Tax Returns: Reading Between the Lines

Disputes in either business or amongst family members have one common aspect: money. Who has it, who had it, where did it go and how do I get more of it. Inevitably the first set of documents requested in any dispute is the previous five years of filed tax returns.

The review of tax returns is an important starting point as it begins to paint the financial picture behind the dispute. Despite the fact that not everyone is, shall we say, transparent and forthcoming in their tax reporting, and the fact that the forms are loaded with government speak and tax law contortions that defy the laws of economics, there are several areas worthy of greater focus and scrutiny. Summarized below are 10 items forensic accountants initially look for when analyzing tax returns.

The income, expenses and balance sheets disclosed on the tax returns are initially scheduled out for the 5 year period and analyzed for any fluctuations. Business returns are also compared to industry data or other relevant benchmarks. This process will quickly isolate any areas requiring additional review and inquiry.

When evaluating the cash flow to an owner of a business based on the tax returns, it is important to remember that operating income is not equivalent to cash flow. Cash is often retained in the business to fund operations or if the accrual method of accounting is used income is reflective of unrealized receivables and payables. Instead, distributions, guaranteed payments, wages and other perks, the actual funds taken out of the business from the earnings, are used to calculate the actual cash flow.

The evaluation of reasonable compensation requires an understanding the differences that are inherent in the type of business entities. Officers of a corporations and S-Corporations are considered employees and receive a W-2 for their services. On the other hand, owners of a partnership are not considered employees; therefore, they receive their compensation through guaranteed payments.

Distributions through an S-Corp must be in proportion to the shareholder’s interest. Disproportionate distributions could cause the S election to be invalidated. If distributions appear to be disproportionate, it’s important to review the shareholder agreement to ensure proper treatment.

The allocation of income and losses are allocated based on the partnership agreement. However, distributions can be disproportionate. Although acceptable, it important to review the payments in connection with the partnership agreement and evaluate the rational for the method of allocation.

After the initial contribution, any funds contributed by the owner are often treated as a loan from the shareholder. To withstand scrutiny the loan should be made at arm’s length, in appearance and fact. Standard documentation including an agreement with a stated interest rate, repayment terms, maturity date, collateral and consequence for failure to pay should be evaluated. The second level of review is to ascertain if the company can in fact repay the debt. The result may be to view the debt as equity.

It is not uncommon for owners and officers to stretch the definition of the term business expenses. Typically “perks” such as auto expenses, meals and entertainment, and travel, are expensed under the guise of business expenses. A review of the general ledger detail to note any payees which may be related to personal spending and or large unallocated credit card payments are worthy of further review.

Understanding how to read three schedules on a business return known as M-1, M-2 and M-3, will provide valuable insight into how the business accounts for items on their books versus what the IRS requires on the tax returns. These adjustments can include income recognition, timing of expenses, and the write off of property and equipment amongst a myriad of other items. Once properly evaluated adjustments can be made to reflect the actual economics (cash flow) of the business.

An understanding of any related entities with similar owners is essential. One common situation is the payment of rent to a related entity. Obtaining all lease agreements to evaluate the arm’s length nature of the agreement and whether the payment is equivalent to market value is essential to understanding the totality of the financial value being derived by the owners.

Entities in a cash business, (restaurant, hair salon, landscaper, auto repair shop, ect) may struggle to properly document and report their cash receipts. The evaluation of unreported income is a vital step in the process. Methodologies such as reviews of business bank statements and use of income reconstruction techniques become important tools in evaluating the business cash flow.