Our clients are experiencing increased audit activity over the past year from both the IRS and the States that they operate in. This increased activity does not appear to be focused on auto dealers specifically.
The State activity is particularly disturbing. At times the audit activity will focus on an issue that may result in the same income being taxed in multiple states. There may be language in a particular state’s tax code that allows the state to tax the entire amount in the resident state even though the out of state revenue is subject to tax in another state. This activity is obviously driven by budget shortfalls.
Over the past several years the IRS has increased its audit staff significantly. This is allowing the IRS to conduct additional audits. Many of these new agents are CPAs.
What should you expect if you get an IRS audit letter? Typically, the length of the audit will be determined by the total assets of your dealership. If your dealership reported assets of over 10 million dollars, then you will fall under the guidelines of the Large & Medium-Sized Business Division, or LMSB. If your dealership has fewer than 10 million in assets, then you fall under the guidelines of the Small Business and Self Employed Division. Keep in mind that even medium-sized dealerships may have 10 million of assets due to inventory levels.
If you are considered a Small Business in the eyes of the IRS, then the audit may last several days to a few weeks. The IRS will ask for a lot of documents, including ledgers and journals, bank statements, and your CPA’s tax workpapers. The agent may not spend much time on these documents. Instead, he(she) will typically review your tax returns in advance and have a few items in mind that he wants to focus on. He will not disclose the areas of focus at the outset. No matter what Division you fall into, you will be asked a series of questions at the start about your business, the nature of your transactions, and your related parties. The agent will perform a search of certain records to determine who the related entities are. Be honest about disclosing the related entities as the agent will most likely already have information on them.
Those unfortunate dealers who fall under the “LMSB” will be shocked to find out the time estimate for their audits. The IRS will provide a timeline that states that the field audit will last approximately six to nine months, with the agent spending one to three days per week at your store. The wrap up period will be approximately another three to six months. The field work is typically shorter than six months but could still be several months.
The auditor may ask the taxpayer to produce all of the accounting records electronically. He can ask for the last three years’ worth of records in this format. The IRS will send in a “computer audit specialist” to retrieve the records and use the data to pull samples for testing and to review transactions. A dealer is required to have such data electronically. There are fines if you can’t produce the electronic data. It is my understanding that many dealers do not have three years’ worth of electronic records. Dealers should consult with their software vendors to ensure compliance with this important requirement.
In conclusion, it is disturbing that IRS audit activity has increased dramatically. Dealers who use CPA firms that are keenly aware of auto dealer tax issues can gain credibility with the IRS auditors. When the IRS auditor is comfortable with the dealer’s CPA’s knowledge of the auto industry’s unique tax and accounting matters, the scope and timing of the audit can be reduced significantly.
If you have any dealership management questions, please contact Paul McGovern at pmcgovern@downeycocpa.com.
