For business returns, the IRS may review entries that reduces taxable income, such as a deferral or postponed recognition of income. A deferred income account (typically included in the liability section of the balance sheet), may indicate income from services performed or merchandise shipped and received by the customer. A deferral of income is not proper in these cases. Additional examples include “loans to shareholders,” suspense accounts, and reserve accounts.
The IRS may analyze Cash accounts s to identify unusual transactions, i.e., transactions that are not part of the day-to-day operations, and transactions involving shareholders, partners, or employees. They may also:
The IRS may start from your beginning and ending balances, and then tie those balances to the general ledger to the subsidiary ledger. Credit balances may indicate additional income or unrecorded sales. The IRS may also review old receivables, where no legal or collection action has taken place. The receivable may have been paid directly to a shareholder, partner or employee and left on the books.
The IRS is aware that Ending inventory can be manipulated to control new profit, therefore agents may look for write-downs, review items valued at $0, and trace values back to purchase invoices. They may also review your inventory sheets and identify how the inventory value was determined (Cost or Market, LIFO or FIFO).
The IRS may review Loans to shareholders to ensure entries to this account are not distributions of earnings, dividend income, or another form of taxable income reportable by the shareholder. If a loan exists and interest is paid, IRS may consider imputing interest at the current rate. If no repayments have been made, the agency may consider whether the debt has been forgiven.
In some cases, business owners incorrectly or due to oversight continue to keep assets on the balance sheet, even if disposed of. The IRS may review Buildings and other depreciable assets to verify additions and deletions. They may also like to know how the purchase was financed. Whether the asset is being exploited for personal use. If assets are removed from the balance sheet, how did the disposition occur? Was the disposition accounted for?
The majority of accounts payable should be inventory purchases; when the value of the account payable is similar to or greater than inventory, there may be a misstatement of ending Inventory.
Accounts payable should be identified (beginning and ending balances); the IRS may tie the trial balance to the general ledger; check for adjusting entries, netting of related accounts receivable, or reclassifications that may be unreported income or understatement of sales. The IRS may also Review your policies for making payments; deviations may be reviewed as well.
Loans from financial institutions to the taxpayer, where the shareholder cosigned or guaranteed the debt, are not loans from shareholders; these loans should be included in Notes Payable.
According to the IRS, auditors should make sure the transactions reflect a bona fide loan and loan repayments; there should be a loan instrument with terms and stated interest rate. The auditor is also required to review whether the shareholder have the means to loan the money to the entity? If not, what was the source of funds? Finally the agents are told to consider whether the loan is a capital contribution and if the interest paid to the shareholder is really a dividend.
The IRS may review Schedules M-1 and M-2 and make sure items such as meals and entertainment, book versus tax depreciation, penalties, etc. are accounted for and that no item with potential tax impact is incorrectly included in retained earnings rather than addressed on the tax return.
They may analyze retained earnings including all adjustments and adjusting entries. The reasons for the adjustments must be reasonable. Entries that are debited or credited to retained earnings have no effect on the profit and loss statement for the current year.