When we last left our anthropomorphic friends, Rigby was in a serious coma due to an allergic reaction from the eggs in the Eggscelent omelet, and doctors were not optimistic about his chances. Meanwhile, Mordecai discovered a long-lost journal from a former park employee that may hold the key to winning the challenge and the coveted trucker’s hat.
More to the point, when we last left our anonymous CFO and the company’s intrepid legal team, they were preparing for an “eggshell audit” from a government investigator. A Kovel Agreement can encourage open dialogue between professionals by expanding the attorney-client privilege, and there are certain things that government auditors can and cannot do. But what exactly are they looking for when they arrive? And how can you be ready?
According to Larry Campagna, auditors often target small businesses and sole proprietorships, on the theory that these firms may have sloppy or incomplete accounting procedures. A hint of bankruptcy or tax fraud also sends up red flags, on the theory that where there is smoke, there is fire.
The ‘Badge’
Once on site, the examiners are trained to look for what they call “first indicators” or “badges” of fraud. Specific items on the list include:
- Unexplained failure to report income
- Mysterious increases in net worth, especially if over a long period of time
- Personal expense accounts that exceed company revenue
- Large amounts of cash, especially in a traditionally noncash enterprise
- Irregular deposit records
- Cashing checks at a check-cashing store or at a different bank
Taken individually, these items are totally innocuous. Merchants often cash checks in nontraditional ways if they suspect the payment may be NSF and many business owners reach into their own pockets to pay expenses. Be prepared to offer these explanations, along with evidence to support your story, such as a prior bad check from that customer.
There are some “badges” on the other side of the ledger as well. Questionable expenses and deductions create the appearance that you have something to hide. Oftentimes the examiner questions the appropriateness of the deduction as opposed to the deduction itself. No one doubts that a taxpayer can write off certain interest and insurance payments, but not all are deductible. Your best defense in these situations is to find revenue decisions, court cases or at least law review articles that support your position.
The records themselves can sometimes be a red flag. Multiple sets of books, no books at all, irregularly numbered invoices, unusual endorsements, and lack of basic GAAP/IAAP standards are all very bad signs. If the books are always the last thing you do at the end of the day, or if you don’t do them at all until the end of the month, hire an accountant. Your attorney may be able to give you a good referral. It’s an added expense, to be sure, but it’s cheaper than dealing with a government audit.
Play Nicely
While the examiner has one eye on your financial records, the other eye is on you. As far as the auditors are concerned, repeated cancelled or rescheduled appointments is a sure sign that there is something you do not want the examiner to see. You can only have so many business meetings and dental appointments. Do not try to cover your tracks, by activating the paper shredder as soon as the auditor leaves or transferring assets to different accounts or entities.
Also be mindful of what your employees say. They may give false testimony or provide inconsistent information. When the auditors show up, send all nonessential employees home. Better yet, see if you can arrange an after-hours visit. The fewer interview targets, the better.
Criminal Investigation
If the auditors suddenly get up and leave, that is not a good sign, because the examiners probably feel they have enough information to open a criminal investigation. The auditors will complete Form 1161 and forward it to a Fraud Technical Adviser for review.
Next, the FTA completes Form 2797 and forwards it to the Criminal Investigation division. Even if the CI declines to move forward, the FTA still has the option to pursue civil penalties, including the dreaded 10-year ban on the Earned Income Tax Credit.
This process is very cold and bureaucratic. If you have appeared on the IRS’ radar, the best way to get off the scope is to walk on eggshells during the audit. You are already in trouble, at least to some extent. Don’t make it worse.