• Home
• Federal Income Taxes
• State Tax Laws
• Estate Planning
• Publications
  • Ag. Handbook #731
  • Internal Revenue service
  • Tax Articles
  • Historical Documents
  • Forest Service Publications
• Professional Research
• Tax Workshops/Education
• Tax Policy
• Links

Chapter 8 - Examining Expenses

Examining Expenses Cash Disbursement Journal

Of the books and records examined by the group, approximately 50 percent were prepared by an accountant or a bookkeeper. The journals will usually be simple cash disbursement registers. It is rare that a double entry set of books will be used unless the contractor is fairly large. However, the accuracy of these journals depends on the source of the entries. In many cases the source of the entries will not be the cancelled checks but the check stubs. The check stub typically will not be complete as to the payee, date, and amount; the contractor will simply write the account number in which he or she wishes the expenditure to be placed. Simply coding checks to different accounts may permit the bookkeeper or accountant to miss personal expenses included by the contractors. As is the case of many accountants, the quality of the records kept depends upon the quality of the accountant.

When the contractors maintain their own books and records, they provide the preparer with a list of their income and expenses. Normally, the contractors will total their cancelled checks plus the expenses paid in cash to determine total expenses and use the bank deposits to determine income. As previously mentioned, the taxpayer usually will have a family-owned business with poor internal controls, so the contractor's records rarely will match what is reported on the return.

Invoice/Receipts

Because of the lack of internal controls within the contractor's business, there will often be missing or nonexistent invoices to verify expenses. This is especially true for expenses that are purportedly paid in cash.

Payroll Tax Records

In some cases the contractor will keep the basic payroll records, that is, timesheets and payroll checks. Normally the contractor will not have any type of formal payroll journals.

Other Records

If you are lucky, the contractor may provide you with copies of his or her contract award letters, and copies of his or her job bids. However, this is normally the exception, not the general rule. You can get copies of the job bids from the Federal agencies provided you obtain enough specific information about the contracts to request the information, (that is, contract numbers, the locations of the job, the agencies issuing the contract, etc.).

Audit Techniques

Standard audit techniques may be used to examine the contractor's expenses. The group has found that returns should be scrutinized to determine whether or not the contractors are involved in any of the following or similar types of practices:

1. Padding Expenses

Expenses which are reported on the tax return are often larger than those expenses which have been recorded on the check disbursement journal or worksheets. The group has found that since the reforestation contractors deal in large amounts of cash, the contractors are padding their expenses to deduct cash payments or to reduce their taxable income.

Padding occurs when the books are prepared using a combination of the disbursements journal and available receipts or invoices. There is no problem if the receipts are for cash payments rather than for payments made by check. The problem occurs when the receipts paid by check are used as sources for additional deductions. This is the situation that the group has found to be the most common. The contractors will give you all types of receipts to substantiate the cash expenses, including invoices for items which were paid by check.

A similar situation exists when the contractors use cash to pay ordinary and necessary business expenses for which no invoices are retained. It is not uncommon in this industry for the contractors to use cash to pay wages, gas, food, and other expenses. In this case, the expenses are simply based on the contractor's estimate of cash spent. When the contractor maintains some sort of books and records, you can determine if the contractor is padding his or her expenses through a reconciliation of the "books" to the tax return. However, it has been the experience of the group that the items deducted on the return are not a good representation of the books and records kept by the contractors.

A statistical sample can be used to determine the portion of the expense items which are allowable business expenses under IRC section 162. The size of the taxpayer will normally dictate the type of statistical sampling that will be the most effective.

2. Personal Expenses

Personal expenses are often paid out of a business account as a convenience to the contractor. These expenses should be classified as personal by the accountant or simply added to a nondeductible drawing account. However, in most cases the accountant will accept the figures provided by the contractor and thus personal expenses are not excluded. In other cases, the accountant simply includes personal disbursements, since the check stubs do not contain adequate information to designate that the expense is personal.

Review the cash disbursements journal or check register to determine if personal expenses are being deducted by the contractors.

3. Auto/Truck Expenses

The contractor will purchase trucks to transport the workers to the job site. Auto expenses need to be examined carefully since the contractors may be including other types of expenses in this account. For example, the contractor may be deducting gas purchased for personal usage. The contractor may be purchasing gas for his or her employees which should be included in wage expense. The auditor should also determine if the contractor has included expenses for the repair of automobiles that he or she does not own.

4. Depreciation

In many instances the contractor's detailed depreciation schedule will show that he or she is currently depreciating several vehicles. The areas of concern are unreported sales of vehicles and the determination of the correct asset valuation. The group has found instances where individual contractors are reporting purchases of vehicles, with cash, from other contractors or employees and have no invoices to substantiate the cost of the assets.
Secure the prior and subsequent year returns and compare the depreciation schedules. Look for vehicles which have been removed from the schedules or old vehicles that are fully depreciated. Inspect the prior and subsequent year returns to see if the contractor has reported the sale of any vehicles.
Request invoices to verify the cost of new assets purchased by the contractors. Request a run from the State Motor Vehicles Department (DMV) to show the number of vehicles owned by each contractor. When requesting information from DMV, be sure to include as much information as you have about the contractor. For example, search under the contractors name (include middle name or initial), under any DBA's used by the contractor, and the spouse's name; otherwise your list may be incomplete.

We are currently trying to determine the reasons why the contractors own so many vehicles. We have found that contractors own as many as 20 to 25 vehicles. Our concern is that the contractors may be using the vehicles to transport workers to Oregon, charging a fee for the service and not reporting the income. Our concerns stem from an article that appeared in the Salem newspaper in June of 1990. The article stated that an Oregon contractor was advertising for tree planters in the Los Angles Times. According to one of the individuals who made the trip to Oregon, he was required to pay $250 to the van driver. At this time we have no evidence that reforestation contractors are reporting income from sources other than tree planting or tree thinning.

5. Housing Expenses

The contractors may be paying housing expenses for their employees. These expenses need to be reviewed since only certain housing expenses are allowable deductions under IRC section 119 (employer-paid housing for employees when they are required to stay at the job locations versus paying their monthly apartment rent). Paying the monthly apartment rent is considered additional compensation to already existing employees and must be included as employee wages.

6. Verify Expenses/Oral Testimony

When you have cash expenditures and little or no substantiation, you will be able to allow the taxpayer something provided you can substantiate his or her oral testimony with the documents that you are given. Review the receipts and look for inconsistencies between the contractor's testimony and the invoices he or she has provided.

a. Inspect the receipts looking for items being purchased for the workers which are likely being deducted from their pay. For example, the contractor may include five invoices for the purchase of a single pair of boots from the same store and issued on the same day.
Get a statement from the taxpayer about what he or she provides for the workers and why he or she provides the item. Purchases of personal items for employees are considered to be compensation to the employees.

b. Request the auto repair slips, looking for repairs made on automobiles that are not owned by the contractor. Repairs paid for employees should be considered additional compensation and subject to employment taxes.
As previously discussed, requesting a list of the automobiles owned by the taxpayer will give you the make, model, and license numbers of the vehicles. This list can be compared to the license number on the repair invoices.

c. Automobile and truck expense normally includes gas purchases paid by check and cash. This expense may include personal purchases of the contractor or gas purchased for the employees which should be included in wage expense.

Check for inconsistencies in the contractor's testimony; for example, if the contractor says he or she gives the crew foremen cash to buy gas but makes large monthly payments to major gas companies, such as Texaco, Chevron, Exxon. Check the credit card receipts to see if the crew foremen have credit cards. Call the credit card companies and determine the number of credit cards issued to the contractor.

The regulations under section 62 of the Code provide that an arrangement will satisfy the business connection requirement if reimbursements or allowances are provided for expenses that are deductible under IRC sections 161 through 196. In the reforestation industry, these expenses are deductible solely under IRC section 162.

Get a statement from the taxpayer explaining his or her business practices, that is, who uses gas and who uses credit cards. Inspect the cash receipts to see where the gas was purchased. Determine if total gas purchased is reasonable for the number of miles driven and the number of vehicles owned.

7. Verify Expenses/Reasonableness

The group has not been able identify any sure fire method for estimating income based on expenses or expenses based on income. The closest thing we have to an industry standard appeared in an article in the Oregonian, see Exhibit 6-1. According to this article, a standard for wage expense is between 50 to 60 percent of gross receipts.

We have not been able to determine any other ratio to use as a guide in determining the reasonableness of income reported or expenses claimed. The reason for this is that the Government's estimate is not necessarily based on a true reflection of the actual costs of completing the job. However, as previously mentioned, due to the competitiveness of the industry, the contractors' bids are not a true reflection of the costs of the job, since wages or other costs are cut in order for the contractors to make a profit. In turn, the Government does not have a benchmark to use in determining costs other than payroll.