A tax audit avoidance strategy can help body shop owners avoid or reduce the likelihood of an IRS audit
Proving that it doesn't pay to try to fool the ever-vigilant Internal Revenue Service (IRS), one body repair shop owner recently learned that he must pay a steep price for tax fraud. Fraud penalties, unpaid taxes, interest and other penalties could have been prevented by using a little common sense and employing a simple — and legitimate — tax audit strategy.
That same audit avoidance strategy would in all likelihood have helped the body repair shop owner avoid or dramatically reduce the odds of an IRS tax audit, such as the one that initiated this situation that ended in front of the U.S. Tax Court.
Setting the scene
Flair Enterprises Inc. operates three full-service automobile paint and body shops doing business as Flair Body Works in the Oklahoma City area. Flair Enterprises, operating as an S corporation, has as its sole shareholder, Lee F. Haney Sr., while Flair Body Works is managed by Haney's sons, Phillip and Alan.
According to U.S. Tax Court testimony, Flair Body Works is a preferred provider for several major insurance companies and, as even the IRS admitted, complied with the requirements that companies maintain complete and accurate records. However, in addition to the set of books recording transactions covered by the insurance companies, Flair reportedly maintained another set of books for transactions with non-insurance customers and other regular payors.
Checks from customers with insurance were deposited and recorded through a computerized accounting system. Checks from non-insurance customers and other payers were simply recorded and totaled on a legal pad bearing the title "Do Not Touch." Jeanie Haney, Lee's wife, endorsed and cashed these off-the-book checks for Flair Enterprises, d.b.a. Flair Body Works. She often divided the cash among herself and her two sons.
Federal tax laws define gross income as "all income from whatever source derived, including but not limited to, income derived from business." Generally, in determining the tax of a shareholder of an S corporation, the shareholder's pro rata share of the corporation's items of income, loss, deduction or credit must be taken into account.
As the sole shareholder of Flair Enterprises, the adjustments to the company's ordinary income would flow through to Lee Haney Sr. and be included on his individual income tax return. The IRS contended, and the tax court agreed, that the evidence clearly established Lee Haney's solely owned S corporation received and failed to report taxable income.
Many of the checks received and cashed by Jeanie Haney were from COPART Salvage Auto Auctions, for towing, storage and expenses incurred with regard to vehicles eventually declared totaled by insurance companies and hauled away from Flair Body Works. These costs, reimbursed by COPART, had already been included in expenses deducted by Flair Enterprises. IRS auditors discovered Flair Enterprises failed to take the COPART reimbursements into account, either as reductions in its claimed business expenses or as taxable income. In other words, the company underreported its net income by the total amount of COPART checks cashed by Jeanie Haney.
It should not surprise anyone that the IRS discovered this off-the-books income. While several of Lee Haney's family members participated in Flair Enterprises' dual recordkeeping process, by which they were able to avoid reporting substantial amounts of income received by the company, much of that income resulted from transactions with other businesses that claimed the payments as tax-deductible expenses.
And, then, there was Karen Steelman, hired as Flair Enterprises' bookkeeper and accountant. Steelman was fired when it was discovered that she was embezzling substantial funds, $86,950 in the year the theft was discovered.
The Haneys and Flair Enterprises engaged the services of an attorney/CPA, Jeffrey C. Trent, to investigate misappropriation and embezzlement of corporate funds and, later, to reconstruct the operation's records and prepare tax returns for the tax years in which the embezzlement occurred. Trent also assisted law enforcement, including the FBI, with the criminal investigation of Steelman.
Trent discovered and reported that Steelman embezzled funds in three ways:
- Additional weekly payroll checks that Jeanie Haney was tricked into signing by showing her a check stub payable to one entity and then making the actual check payable to a different person;
- Credits posted to Steelman's personal credit card account from Flair Enterprises' credit card machine, and;
- A pension and profit-sharing plan Steelman created without authorization and enhanced using company assets. Trent also stated that Flair Enterprises kept no cash on hand and there was no petty cash fund set up at the company.
Out of excuses
When audited, Lee Haney claimed that all cash received from the cashed checks was given to Ms. Steelman, who allegedly kept it as a large petty cash fund. However, investigators had discovered — and reported — that the company did not maintain a petty cash fund.
The Haneys also attempted to assert that they are entitled to an increased deduction for cash funds allegedly embezzled by Steelman before her embezzlement was discovered. However, as the investigation revealed and the tax court noted, Steelman did not have access to cash that Jeanie Haney received upon cashing the checks received by Flair Enterprises.
The Haneys' consistent failure to report taxable income and their improper deductions of personal expenses on the company's accounts resulted in substantial underpayment of tax as IRS auditors quickly discovered. The U.S. Tax Court agreed and levied additional penalties for fraud. If not for the embezzlement, if not for greed and with the help of a good – and legitimate – audit strategy, all of those expensive penalties might have been avoided.
Who wouldn't like to ensure their tax returns — or those of their automotive body repair business — are not targeted for examination by the IRS? One sure-fire way to ensure that your return is selected for review is to take major losses, operate the business as a cash business and keep sloppy records.
While there is no justification for sacrificing valid deductions even if large or unusual, keep in mind that income earned from third-party payers is usually reported to the IRS. As the Oklahoma City body shop operators recently learned, all income and deductions should be reported truthfully.
An excellent strategy for avoiding an audit is to point out "oddball" items on the tax return. Give the IRS the answer before they ask the question. Attach a note, a brief statement, documents and explanations for all unusual transactions.
For large transactions that may fall into one of the innumerable "gray areas" of our tax laws, there is yet another tax form. Form 8275, "disclosure statement," may help avoid penalties by disclosing questionable deductions, positions or investments. Few experts think using this form will increase the chance of an audit.
When offense is not enough
What happens if, despite your best efforts, the IRS requests your presence to review your tax returns? Obviously, the worst thing that any business owner can do if they receive an audit notice is to ignore it. The best bet is a quick response. It also helps if the business owner works with the IRS to resolve the matter.
If a small body repair shop or business has kept organized records, including bills, receipts and canceled checks and has in place the proper internal controls, there is little need to worry. The IRS may interpret the operation's situation differently, but there is no crime in having differences of opinion.
Thanks to the IRS Restructuring and Reform Act of 1998, the IRS's ability to conduct so-called "lifestyle" or "economic reality" audits has been diminished. Today, the IRS is generally, prohibited from asking for extensive information about anyone's financial status, standard of living or other information to determine the existence of unreported income. The IRS can only ask for that information if it has a reasonable indication that there is a likelihood of unreported income based on the tax return and information reports from third parties.
What the IRS is looking for
Many experts agree that an improperly prepared tax return is a good way to ensure an IRS audit. Sloppy returns are also hazardous.
Those body repair business owners who fail to report all income, send up an instant red flag in today's computerized business world. Information mismatches produced by erroneous Form 1099s received by some shops often create disparities in reported income. If the amount reported on the Form 1099 is wrong, the individual or firm that sent the form should correct it and file an amended Form 1099. Intentionally mismatching the information on the tax return can only draw attention to your business.
The biggest problem for most auto body repair business owners is a lack of good expense records. The use of an automobile for business purposes is a classic example. Although the vehicle may have been used 75 percent of the time providing off-site estimates, many shop operators fail to keep a detailed record and, thus, are unable to state that clearly on a tax return. Records are easily maintained, often in the form of a log.
The Taxpayers Bill of Rights, part of the IRS Restructuring and Reform Act of 1998, requires the IRS to explain a taxpayer's rights and the IRS's obligations during the audit, appeals, refund and collection processes. A taxpayer also is guaranteed the right to be represented by any individual currently permitted to practice before the IRS. What's more, any interview must be suspended when the taxpayer clearly requests the right to consult with a representative.
Among the more important rights given any auto body repair shop owner whose returns are targeted for further examination is whether to be represented by a tax professional or whether to attempt to answer the IRS's questions alone. Unless it issues an administrative summons, the IRS cannot require the taxpayer to accompany the representative to the interview.
An important consideration for everyone being audited is where to hold that meeting. Should the meeting be in the accountant's office where all of the working documents are easily accessible? Should it be at the auto body repair shop, the place where all the records are kept, in order to demonstrate to the IRS auditor that there is nothing to hide and that the operation is legitimate? Or, should the shop owner and/or his representative trudge down to the IRS office armed only with the specific documents and information requested by the IRS auditor? There is no single right answer.
Ignoring the IRS does not work. The IRS may issue summons to third-party record keepers (attorneys, enrolled agents, banks, brokers, accountants, etc.) for the production of records concerning the business transactions or affairs of an auto body repair shop and its owner. Of course, the taxpayer must be notified of the summons and has the right to intervene. The taxpayer can begin a proceeding to quash the third-party summons.
Appeal after appeal
As mentioned, the majority of auto body shop operators file relatively honest returns. The occasional error, misinterpretations or honest disagreements of "gray areas" may result in additional tax assessments. However, from the initial screening for accuracy each return receives until the final appeal is exhausted, mistakes in favor of the taxpayer have been discovered in about 25 percent of all cases.
The IRS is usually quite sympathetic to honest mistakes and more than willing to discuss underpayment of taxes that may result from the many so-called "gray" areas of our tax rules. On occasion, they will negotiate the amount of tax due. But they do not like fraud.
Deal with it
Changes to our tax laws in recent years have resulted in tax professionals generally taking a more conservative approach to the tax advice they render and the tax returns they prepare. After all, should a transaction be labeled as incorrectly structured or if the tax laws were ignored, the professional as well as the taxpayer face penalties.
Despite the ultra-conservative position now taken by many tax professionals, however, no body repair business — or body repair business owner — should forego or ignore valid tax deductions. Often, disclosing those transactions or deductions on the tax return will be enough to pass the scrutiny of the IRS, eliminating a full-blown audit. At worst, disclosure may help avoid the levy of numerous penalties for taking a "frivolous position," or claiming deductions that result in "accuracy-related" penalties.
Honesty and clarity can go a long way toward preventing and dealing with an IRS audit. Obviously, every automotive body shop repair business owner and manager needs an audit strategy as well as a fallback position should those strategies fail. Outright fraud rarely works over the long term and clearly does not pay.
Editor's note: Case details are from Lee F. Haney, Sr. et ux, vs. Commissioner of Internal Revenue, T.C. Memo. 2007-238.