Did you know that the IRS can assess penalties against
a tax preparer as well as a taxpayer?
I am looking at an IRS Chief Counsel Memorandum recommending
a preparer be penalized for a deduction on a client return.
You do not see that every day.
Let’s talk about it.
As is our way, we will streamline the issue so that it
is something you might want to read and something I might want to write.
A taxpayer accrued expenses on its books for customer early
payment discounts and estimated write-offs for disputed billing and shipping
charges.
Sure, easy for a CPA to say.
Let’s clarify. The company sold stuff. It allowed
discounts if a customer paid early. It also had routine billing disputes – for quantity,
quality, price, damage and so on. As part of its general accounting, it
estimated these charges and recorded them as expenses when the related sale was
recorded.
Makes sense to me. Generally accepted accounting wants
one to record all related expenses when the sale is recorded. This is called
the “timing principle,” and the idea is to present net profit from a sales
transaction as well as reasonably possible. What if all the expenses are not
known at that precise moment - say, for example - the amount of product that
will be returned because of damage in shipping? Generally accepted accounting
will allow one to estimate that number, normally by statistical analysis of
historical experience.
BTW you better do this if you expect to have your
financial statements audited. Part of an audit is a review of your accounting
method, and the “estimate that number” described above is considered a
best-of-breed.
Generally accepted accounting might not work when you
get to your tax return, however. Why? Well, generally accepted accounting is
trying to get to the “best” number in an economic sense. Tax accounting is not
trying to get to the “best” number; rather, it is trying to measure your
ability to pay. Pay what? Taxes, of course.
Let’s go back to our taxpayer. They estimated a bunch
of expenses when they recorded a sale. They included those numbers on their
financial statements. They then wanted to deduct those same numbers on their
tax return.
Problem:
The taxpayer utilized statistics to record the expenses for the two items. The courts held that statistics were not a valid method to record the amounts.”
Their CPA firm had to review the accounting method and
decide whether it was acceptable for tax purposes.
There is even a Code section and Regulations:
Reg § 1.461-1. General rules for taxable year
of deduction
(a)(2) Taxpayer using an accrual method.
(i) In
general. Under an accrual method of accounting, a liability (as defined in
§1.446-1(c)(1)(ii)(B)) is incurred, and generally is taken into account for
Federal income tax purposes, in the taxable year in which all the events have
occurred that establish the fact of the liability, the amount of the liability
can be determined with reasonable accuracy, and economic performance has occurred with respect to the
liability.
You see that
last sentence and its reference to “economic performance?”
For
generally accepted accounting, one must:
· Establish the fact of the liability.
· Measure the amount of the liability with
reasonable accuracy.
Tax then
adds one more requirement:
· Economic performance on the liability
must have occurred.
That third
requirement is what slows down the tax deduction.
What is an
example of economic performance?
Say that you
record expenses for services related to the sale. Economic performance wants to
see those services performed before allowing the deduction. What if you know -
because it has happened millions of times before and can be calculated with
near-arithmetic certainty – that the services will occur? Tax doesn’t care.
But the auditors signed-off on the financial statements, you say. Doesn’t that mean that experts agreed that the accounting method was valid?
A taxpayer’s conformity with its accrual method used for financial accounting purposes does not create a presumption that its tax accrual method clearly reflects income.”
And there you have a brief introduction to why a company’s financial statements and its tax return might show different numbers. Financial statement accounting and tax accounting serve different purposes, and those differences have real-world consequences.
In this situation,
I side with the IRS. Work in a CPA firm for any meaningful period and you will
see tax people repetitively “tweak” the audit people’s numbers. It happens so
often it has a term: “M-1.” Schedule M-1 is a tax schedule that reconciles the
profit per the financial statements to the profit per the tax return. The
possible list of differences is near endless:
· Entertainment
· Depreciation
· Allowance for uncollectible receivables
· Accrued bonuses
· Reserve for warranties
· Deferred rent
· Controlled foreign corporation income
· Opportunity zone income
And on and
on. Knowing these differences is part of being a tax pro.
The Chief Counsel
wanted to know why the tax pros at this particular CPA firm did not know that
this generally accepted accounting method would not work for purposes of the
tax return.
To be fair,
methinks, because it is complicated …?
No dice,
said the Counsel’s office. The preparer should have known.
The items deducted constituted a substantial part of the return.
TRANSLATION: It was a big deduction.
And therefore the preparer penalty is appropriate.
TRANSLATION: Someone has to pay.
Mind
you, a Chief Counsel memorandum is internal to the IRS. The taxpayer – and by
extension, its CPA firm – might appeal the matter to the Tax Court. I would
expect them to, frankly. The memorandum is just the IRS’ side.
For
the home gamers, today we have been discussing Chief Counsel Memorandum
20223301F.
