Construction Industry ATG Chapter 11 Contractor Square Foot Costs - Audit Issues and Examination Techniques
Publication Date - May 2009
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.
Examiners will consider gross income during the examination of all income tax returns. The following techniques are the minimum income probes required for this type of taxpayer. Also consider any large, unusual or questionable income items and if the amount is material, net operating loss deductions. Discuss with Group Manager omitted income items greater than $10,000 and document the discussion on Form 9984. Guidelines for limiting the scope of the examination of income are contained in IRM Section 22.214.171.124.1. Cite the reasons if the scope of the examination of income is limited.
Individual Business Returns: A preliminary Financial Status Analysis based on the tax return and available data will be completed as outlined in IRM 126.96.36.199.3.1(7)(a). If the analysis indicates a material imbalance, the excess expenditures are considered a potential understatement of taxable income and the minimum income probes should be completed. See IRM Section 188.8.131.52.1(2).
Cost of Goods Sold
The following techniques are not intended to be all-inclusive nor are they mandatory steps to be followed. Judgment should be used in selecting the techniques that apply to each taxpayer.
- Check for changes in inventory valuation methods.
- Reconcile beginning and ending inventory with prior and subsequent years.
- Examine cancelled checks, receipts, purchase journals, etc, to validate cost of goods purchased for re-sale and to verify business use of goods.
- Examine cancelled checks, receipts, purchase journals, etc, to validate cost of labor, materials and supplies to raise or produce goods for sale.
- Ensure amount on the return does not include items purchased for personal use.
- Compare cost of labor, materials and supplies to total cost of goods sold for reasonableness.
- Calculate cost of goods sold (Beginning Inventory + Purchases + Labor + Materials + Supplies + Other Costs) - (Withdrawals for Personal Use) - (Ending Inventory).
- Compare calculated Cost of Goods Sold to Cost of Goods Sold on the taxpayer return.
- Reconcile variances.
As of October 31, 2007, EOAD data shows the most frequent issues examined and adjusted on contractor returns (NAICS 238XXX) during FY 2007. If available, use the appropriate examination lead sheets when examining tax issues.
% Issues Adjusted
|Form 1040 Gross Receipts or Sales||63.37%|
|Form 1040 Cost of Goods Sold||65.48%|
|Form 1040 Depreciation and Sec 179 Expense Deduction||71.31%|
|Form 1040 Car and Truck Expenses||74.02%|
|Form 1040 Supplies||75.28%|
|Form 1040 Repairs and Maintenance||76.27%|
|Form 1040 Insurance (Other than Health)||78.43%|
|Form 1040 Other Expenses||78.49%|
|Form 1040 Meals and Entertainment||85.80%|
|Form 1065 Purchases||51.28%|
|Form 1065 Gross Receipts or Sales||52.69%|
|Form 1065 Other Costs||54.76%|
|Form 1065 Cost of Goods Sold (No Schedule A)||57.14%|
|Form 1065 Guaranteed Payments to Partners||57.89%|
|Form 1065 Cost of Labor||60.00%|
|Form 1065 Other Expenses||73.08%|
|Form 1065 Taxes & Licenses||84.21%|
|Form 1065 Sec 179 Expense Deduction||85.71%|
|Form 1065 Other Deductions (No Schedule)||86.21%|
|Form 1065 Ordinary Income (loss)||94.74%|
|Form 1065 Gross Nonfarm Income||95.24%|
|Form 1065 Depreciation||100.00%|
|Form 1120 Other Costs||30.05%|
|Form 1120 Gross Receipts or Sales||33.45%|
|Form 1120 Purchases||35.34%|
|Form 1120 Cost of Goods Sold (No Schedule A)||37.00%|
|Form 1120 Compensation of Officers||47.58%|
|Form 1120 Auto & Truck Expenses||55.47%|
|Form 1120 Other Deductions||60.38%|
|Form 1120 Depreciation||65.14%|
|Form 1120 Other Expenses||67.39%|
|Form 1120 Net Operating Loss Deduction||86.57%|
|Form 1120S Cost of Labor||29.69%|
|Form 1120S Other Costs||38.85%|
|Form 1120S Insurance Expense||44.74%|
|Form 1120S Purchases||47.06%|
|Form 1120S Gross Receipts or Sales||47.48%|
|Form 1120S Compensation of Officers||50.87%|
|Form 1120S Total Property Distributions||53.41%|
|Form 1120S Automobile Expense||64.29%|
|Form 1120S Other Expenses||70.86%|
|Form 1120S Depreciation||73.01%|
Related Returns: Determine whether the related return warrants examination from a classification perspective. For example, trace transactions between the related taxpayers, complete a financial status analysis based on the return and internal sources of information and review the return for other potential issues. See IRM Section 184.108.40.206.
Net Operating Loss Deduction: The following techniques are not intended to be all-inclusive nor are they mandatory steps to be followed. Judgment should be used in selecting the techniques that apply to each taxpayer.
- Review or prepare a schedule of the net operating loss deductions and how they were carried back or over.
- Determine if a timely irrevocable election under IRC § 172(b)(3) to relinquish the entire carryback period was made. IRC § 172(b)(1)(A) generally allows an NOL to be carried back 2 years and carried forward 20 years for tax years beginning after August 5, 1997. For tax years beginning on or before August 5, 1997, carrybacks were generally allowed three years back and fifteen years forward. A five-year carryback period was allowed for NOL's arising in a tax year ending during 2001 or 2002.The election has to be made on a timely filed return, including extension. In addition, in the instruction to the Form 1139, the IRS has stated that the election to forego the carryback can be made on an amended return filed within 6 months of the due date (including extensions) of the loss year. Special rules may apply to farming losses.
- Determine if the NOL was properly carried back. It must be carried back first to any preceding years prior to any carryforward.
- Determine the correct NOLD in the year under examination. Generally, this does not require the NOL year(s) to be put under examination though you are allowed to review any NOL year or carryover year in order to determine the correct NOLD in the year under examination. If the carryover NOLD includes nondeductible penalties (determined by examining the transcript for transaction codes - 160s, 170s or 180s), reduce the carryover by the penalty amounts.
- When making current year adjustments, evaluate whether the issue existed in a prior year, it may result in reduction in the current NOLD carryforward.
- Determine if the NOLD applied in consolidated returns and carried over from acquired entities meets the limitations of IRC sections 381 and 382 and the SRLY rules found in the regulations under IRC section 1502.
- Compare computations for the regular NOL and the alternative minimum tax.
- Flag the return with NOL carrybacks to indicate that restricted interest is involved.
- Determine if the contribution deduction was treated properly. There is no contribution deduction allowable in the NOL year or any carryforward year where taxable income is completely eliminated. Note: There are not changes for carryback years for contributions. IR.C § 172(d)(5).