Audit update

[geekgirldany]

I posted some threads awhile back about a customer of mine that was/is getting audited. Business is a cabinet shop. Been open since May 05. About two weeks ago they got the final ressults. Examiner said they were under the 2002 code for requiring inventory and went into great detail about why, did the changes, and also explained why they are not a custom cabinet shop. Changed them to the accural method.

CPA met with supervisor of agent. He told the supervisor that they company is under the 2001 code... under 1 million in gross receipts. Supervisor said 2002 supercedes the 2001 code. CPA said no its either one or the other. So the supervisor said he would have to look it up and double check.

CPA got call back that the IRS is dropping the whole thing. That my client and the CPA is correct and the clients fall under the 2001 code.

I just wanted to let you all know the outcome because I have discussed it here alot and got so much help from you all. I'm glad it turned out okay and nothing had to go to court.

Thank you

[Gretel]

Thanks

for sharing. I am glad it went well. We are not supposed to use names here, but it really sounds upsetting that IRS agents can do about anything, right or not, and we always have to fight. I thought I have a peaceful occupation, ha.

[dmj4]

What do you do?

What do you do when they start out under a million with cash and then they rise above a million after a few years? Do you have to change to accrual?

[geekgirldany]

If it goes over a millon then you go to the next test which is the 2002-28. It states:


* You satisfy the gross receipts test for each prior tax year ending on or after December 31, 2000 (see Gross receipts test for qualifying small business taxpayers, next). Your average annual gross receipts for each test year (explained in Step 1, listed next) must be $10 million or less.
*You are not prohibited from using the cash method under section 448.
*Your principle business activity is an eligible business.
*You have not changed (or have not been required to change) from the cash method because you became ineligible to use the cash method under Revenue Procedure 2002–28.

So if you are under 10 million or less the company is okay. I'm unsure of what the section 448 is.. forgot. Thing is it has to be Eligible business. This is where my clients were being challanged. They fell in an ineligible business class code according to the IRS.

IRS was saying they are manufacturers so they must use accural. The exception to the rule is if the manufacturer is custom. The company then really has to prove it is custom. I looked up many many cases where this was or was not proven. The IRS was saying my clients are not. But they are and was ready to prove it. Thankfully the IRS saw they fit under the 2001 class code and it didn't go any further. But I'm sure the will be watching the returns in the future.

I'm happy how it has turned out. Nothing in writing yet though. Even though the CPA did represent the client I also did alot of research on it. Looking through court cases and IRS regulations. Quite a learning experience. I don't see how the agent did not look at the 2001 revenue code first though. Maybe he just assumed.

[Unregistered]

manufacturer's do get to be cash

TTB 8-20 shows the list of eligible businesses for cash basis under 2002-28 and manufacturers whose business code falls under the manufacturing NAICS codes are eligible businesses. TTB doesn't say that they must be custom manufacturers, just manufacturing. I have a manufacturer that makes commercial light fixtures and they fall under this prodedure, or so I thought.

[Bees Knees]

You read it wrong. TTB page 8-20 says:"Under number (2) above, an eligible business is one with a principal business activity described in a North American Industry Classification System (NAICS) code that is not one of the following:"

And then it lists manufacturing.

Basically, the ones that are not on the list (and thus qualify for the cash method) are all of your service type businesses.

[Unregistered]

what is "custom"?

So how do you prove that a manufacturer is creating a custom product? In the case of my lighting manufacturer, each run of product is designed specifically for the end customer. They keep no finished goods inventory on hand, as they may not know the specific specifications each end user may need. Would this count as "custom"?
Also, thanks for catching my momentary bout with dislexia. LOL.

[Bees Knees]

So how do you prove that a manufacturer is creating a custom product? In the case of my lighting manufacturer, each run of product is designed specifically for the end customer. They keep no finished goods inventory on hand, as they may not know the specific specifications each end user may need. Would this count as "custom"?

Rev. Proc. 2002-28 (the $10 million or less exception) says that NAICS codes 31 – 33 for manufacturing do not qualify for the cash method exception. Except for average gross receipts under $1 million, a manufacturer is subject to the accrual method of accounting.

Rev. Proc. 2002-28, Section 4.01(1)(c) provides an exception. It says:

“Notwithstanding that a taxpayer's principal business activity is
described in one of the ineligible NAICS codes listed above in section
4.01(1)(a), the taxpayer reasonably determines that its principal business
activity is the fabrication or modification of tangible personal property
upon demand in accordance with customer design or specifications. For
purposes of this rule, tangible personal property is not fabricated or
modified in accordance with customer design or specifications if the
customer merely chooses among pre-selected options (such as size, color,
or materials) offered by the taxpayer or if the taxpayer must make only
minor modifications to its basic design to meet the customer's
specifications. Moreover, a taxpayer that manufacturers an item in
quantities for a customer is not treated as fabricating or modifying
tangible personal property in accordance with customer design or
specifications.”

The Rev. Proc. then goes on to give examples:

“EXAMPLE 10 -- TAXPAYER DOES NOT SATISFY THE NAICS CODE EXCEPTION IN
SECTION 4.01(1)(a), the Service Exception in Section 4.01(1)(b), or the
Custom Manufacturing Exception in Section 4.01(1)(c). Taxpayer is a sofa
manufacturer that only produces sofas upon receipt of a customer order.
Customers are allowed to pick among 150 different fabrics offered by the
Taxpayer or to provide their own fabric, which the Taxpayer will use to
finish the customer's sofa. Taxpayer's principal business activity is
described in the ineligible NAICS code 33. Taxpayer does not provide sofas
incident to the performance of services for purposes of section
4.01(1)(b). Rather, Taxpayer performs certain services (upholstering)
incident to the sale of sofas. Taxpayer also does not fabricate or modify
tangible personal property for purposes of section 4.01(1)(c) because
customers merely choose among pre-selected options offered by Taxpayer and
Taxpayer only makes minor modifications to the basic design of its sofa.
Taxpayer may not use the cash method under this revenue procedure.”

“EXAMPLE 12 -- TAXPAYER CREATING PROTOTYPE DOES NOT SATISFY THE NAICS
CODE EXCEPTION IN SECTION 4.01(1)(a) BUT DOES SATISFY THE CUSTOM
MANUFACTURING EXCEPTION IN SECTION 4.01(1)(c). Taxpayer makes tools based
entirely on specific designs and specifications provided to it by
customers. Taxpayer produces the customer's prototype and gives the
prototype to the customer for production. Taxpayer's principal business
activity is described in the ineligible NAICS code 33. However, Taxpayer's
principal business activity is the fabrication of tangible personal
property upon demand in accordance with customer design or specifications
for purposes of section 4.01(1)(c). Taxpayer may use the cash method under
this revenue procedure (subject to the potential application of section
460).”

[Unregistered]

cash method

Thanks for the reference material. I had already read both of these examples this morning and am still on the borderline as to whether my client falls under an eligible classification.
The only problem is that the second example referenced seems to be saying that if a taxpayer creates a prototype for a customer and then, upon customer approval, builds 1000 pieces of the prototype for customer use they fail the test and are ineligible. Am I interpreting this example correctly, and if so do you believe that I am applying it to this situation in the proper context?

[Bees Knees]

My interpretation is that it is not talking about prototypes. It is talking about custom items that are not going to be mass produced later. Or maybe the custom manufacturer who builds a prototype is a custom manufacture if it is another company that actually does the mass production based off the custom manufacture's end design.

[Bees Knees]

I would think it is probably also applicable to a custom cabinet maker, who makes special cabinets for each job and no two jobs are ever identical.

[geekgirldany]

It is a very thin line to the IRS on what is custom or not. I found a court case where an asphalt company had to go to court to prove they could not have inventory. IRS was saying even if they held the inventory for just a few hours or a day they should be accural. The Tax court found in favor of the asphalt company.

The IRS took the position on the custom cabinet shop... that yes they do a few custom jobs but most are not. That because the builders or contractors pick out the design makes them not custom. Just because they have different designs and colors for them to pick from does not make them custom. Well I'm sorry but to me this is the very custom. These are not prefab cabinets they are custom made for the customer.

Like I said the client was ready to prove they are custom. But under the NACIS code it says for cabinets shops... even those that are custom. The CPA told the supervisor that it sounded like to him no one could be custom under this defintion.

[geekgirldany]

Okay now the agent has come up with one last thing. He is saying that inventory was not carried forward to 2004. It is about $1000. I did carry it forward. The amount was adjusted under Purchases. But it is not showing on page 2 under COGS. So I believe that the agent thinks the amount was not accounted for.

The CPA says the clients should settle. They will owe $500. He says that if they disagree with it then he is going to charge them several thousand dollars to go back to the agent. He says they need to just make it go away. The client is not willing to settle.

What do you guys think? Would you advise the client to settle even though you know the agent is wrong... even though they would only owe $500? I'm not so sure. I believe it is the principal of the thing that they are in the right.

They are now wanting me to take over.

[JON]

Missing something

Are they back to the "cash". You adjusted the $1,000 of inventory through purchases???. Even on cash invenories remain, prepaids. A $500 change in inventories does not cause $500 in taxes. There should be something in "prepaid" for the invenorties-are we agueing over $500-$1000. If so you will get the expense as the inventory comes down in 2006.. If that is the only point and inventory was recorded wrong on the original return there is probably not a lot of argueing, but a mention that it should be only $500 to the auditor would be nice. If he does not budge you correct it in 2006 and they get the deduction then.

Those CPAs are terrible...

[geekgirldany]

I'm sorry I guess I didn't explain well. Got the fuzzy head today

Yes they are back to Cash Basis. Well what happened was the previous accountant did not list the inventory on page 2 under beginning inventory/ending inventory. He made the adjustment under purchases (quickbooks). I know its strange.

The ending inventory in 2003 was $2000. The ending inventory in 2004 was $850 (real numbers not rounding). According to the reading of the paper work he is saying that I did not carryfoward the $2000 in inventory to 2004. So he made a $1150 adjustment to 2004. But I made an adjustment under Purchases account of $1150. So say at the end of 2004 the Purchases account was 50,000... I added $1150 to that so the inventory would be accounted for and come down to $850. The 50,000 now shows $51150.

So Page 2 should have shown:

Beg Inv: $2000
Purch: $50000
End Inv:$ 850
Cogs: $51150

Instead it shows:
Beg Inv: 0
Purch: $51150
End Inv: $0
Cogs $51150

It comes out the same but it just wasn't listed correctly. The amount is correct but it wasn't shown correctly. It showed the inventory on the balance sheet though. I know this is crazy way to do it and I can understand why he wouldn't know it was there or not. At the time I took on the client I thought it was best to leave it how the previous accountant had done it. I know now I should've showed it.

So if we go by what the agent is saying there will be another $1150 added which results in $500 in taxes they will pay. I don't think they should fight it too much but it is the principal of the thing.