Over the last few years, auto dealer audit activity has increased dramatically.  We do not feel that there is an attack on the automotive industry.  The IRS has ramped up its audit activity across all industries.  Compared to other industries, auto dealers get selected more frequently because their total assets and sales are high compared to other businesses.

If your total assets are less than ten million dollars, you will fall under the small business audit division of the IRS.  In this division, you are grouped with businesses that may have as little as a few thousand dollars in annual sales.  These auditors are not experienced with taxpayers the size of auto dealers and the agents are not familiar with automotive accounting and procedures.  They tend to focus on basic issues such as T & E, transactions with related parties, CPA journal entries, and attempting to reconcile the receipt of cash to sales.  They have an audit program that requires them to somehow justify that the cash received has been recorded properly on the tax return as sales.  These audits will last from three to fifteen days of field work, spread over several weeks, and will take approximately three months to conclude. 

Dealers with over ten million in assets will fall under the mid to larger audit division.  If you are in this category, you will be given a timeline that suggests that these audits will take nine to twelve months to complete.  If your records are clean and there are not many issues, the audit could be wrapped up sooner.  You will receive an Information Document Request, asking for all schedules and journals, bank statements, dealer year end statements, adjustments and CPA tax work papers that reconcile your figures to the tax returns.  These auditors will be veterans that generally audit taxpayers that are at least the size of auto dealers.  They may reference the IRS audit guide for auto dealers.

Either division will be requesting shareholder and related party returns.  This does not encompass auditing those other entities, but they will focus on related party transactions. 

If you have not been audited recently, you should consider the following items:

• Make sure that you are properly charging employees and owners for demos.  The IRS came out with simplified methods in 2002 and you should be using these methods.

• All related party loans should be performing loans with interest, written agreements, and scheduled principle payments.  Owner accounts and notes receivables are red flags and the auditors will consider reclassifying these as dividends.

• In recent years, losses have been incurred by many dealers and those losses have been deducted on the owner’s personal return.  Losses can be deducted when the owner “has basis and is at risk.”  What this means is the owner has capital and or loans to the company in excess of the cumulative losses that have been deducted.  Your CPA must be able to produce meticulous records going back several years to support the deductions.  Your chances of audit increase significantly when your retained earnings are negative as the IRS will want to verify that you have proper basis when deducting losses.

• You are responsible for producing electronic accounting records to the IRS, going back three years.

• Be smart about owner meals, entertainment, and personal expenses flowing through the business.  If the agent finds any type of impropriety in this area the scope of the audit will increase. 

• Do not get frustrated when the agent asks a “dumb” question due to his lack of knowledge of your industry.  These silly questions will force him to waste a lot of time on matters that will lead to nothing. 

• The audit will run much smoother and come to a conclusion sooner when the agent feels your CPA is an expert on automotive tax and accounting matters.

Downey & Company specializes in accounting and taxation of automobile dealerships.  For more information, email Paul McGovern at PMcGovern@DowneyCoCPA.com or call 781.849.3100.