The tax agencies (Federal, State and Local) remain ever vigilant in their efforts to ensure the compliance of individuals and entities with tax laws. Yet, there are instances when a civil enforcement action takes an unexpected turn, or a whistleblower provides information that results in far more severe consequences. It is those times when the Criminal Investigation Division of the IRS or the State equivalent gets involved.
Certainly not every audit or complaint results in a criminal referral. The resources of the IRS and the Department of Justice are limited (it may not seem that way). As a result, the government focuses on high profile and egregious cases, the ones most likely to garner press coverage, to deter others who would attempt to engage in criminal tax shenanigans.
The focus here is on the manufacturing industry. From procurement and subcontractors to supply chain and warranty claims, opportunities for perpetrating fraud in a manufacturing company are plentiful.
Tax frauds affecting manufacturers can be industry specific or industry agnostic, such as the overstatement of personal expenses, unreported perquisites accorded to officers and owners, and fabricated deductions (no pun intended). Discussed below are the types of tax frauds endemic to the manufacturing industry. While reading, keep in mind that the difference between civil and criminal liability is intent, and while any of the schemes described below could give rise to civil liability, it takes another level of planning and coordination to get to the level of criminal intent.
Research and Development Credits
Many manufacturers are involved in ongoing research and development (“R&D”) to create new products or improve old ones. The IRS as well as some states provide for R&D Credits, which can be used to offset a company’s income tax liability. The Tax Cuts and Jobs Act expanded the credit to also allow for the offset of payroll taxes. When manufacturers do not appear, on the surface, to be engaged in R&D type activities, a careful assessment of whether the company has eligible expenses to claim the credit is especially critical. This assessment will typically require an appropriate review of the business activities and expenses of a company and a third party evaluation on the value of the allowable expenses.
Where manufacturing companies tend to run into trouble is in the quantification of eligible expenses. Many manufacturers have been known to fabricate R&D expenses resulting in the inclusion of non-includable items in the company’s calculation of R&D credits.
Inventory Capitalization 263A
Inventory is particularly vulnerable to fraud because it is eventually charged to cost of goods sold (COGS), one of the largest expenditures for most manufacturers. Manufacturers must account for inventory whether in the form of raw materials, work in progress or finished goods. Therefore, companies need to keep accurate records to support the reporting of their inventory; nothing new there. Part of the process of accounting for inventory is the inclusion of overhead and some general and administrative items under Internal Revenue Code section 263A. The value of a company’s inventory has a direct correlation on its deductible cost of goods sold (the lower the inventory, the higher the cost of goods). For this reason, a company has an incentive to skew inventory valuations lower to increase the cost of goods expense and thereby lower net income. While there is some flexibility here, the 263A rules provide overall guidance on how to allocate these costs and stay compliant. Given the complexity of the calculations required, there is plenty of room for error as well as abuse.
After the Supreme Court decided South Dakota v. Wayfair, physical presence in a state is no longer required for that state to have the power to compel businesses to collect sales or use taxes for sales made to its residents. Therefore, companies may be surprised by the number of state and local tax filing obligations and requirements they have.
There are hundreds of possible jurisdictions that require tax compliance, leaving the door open to widespread confusion and honest error. Moreover, there are those who collect tax and fail to remit it, as well as those who knowingly fail to register with a state or collect state and local taxes. The potential for mistakes that could lead to a criminal referral is considerable. Even more importantly, state and local tax liabilities typically carry personal responsibility. Consequently, working with a tax professional can prevent an honest error from becoming a criminal liability.
Transfer what? This is an area that has recently gained significant scrutiny as a result of several high-profile tax cases. These transfers are often used to allocate profits between related companies in a multi-national organization. The transfer of goods and services can also be used by manufacturers looking to shelter income by transferring costs from profitable companies to related entities with losses, or between a for profit and not-for-profit entity under common control. Therefore, when goods or services are transferred between related entities, the cost of the transfer must be done in a commercially reasonable manner. The tax authorities investigate these transactions to insure they are not merely a ploy to shift income to low tax jurisdictions and expenses to high tax jurisdictions.
As with R&D credits, a third party is typically needed to opine on the terms of these transfers of goods and services. Due to the room for enormous abuse, the government closely scrutinizes the value at which these transferers are made; therefore, it is important to have them valued by an independent expert.
“Employees” Paid in Cash
Payroll expenses are usually a relatively large expenditure for manufacturing companies. For this reason, taxing jurisdictions have come to realize they may be losing a significant amount of payroll and related taxes from manufacturing companies due to practices such as cash payroll and worker misclassification of workers whose taxes are not being withheld and remitted to the government. The short-term economic incentives of paying employees in cash can be exciting for employers, as cash payments “allow” companies to avoid insurance, tax, and reporting obligations. Where gray areas may exist with respect to some of the schemes mentioned above, paying employees in cash, and avoiding employer tax obligations is an obvious and blatant disregard of the tax laws. The underpayment of withholding taxes coupled with affirmative acts by an employer that demonstrates gross disregard of employment tax laws constitutes employment tax fraud.
If you are a manufacturing company whose previous actions could raise questions concerning your exposure to civil or criminal penalties, reach out to a Withum tax controversary professional, who is well-positioned to assist you in developing a plan to resolve the issues of the past and move forward.
Contact Withum’s team of professionals if you have any questions or concerns.