I was involved in a pretty toxic IRS audit of the tax return of one of my clients (a plumber who was operating his business as a Sole Proprietorship) a while back. The auditor seemed pretty intent on not allowing his business deductions as business expenses because, although his income had been steadily going up, his expenses had been also. This had been happening largely because of extensive further education AND more extensive and aggressive marketing. And, he had been operating in the red for more than three years.
After several hours in this audit, where each of the “validations” of expense were produced and then systematically challenged for necessity, I politely asked the auditor if she had ever been in the plumbing business. When she replied in the negative, I said, “Well, you know, neither have I. But this man has been in it for nearly seven years, and he worked alongside his father in it for over 10 years before that.
Can’t we give him the benefit of the doubt of these things that don’t make all that much sense to us?”
After a short consideration of the question by the auditor, and a couple of finger-taps on her desk, she said, “Good point!” Within a few minutes the audit was over. The result was “no change”.
About two years later this same client was audited again. His gross revenue is now up above the two-million mark. And he is still operating as a Sole Proprietor. This time it’s one of their dreaded “office audits”.
This is where they basically come in and nest with you, right where you live. They’ll stay anywhere from a few hours, to a few days. It can be quite un-nerving and business disrupting, to say the least. For my client, however, it was business as usual while this thing played itself out
This field auditor was VERY thorough! The plumber had over 150 items of depreciable assets. The auditor studied the purchase records and the depreciation worksheets on each of these assets with the diligence of an NSA Cold War Code Breaker!
He changed nothing.
Amazingly though, he managed to find a flaw. This was VERY important to my client as well as the auditor, however. Seems that one of the office personnel who worked in the Accounts Payable arena was NOT thoroughly checked out on how to correctly record Credit Card charges, and THEN correctly record their payments, in my client’s computerized accounting system!
Generally, when the Credit Card charge is recorded, the EXPENSE related to the charge is recorded at the same time. But, when subsequent payment is correctly made on the charge you just reduce the Credit Card balance and don’t touch the expense again. Well, the Accounts Payable lady had this a little inside-out!
When she made the payments, she ALSO “added” to the expense, again! And…as a result of this error…not only was the expense being overstated, BUT the balance on the Credit Cards was increasing instead of decreasing! Of course, these overstatements had an impact on the Income Statement and the Balance Sheet! Overstatements on expenses lower Net Income, which lowers New Worth. And overstatements on Credit Card balances additionally lower Net Worth! Two pretty important issues to business owners and their families, their bankers, as well as the IRS!
BOTTOM LINE: This “cost” my client just over eleven-hundred dollars in taxes. (Which by the way was ALL he paid in taxes that year, on over $2 Million of Gross Revenue!) But it SAVED HIM multiple times that in all-else he stood to lose by NOT having this little discrepancy isolated and corrected quite quickly.
