New issues and additions during the period

    1. Compare data date obtained from the corporate minute book and charter with items recorded on books to determine if proper entries have been made.

    2. Verify all credit entries. Give consideration to such features as: stock issued for services or properties, stock dividends, employee stock options, stock issued at less than fair market value, reorganizations, taxable and nontaxable exchanges, etc.

    3. Determine if expenses relating to the issuance of stock have been properly handled (legal fees, registration fees, etc.).

    4. Determine if documentary stamps have been acquired and properly affixed, and cost correctly reflected.

    5. Determine during the examination of a recapitalization of the stock in a closely held company that the fair market value of the stock to be received by each exchanging shareholder is equal to the fair market value of the stock surrendered in the exchange. If there is a significant difference, the examiner should be alert to possible gift tax consequences.

4.35.2.5.2.5.3  (05-05-2006)
Reductions and Cancellations

  1. Reductions and cancellations during the period

    1. Compare data obtained from the corporate charter and minute book with items recorded on books to determine if proper entries have been made.

    2. Verify all debt entries. Give consideration to such features as, partial or complete redemptions, cancellations, or liquidations; write-offs; distributions essentially equivalent to dividends; etc.

4.35.2.5.2.5.4  (05-05-2006)
Treasury Stock

  1. If treasury stock transactions have occurred, consider such possibilities as acquisitions being essentially equivalent to dividends, etc. See IRC section 302.

4.35.2.5.2.5.5  (05-05-2006)
Paid-in or Capital Surplus

  1. Analyze and reconcile the surplus accounts. Verify correctness of all items, both increases and decreases, appearing on the books or return.

4.35.2.5.2.5.6  (05-05-2006)
Schedule M-1

  1. For C Corporations, Schedule M-1 is the reconciliation between the net income per books and the taxable income before the net operating loss deduction and special deductions. For S corporations, Schedule M-1 is the reconciliation between the net income per books and the sum of the ordinary and separately stated items of income and deductions.

  2. A complete and detailed Schedule M-1 will provide an examiner with the information needed to reconcile income per books and income reported on the return. Variations can arise either because of timing differences or permanent differences between financial accounting and tax accounting. The Schedule M-1 lines are different on an 1120 versus an 1120S. These could surface in lines 4, 5, 7, or 8 of Schedule M-1.

  3. Statement No. 5, Accounting for Contingencies, of the Financial Accounting Standards Board (March 1975), issued by the American Institute of Certified Public Accountants, defines a loss contingency as an existing condition, situation, or set of circumstances involving uncertainty as to the possible loss that will be resolved when one or more future events occur or fail to occur. An estimated loss from such a contingency shall be accrued by a charge to income if the following conditions are met: It is probable that a liability has been incurred at the date of the financial statement; and the amount of the loss can reasonably be estimated. The Standards define probable to mean that the future event or events are likely to occur. With respect to unasserted claims, litigation, and assessments, the Standards provide that an enterprise must determine the degree of probability that suit may be filed or a claim or assessment may be asserted, and the probability of an unfavorable outcome. If an unfavorable outcome is probable and the amount of the loss can be reasonably estimated, accrual of the loss is required.

  4. It should be noted that the above definition is only applicable in arriving at book income. For tax, no deduction is allowable for an estimated loss. IRC section 461(h) deals with when an expense may be accrued for tax purposes and it holds that for an accrued expense to be allowable, economic performance must have occurred. Also, in the Supreme Court case, United States v. General Dynamics, General Dynamics Corporation vs. Commission, 481 US 239 (1987), the Supreme Court created a very strict definition of the all events test.

4.35.2.5.2.6  (05-05-2006)
Partnership Anti-Abuse Regulations

  1. The Partnership Anti-Abuse Regulations give the Service the ability to recast transactions which may comply with the literal language of the Code and Regulations, but which produce tax results never contemplated by Subchapter K. The Regulations refer to and incorporate the established judicial doctrines of the business purpose and substance over form. Partnership transactions, like all other business transactions, are subject to those doctrines. The Anti-Abuse Regulations reiterate this point. The Anti-Abuse regulations are intended to clearly signal that partnerships are not a vehicle for non-economic, tax-motivated transactions.

  2. Given the Service's broad authorization to recast transactions to reflect the intent of Subchapter K, examiners must coordinate the application of the regulations with both the Partnership Technical Advisors (LMSB -- Office of Pre-filing and Technical Guidance) and the IRS National Office. The practice is intended to result in fair and consistent use of the Partnership Anti-Abuse Regulations.

  3. With the exception of the abuse of entity regulations, which were effective December 29,1994, the Partnership Anti-Abuse Regulations became effective May 12, 1994.


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