September 3, 2013
If income taxes are one of the few guarantees in life, the necessity to file income tax returns is another.
This is fortunate because tax returns can be a wealth of information. For example, information obtained can assist in the process of conducting essential due diligence or provide information needed in litigation.
Fraud, errors, inconsistencies and incomplete representations can be damaging if not uncovered. Most distressing is a problem that could have been detected or a surprise that could have been avoided. If harm results to your client, there is exposure to an action for negligence.
First some caveats:
- Don’t assume that the tax returns provided to you are the ones that have been filed.
- Don’t assume that any or all tax returns have been filed.
- Don’t assume that tax returns have been prepared accurately or completely.
- Don’t assume that taxes have been paid.
- Be alert to the existence of amended income tax returns.
- Determine whether audits have taken place or are in process.
- Obtain representations that the information provided is complete and accurate.
To verify the authenticity of the return you have been provided, obtain IRS Form 4506, Request for Copy of Tax Return. The fee is currently $57 for each year, a bargain compared to the potential for embarrassment or worse.
When requesting and analyzing tax returns, request several years’ worth and include state income tax returns as well – they may contain useful information. Be sure to identify all states that the entity is required to file in. Detecting a failure to file in a state is a finding in itself.
Tax returns include business partnership or corporate as well as personal income tax returns, payroll tax, sales tax and 1099 forms.
Payroll tax returns will provide information regarding employees, their compensation, location, periods of employment and apparent value to the organization.
Assuming the returns have been accurately and completely prepared, they can reveal:
- The name of the entity and when it was formed
- The preparer name, address and dates the returns were prepared
- The EIN or employer identification number of the entity and related entities
- Names, Social Security numbers and the addresses of related individuals
- The amounts paid to related parties, both entities and individuals
- The physical address(es) of the entity
- Mailing addresses of the entity and related parties
- The states the entity has operated in, its locations, employees, phone numbers, level of sales, profitability, average inventory, number of and identity of employees, and their payroll
- Ownership and changes in ownership
- The addresses of the owners and related parties
- The method of accounting
- The dates certain elections were made
- The balance sheet at the beginning and end of the tax year
Be sure to review and include supporting schedules. Make year-to-year comparisons looking for changes. A change may be a clue and can include a change in address, ownership, officer, even tax preparer.
When you have identified related parties, consider requesting copies of their income tax returns and financial statements as well.
Individuals who want to keep parties in the dark have been known to use one preparer for one return – say the business return – but another preparer for their personal return. In this way, no preparer sees the total picture, and information can be concealed.
Summarize several years of information on a spreadsheet, a column for each year. Information to be captured includes not only amounts but also descriptions and answers to questions. Enter the answers and amounts on your spreadsheet. Insert columns between the years to calculate percentage changes from year to year. Look for significant dollar and percentage changes.
Applying similar procedures to the non-numerical items on the return will also make changes more apparent. Such items could be changes in ownership, address changes for a shareholder or partner, or a new shareholder or partner.
Information on a business tax return should be consistent with information on the individual’s or related party’s return. For example:
- Wages paid to officers should agree with the wages declared on the personal returns.
- Total sales as presented on sales tax returns should reconcile to total sales on the financial statements and income tax returns.
- Payroll information per state and federal quarterly and annual payroll tax returns should reconcile to information presented on the business return.
- Net income per the financial statements should reconcile to taxable income on the income tax return.
- Information presented on Forms 1099 should reconcile to financial statement and income tax information.
Using color shading to reconcile amounts or highlight discrepancies facilitates your review and the sharing of information with others.
This article was originally posted on September 3, 2013 and the information may no longer be current. For questions, please contact GRF CPAs & Advisors at firstname.lastname@example.org.