Audit techniques vary for different businesses, so small business owners need to be armed with how an agent might approach their inspection.
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The IRS website publishes audit training guides for essentially every profession. So if you are slated for a tax audit of your business, read the IRS Audit Technique Guides to discover what you should expect.
The IRS often targets farmers for an audit for a variety of reasons, but primarily because income is not reported to farmers on W2s or 1099s. Without an audit, it’s difficult for the IRS to know if a farmer is accurately reporting income. The IRS also tends to suspect that farmers’ book keeping procedures aren’t up to par, and that their internal controls to test income may be lacking. The agency also knows that farmers face significant swings in profitability that hinge on unpredictable events like weather and the economy.
When the farmer is selected for audit, the auditor will seek information to establish background and income potential. She will want to know how many hours the farmer and his spouse work on the farm to determine if there are any passive activity issues, such as losses that cannot be claimed but should be carried forward.
She’ll want detailed depreciation schedules to tie out the capital assets to the ability to purchase them and will study them in conjunction with lease and loan documents and repayment schedules. She will also review grower statements and other income records, as well as crop maps with acres, type of plants and year of planting. She will also ask for crop reports including insurance damage reports. Some of these items will be requested before you ever come face to face with the auditor.
The crop map is a useful tool for the auditor: it allows her to compare the map with industry averages to estimate both income and expenses and compare it to what you reported. If you are within those guidelines, the audit may be cut short. She can compare the crop map with lease agreements to verify if income and expenses are properly allocated. By judging distances between parcels, she can determine if the farmer should be completing highway use tax returns.
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The auditor will want to tour the farm to look for capital improvements and compare those with the items listed on the depreciation schedule. She will check to make sure that any vines or trees have been capitalized. The auditor will check the number of houses on the farm and whether or not they have been rented out and if so, determine if the rental activity has been declared on the tax return.
She will also look at the farm animals during the tours to check for the sales of calves (dairy farm) that may have gone unreported. She will inspect the equipment and confirm its use to determine if there is unreported income. For example, if a grape farmer has a cotton picker, eyebrows will go up. If the farmer owns any large trucks, the auditor will wonder if hauling is another source of income and will want to confirm that it has been declared on the tax return.
One of the big issues regarding a farmer’s tax return is a “structural analysis.” The auditor will want to know if there are any related entities: perhaps the farm is a partner in a larger partnership, part of a corporate structure, trust or family partnership. If so, the auditor may move the audit to the larger entity with hopes of attaining more tax revenue. It’s also possible there’s been a misallocation of income and expenses between the entities. One way the auditor discovers related entities is by looking at crop loan documents. It’s all about following the money.
Crop contracts will also be reviewed to determine if the quantities sold match up to industry standards and to see if there is any deferred income. Not all deferred payment contracts are valid; much of it depends upon delivery terms.
Grower statements show quantities delivered, and the auditor will compared them to crop contracts for consistency. Quantity accepted by the buyer will be analyzed, the auditor will want to know what happened to any rejected crops – were they sold to another buyer or sold in a different market for a lesser price or disposed of. Was the crop insured?
Farmers will need more than bank statements and cancelled checks to satisfy an auditor. If you are a farmer, be sure to keep all contracts, loan documents and crop maps as they become an integral part of an audit.
Bonnie Lee is an Enrolled Agent admitted to practice and representing taxpayers in all fifty states at all levels within the Internal Revenue Service. She is the owner of Taxpertise in Sonoma, CA and the author of Entrepreneur Press book, “Taxpertise, The Complete Book of Dirty Little Secrets and Hidden Deductions for Small Business that the IRS Doesn't Want You to Know.” Follow Bonnie Lee on Twitter at BLTaxpertise and at Facebook.