Why Does the IRS Want to Audit My QuickBooks File?

auditIf you are reading this article then it is likely that you or your client has received a request to submit a QuickBooks file in conjunction with an IRS Audit or an audit by another government agency. The Internal Revenue Service started this new level of enforcement in 2010 in which their agents are now requiring the actual accounting database (be it QuickBooks or another accounting software) as a part of the audit process. Certainly, government revenue departments can use information to gather any sort of data relevant to an audit. In my role in helping clients prepare their files for submission to these governmental agencies I have noticed some patterns in what the IRS seems to be looking into and I wish to share that with you here.

Improper Payments to Owners

Throughout the history of S corporations (can apply to LLCs also) there has been an undefined area in the IRS code relative to wages vs. dividends. Typically the owner/s of an S corporation (which are generally small in nature) earns ordinary income as the manager of the business and earns dividends as an investor in the business. There is an incentive from a tax perspective for the owner to maximize his or her reporting of dividends because dividends are not taxed for payroll taxes (typically 15.3%) which can be a substantial savings to the owner. There is no direct guideline as to how much the owner must pay him or herself to be in compliance with the IRS, but the owner needs to earn a salary commensurate with what someone performing the same work would receive on the open market.

This opens up a large gray area that seems to be of particular interest to the IRS when reviewing your financial database. Additionally the IRS is looking for any improper payments that pass between the owner and the business that are not recorded in the data file. Prior to submitting a file to the IRS, review any such transactions and have an explanation of why they occurred and why you chose to report the transactions as you did.

Improper Payments to Employees

Likewise, improper payments to employees that are not properly recorded as wages are another area of concern. Especially if you or the client is using QuickBooks Payroll Services, you need to review all transactions between employees and the business to assert that all benefits to employees were correctly accounted for in conjunction with your representations on tax forms.

Make sure to also review any non-payroll transactions with employees and search for any transactions where the employee may have been listed as an “other name” or as a “vendor”, because these will certainly be scrutinized during the audit.

Real Estate Concentration

Nearly 70% of customers who contact us to help prepare their QuickBooks file for submission to the Internal Revenue Service are involved in the real estate industry. Whether they are real estate agents, mortgage brokers, construction companies, title companies or otherwise, This would seem to be a substantially larger percentage than chance would predict and so we need to ask ourselves why is the IRS focusing so heavily in this area.

Real Estate has obviously gone through a major boom bust cycle in the United States over the recent years, and it would seem that the IRS is reviewing QuickBooks files to locate significant transfers of money and whether that money was properly classified on the books of the organization. An example of such a misclassification might be taking what should be classified as a capital loss and reporting it as an expense. Additionally the IRS may be looking at transactions to make sure that the owner is materially participating in the business and thus can legitimately take certain deductions.

Whatever the basis for their inquiry may be, it would seem very important that you review all material transactions in detail before you submit your file to the IRS as these large dollar transactions seem to be of special importance in the evaluation process.

What are they not looking for?

Historically IRS audits have focused on businesses that have a large amount of small cash based transactions which can be easily hidden from reporting on tax returns. You may have encountered the occasional restaurant that will charge you $12 to use credit card vs. $9 if you pay cash. That’s because the credit card transaction can be easily traced by the IRS. These are just the sort of organizations that have classically been the focal point of IRS audits, however in our experience we see very few businesses that have an extensive amount of small transactions or businesses with an intensive use of inventory (i.e. retail in nature) among our customers. If you, or your client, are having the IRS request a QuickBooks file and that business has a large amount of transactional data, we would suggest that the IRS is more likely looking to review one of the above areas rather than the small individual transactions alone.

Note: This will not be true if you are being audited by a sales tax agency.

The possibilities of what the IRS is reviewing in your data file are infinite, but hopefully this can provide you a generalized guideline for what is likely going to be examined as a part of the audit process.