Winter 11 - What Catches the IRS’s Eye?
When IRS Commissioner Doug Shulman announced the agency’s most recent five-year strategic plan, he cited two overarching goals. The first was “to improve service to taxpayers to make voluntary compliance easier.” The second was “to enforce the law to ensure everyone meets their obligation to pay taxes.”
Shulman added: “We will be timely in our enforcement actions and expand the approaches and tools we use in compliance activities.”
Since the announcement, the agency’s 2010 enforcement budget has been increased and activities have stepped up. While ensuring that everyone pays their fair share is a worthy goal, the complexity of today’s tax laws can give even the most scrupulous taxpayer some sleepless nights.
For contractors, several key areas draw particular IRS scrutiny:
Section 199 (Domestic Production Activities) Deduction – Under this program, contractors are allowed to deduct a percentage of their income from qualified domestic production activities for certain projects. The deduction generally applies to the construction of real property including residential, commercial and industrial construction, as well as machinery that is a structural component of the building (such as an elevator). Tangential construction activities such as hauling trash and delivering materials are not included. Income from substantial renovation projects — beyond decorating or redecorating — may also be eligible for the deduction.
The good news is the allowable deduction increased from 6 percent of qualified production income in 2007-2009 to 9 percent in 2010. The bad news is that the IRS is paying closer attention to ensure the deduction is properly applied. It is important to have a well-documented methodology for calculating the qualified Section 199 deduction.
Meals and Entertainment – A perennial area of interest, meals and entertainment expenses have drawn particular attention in recent audits. It is important that such expenses be properly documented, including who, what, when and where. While you may not be required to produce contemporaneous logs of the business discussions that occurred during a meal, you must be able to prove that these costs are directly related to the actual conduct of business, or were associated with a substantial, legitimate business discussion immediately before or after the event.
Long-Term Contract Accounting – When projects generate revenue over the course of more than one tax reporting period, properly allocating the income or loss over the tax periods can be a cause of concern. For example, it is quite common to elect the percentage of completion method of accounting for book purposes, but the completed contract method for tax purposes. Thus, the financial statements you provide your bank and surety would show income from partially completed projects as it is earned, but you wouldn’t declare the income for tax purposes until the job is substantially completed.
While this is often beneficial, it is not always permissible for certain types of projects. The IRS is becoming more stringent in reviewing the “look-back” calculations you must perform to demonstrate that income was properly allocated over the tax periods. To avoid potential penalties and interest, it is important to be able to justify the long-term contract accounting method that you have elected for tax purposes and to be sure to have all the documentation to show how the income was allocated.
Alternative Minimum Tax (AMT) Issues – Long-term contract accounting is also a common issue when computing AMT. You may be able to defer some long-term contract income by using the completed contract method for your regular taxes, but you must use the percentage of completion method to determine potential liability under AMT. Make sure income is properly recalculated for the separate AMT schedule you must file.
Claims, Warranty and Contingency Costs – As with income from long-term contracts, costs associated with claims and warranties can attract an auditor’s attention if you treat these items differently on your tax return than your financial statements. For example, many contractors set up reserves for warranty claims and recognize expenses associated with increasing the reserves on their financial statements. For tax purposes, such reserves are not deductible until you actually honor a warranty claim.
Unreasonable Compensation Issues – The IRS is particularly watchful for signs that companies are trying to strip out all profits and pay them as wages to officers, rather than as dividends, in an attempt to avoid double-taxation of dividends. Be sure your compensation levels are reasonable and consistent with comparable contractors in your market.
Finally, the IRS is not the only tax-collecting agency that has stepped up enforcement. State and local governments have also increased enforcement efforts. A careful review of your state income tax position, along with your procedures for calculating and collecting sales and use taxes, can prevent some very costly penalties in the future.
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The Construction Advisor is produced quarterly by Bober Markey Fedorovich. For more information about our services, please contact our team leader, Dale A. Ruther, CPA, CIT, partner, at (330) 762-9785 or by email.