Just because your Income Increases Doesn't Mean your Taxes Should Too

I was involved in a rather toxic IRS audit of one of my client’s tax return (a plumber who was operating his business as a sole proprietorship). The auditor was intent on not allowing my client’s business deductions because, although his income had been steadily increasing, his expenses had increased also. This had happened largely because of extensive education AND more extensive and aggressive marketing. My client had been operating in the red for more than three years.

After several hours, during which each of the “validations” of expense were produced, and then systematically challenged as being necessary, I politely asked the auditor if she had ever been in the plumbing business. When she replied in the negative, I said, “Neither have I, but this man has for nearly seven years, and previously he worked with his father in business for more than 10 years. Can’t we give him the benefit of the doubt of these items that don’t make that much sense to us?”

After a short consideration of the question, and a couple of finger-taps on her desk, the auditor said, “Good point!” Within a few minutes the audit was over. The result was “no change.”

Approximately two years later, the same client was audited again. His gross revenue is now greater than two million dollars; and he is still operating as a sole proprietor. This time it’s one of the IRS’s dreaded “office audits.”

The auditor comes and nest with you, right where you live. He or she will stay from a few hours to a few days. It can be quite unnerving and disruptive to business, to say the least. For my client, however, it was business as usual, while the situation moved to its completion.

This field auditor was very thorough! The plumber had more than 150 items of depreciable assets. The auditor studied the purchase records and the depreciation worksheets of each of these assets with the diligence of an NSA Cold War code breaker!

He changed nothing.

Amazingly though, the auditor managed to find a flaw. This was very important to my client as well as the auditor, however. One of my client’s office personnel, who worked in accounts payable did not know how to record credit card charges correctly, and then correctly record their payments in the computerized accounting system.

Generally, when credit card charges are recorded, the expense related to the charge is recorded at the same time. When subsequent payments are correctly made on the charges, however, the credit card balance is reduced, without touching the expense again. The accounts payable employee had this a little inside-out!

When she made the payments, she also “added” to the expense, again!  As a result of this error, not only was the expense being overstated, but also the credit cards’ balances were increasing, instead of decreasing! Of course, these overstatements had an impact on the income statement and the balance sheet! Overstatements on expenses decrease net income, which decreases new worth.  Overstatements on credit card balances also lower net worth! Those are two very important issues to business owners and their families, their bankers, as well as the IRS!

The bottom line is that this mistake “cost” my client just a bit more than $1,100 in taxes (which, by the way, was all he paid in taxes that year, on more than two millions in gross revenue!). He saved many times that amount or would have lost it by not having that little discrepancy isolated and corrected quite quickly.