A lot of time, expense and worry results in a clean bill of employment tax health
By Rick Kier, CSP
The letter came by regular mail on June 5. At first we thought it was just about another routine business matter like a new way to file our return or some new tax we needed to pay. We quickly realized, however, that we had been “selected for examination” — the IRS’ nice way of saying we were going to be audited.
The only hint of the reason for the audit was the subject: Employment Tax Examination. Our “examination” was scheduled for July 3…happy holiday! I had been scheduled to be on vacation that week and was pleased to see that they had included a way to contact the IRS and change the date if that one was not convenient. My first thought was maybe July 2035?
When I spoke with the examining officer, I not only changed the date but also took the opportunity to ask why we had been chosen. He was very nice and explained that it could be one of several things or that it was random based on the size of our company and employment activity. We talked briefly about the items on the list of required documents and what we could pro-vide to meet each request.
Enclosed with the initial letter was IRS Form 4564, which spelled out the requested records and information broken into two groups: 1) Items we were to provide a copy of to the IRS and 2) Information we should have available at the interview (see below).
Enclosed with the letter was a publication explaining our rights as a taxpayer, which included having representation by someone (such as a lawyer or accountant) at the audit. Having never been through anything like this, we decided to have our certified public accountant take part.
The worst part of the entire experience was not knowing how bad it might be. We are the kind of company that dots our I’s and crosses our T’s. We always follow the law to the fullest extent and never take shortcuts. We don’t pay anyone under the table, we pay all of our taxes, do all our work “on the books” and don’t play games when it comes to doing things right.
Nevertheless, we worried that there might be something we did not know or something that had slipped past us. Would the IRS try to tell us that our snowplow subcontractors were really employees and we owed thousands in unpaid taxes and benefits? Would they try to say that our managers were not really exempt and we owed them overtime going back three years? It is times like that when our minds wander in all sorts of crazy directions, and worry can overwhelm a person. Would this audit be the end of our company?
In any crisis, the best course of action is to figure out what needs to be done and do it. I set up a spreadsheet with all of the required documents for the years requested and included a column for who in the company was to provide the documentation and a place for my approval once I had seen the documents and confirmed they were ready for audit.
My plan was to have everything they asked for ready and neatly organized for the examiner. I had no idea if it would help with the outcome of the audit, but I was darn sure it would not hurt. Plus, the preparation kept me from worrying about what was going to happen. At the least, I knew we were totally prepared for this audit on the day the interview took place.
Keep in mind, you can’t make stuff up or draft missing documents out of thin air. You really have to have all of the required documents in place long before you ever know your audit is going to happen. Of course, having them and putting your hands on them can be two different things. We did have to do some digging through files to find everything and get it into one place. There were a few anxious moments, but in the end we had all of the required documents. I was very glad we had always followed all the rules and had done everything expected of us (at least as far as the paperwork was concerned).
On the day of the “interview” (another nice IRS term for “audit”) the examiner came to our office with file in hand. He was very friendly and he answered all my questions about what they were looking for. It seems that some contractors pay people under the table, treat some employees like subcontractors, fail to pay all the required payroll taxes and even collect payments without reporting the income and paying income taxes. He explained that he was primarily there to investigate possible employment tax issues but that he was authorized to examine any federal tax issues.
I noticed that in his file he had screenshots of our website pages. Clearly, he had been doing his homework. I asked if he had any reason to believe we had done anything wrong. He indicated that he was not aware of anything but the examination hadn’t started. My CPA asked a couple of questions about procedure the. After all our questions were answered, it was time to start the audit.
Under the microscope
One by one we went through the list of documents that had been requested. The examiner asked many questions about various people and subcontractors. What did they do for the company? How long do they work? Who calls them into work? How do they get paid? How are they trained? Who inspects their work? There were a lot of questions about our managers and their job duties. There were even more questions about the snowplowing subcontractors. There was no question he was trying to figure out if they were classified incorrectly and were really employees. I was well prepared with the subcontractors’ business cards, invoices, contracts and other proof that they were in fact, valid independent contractors.
At that moment, I thought back to my studies for the Certified Snow Professional designation. I was glad I had learned the proper way to hire a subcontractor and that I had taken the time to do it right all those years ago. Then suddenly, the examiner told us he was done for the time being and would take our documents back to the IRS district office and do some research. He told us that depending on what he found, it might be a few days to six months before we heard from him. He left our office without providing even the slightest hint as to whether we were in trouble.
Our audit took place on July 14. We waited until October 14 for the outcome. It made for a very anxious summer. A one-page letter arrived and reported: “We have examined your employment tax returns for the above tax period and made no changes to the tax you reported. This is the final notice you will receive regarding the examination.”
We were thrilled that we had done nothing wrong. There would be no fines, no penalties, no handcuffs, no going out of business! Still, it might have been nice if they said something like “Nice job, good records, you run a clean ship.”
The costs of the audit
Looking back at the whole experience, it was a huge drain on me and the organization as a whole. We spent about 50 man hours pulling together all the documents. We paid our CPA about $2,000 for his involvement and advice. In the end, it all worked out OK, but the drain emotionally, financially and in terms of man hours was unfortunate. The good news was that our years of doing things the right way had paid off.
Copies to the IRS:
- Business brochure and company phone directory
- Form 1120 US corporate income tax returns (2011-13)
- All Form W-2 and Form 1099 (2011-13)
- All documents relating to payments, draws, loans, reimbursements, etc., to owners
- All subcontractor agreements for worker-issued Form 1099, including a list of the workers’ names, addresses and type of work per-formed (2011-13)
- Chart of accounts, purchase journal and trail balance (2011-13)
- Check register
- Business credit card statements
- Any New York employment-related audit reports (2010-14)
Available at the interview:
- General ledger
- Bank statements and canceled checks (if included by bank)
- Employee handbook
- All worker payroll and vendor personnel files, including W-4s, I-9s and worker contracts
Rick Kier, CSP, is owner of Pro Scapes Inc. In Jamesville, NY. He is a founding member of SIMA and a member of the Snow Business Editorial Advisory Committee.
Lack of tax knowledge, poor record keeping proves costly for small Wisconsin company
By Aron Rodman
Around April 1, I was notified that I was being audited for sales/use and personal taxes. We were flagged for two things:
1) We had moved our bookkeeping from in-house to an outside firm that overlooked use tax for a year and a half. It had al-ways been minimal, but the constant zero was a red flag.
2) We have been transitioning from a full-service landscape company to a snow-only company. Our revenue has stayed the same while our sales tax has dropped drastically since snow removal is nontaxable in Wisconsin.
The auditors wanted everything. They downloaded my QuickBooks, which gave them access to everything. I made a huge mistake of not saving receipts, thinking that documentation through my accounting software was enough. They demanded that I recover $1.2 million worth of receipts or assume I never paid sales tax on anything. This would also mean I would assume all penalties (25%), interest (12%), and the actual tax on everything. In addition, no purchases would qualify as a business expense deduction.
I spent over 150 hours on this task and recovered all but about $50,000 in receipts, most of which the auditor eventually allowed.
I was told the process would take about six weeks, but as I write this we are at 18 and counting. Eight weeks in, I was told to expect to pay about $60,000, basically the equivalent of last year’s salary. This didn’t include fees for my accountant and bookkeeper. I have since whittled it down (with supporting documentation) to about $25,000. My accountant also found a $45,000 addition error that the auditor made when calculating taxable sales. The accountant said that he hasn’t typically seen an audit process as aggressive as this has been. We will appeal the audit after it is done and try to negotiate a lower settlement.
I run an honest company and any mistakes I made were not intentional, but I was very surprised by how much she investigated:
- Internet sales / out-of-state sales
- Sales tax on vehicles and equipment
- Sales tax on salt purchases
- Taxes on rental equipment
- Cell phones
- Taxes on equipment purchased through Craigslist or private parties
This experience has been full of life lessons, but these are some of the most important ones I’ve learned:
- Don’t let it ruin your life. An audit won’t go away, and you can’t stop it. It is best to put it in God’s hands. It is, after all, just money. Accept that you are in for a painful process, and hopefully you have an experienced accountant to go to bat for you to minimize the sting.
- Do not speak with the auditor and limit email communication. Have your accountant handle all correspondence. My auditor is very kind to speak with, but unfortunately, she’s very good at her job.
- Don’t let them have a digital copy of your bookkeeping system. Only give them what they specifically request.
- If you don’t charge someone sales tax, make sure you obtain their tax-exempt form. Some organizations that I thought were nontaxable actually were. I did $100,000 worth of work for a government agency only to find that it should have been taxed. That cost me about $8,500 in taxes/fees/interest.
- I was not paying use tax on Internet and out-of-state purchases. We made very large purchases of equipment from out of state, and this was an easy catch for the auditor.
- Double check the auditor’s work. Many times the auditor overlooked receipts that I provided. I resubmitted them and they were allowed.
- Save every receipt.
- I was supposed to charge tax on all used equipment, including vehicles, that I sold. My accountant admitted he should have caught this and he is going to bat for me. We all make mistakes. In the end, the aggressiveness and expertise he brings to the table will far outweigh this mistake.
- Expect an audit when a large change is made that will affect your tax liabilities.
- Don’t do your own books (other than maybe accounts receivable and payable) unless you have a finance background. Simple mistakes will cost you far more than hiring professional help.
Two years ago, I had a workers compensation audit. He stayed for two hours and I was in the clear. This gave me a false sense of security that everything else I was doing was as fireproof. I learned the hard way that was not the case.
Aron Rodman owns Extra Mile Snow Specialists in West Bend, WI.
Customer’s audit triggers one for us
By Jim Hornung Jr., CSP
It is safe to assume that as your business grows, the amount of oversight and the potential for audit will grow with it. In the last five years, Elbers Landscape Service has been through audits for sales tax, Department of Labor prevailing wage, unemployment tax, workers’ compensation and liability insurance. This article focuses on our experiences with a sales tax audit.
Our audit was based on a simple check of our operations, and was not initiated because of any suspected wrongdoing on our part. One of our regular customers was being audited, and because we do a large volume of business with them, our invoices showed up repeatedly. As we hadn’t been audited since the 1980s, we were “randomly” selected for an audit by the New York State (NYS) Department of Tax & Finance. They were specifically looking for “underpayment of sales and use tax.”
Or initial response upon being notified of the impending audit was to contact our accountant. However, the audit was to be less about accounting and more about communicating with the auditor and educating him about our business, how we kept records, etc. So, instead, we hired a tax attorney to assist us throughout the process. The cost was considerable; however, working with someone who understood the laws and tax codes easily saved us tens of thousands of dollars. Internally, hundreds of man hours were invested in the audit — collecting records, verifying information, meeting with attorneys, crafting responses and, most importantly, educating the auditor about exactly what he was seeing.
The audit took approximately 10 months, during which time we provided virtually every type of document you can imagine. An auditor visited our facility twice during that time, where he checked for mandatory employment postings and asked to see payroll records, vendor and customer invoices, bank statements, canceled checks, ledgers, P&L statements and tax returns.
he NYS Department of Tax & Finance’s original resolution – because they did not understand our business – was that we owed in excess of $200,000!
Their lack of knowledge about our business was based on both the complexity of our business and our industry. My experience was that the auditor was most familiar with traditional manufacturing and retail businesses, not service businesses or contractors. We had to spend significant time and money explaining the different types of customers, style of billing and divisions within our company.
The final result was that, over the 36-month period for which we were audited, we were found to have underpaid our sales and use tax liability by just over $3,000 – or .0004% of our gross sales during that period. The underpayment, however, paled in comparison to the “Statutory Penalty and Interest” that was imposed. We paid over $6,000 in penalty and interest on that $3,000 underpayment.
Lessons from this audit
1. Have good representation that can manage all communication — the less you say the better.
2. Assuming you have nothing to hide, understand the auditor has a job to do, take the audit in stride and help him or her complete the audit as quickly as possible.
3. Know the rules and stay current and fully educated on the regulations that govern the day, because ignorance is not a de-fense.
Jim Hornung Jr., CSP, is president of Elbers Landscape in Buffalo, NY. He is a former SIMA board chair and is a member of the Snow Business Editorial Advisory Committee.