“If the World Series were held on Election Day, the networks would project the winner after three innings.”

IRS Audit Guide for Small Retail Businesses

Some readers may have a second small business of this kind, or even a primary retail business. As usual, these IRS audit guides, while intended as instructions to their own auditors, also provide valuable guidelines and warnings for every retailer. Here is a brief overview of what is ponderously called: “IRS Market Segment Specialization Audit Technique Guide — Retail Industry.”

Small retailers tend to be cash intensive. The IRS auditor is looking for controls over cash — and opportunities to under report cash sales (of which there are many).

The examiner will also ask about inventory and specifically inventory tracking and valuation to determine the business’s profits. Of course! Sometimes a small retailer takes his ending inventory by the “ceiling method,” in which he looks up at the ceiling to find the (magic) ending inventory numbers.

The focus here again will be on smaller businesses that often take physical inventories of their goods and keep paper records. Or on the inside of matchbook covers, or on unnumbered sheets (sometimes written in a foreign language, depending on the nationality of the owners).

The IRS typically wants to see lists of: all items paid in cash; all paid invoices for the tax year under examination; sales and cash receipts; cash register tapes; lists of suppliers and wholesalers; and bank statements for the examination year. Here are your overall audit guidelines. Also, I would bet that cash register tapes are the least saved of all those items. (“You see Mr. IRS Agent, once we balance the cash for the day — we throw away the tape.”) Or, if preserved, agree perfectly with reported daily sales.

The audit guide encourages examiners to look into other methods for determining the accounting accuracy of a retailer’s inventory, sales, and purchases. If documentation is not available, or if the examiner believes information is missing, the IRS may look to indirect methods of verification, including direct evidence of income, analysis of gross receipts or bank deposits, or third-party verification. Now the gloves come off! This is the guideline when all the items listed in the preceding paragraph are either not available or not persuasive to the IRS auditor that they tell the complete (and correct) story.

For small retail businesses, the examiner may contact suppliers to verify that the number of items being ordered (e.g., sacks of potatoes) are consistent with other retailers doing approximately the same amount of business. This will help the examiner determine if the taxpayer is using products for personal or other uses, and if so, whether those items are accounted for. It seems the IRS suspects that if one is the owner of a small grocery store — that the owner might be taking home some groceries for their personal use and consumption. Wow! Talk about suspicious! Also, that “other uses” comment probably refers to the possibility of taking out inventory to sell “off the books.” Wow!

The IRS will be examining the business to ensure that all profits are accounted for and that tax is properly paid on all profits. Within that, though, the examiner will be looking for: personal inventory consumption without proper allocation; deferred compensation (such as gift certificate sale); internet sales (for accuracy of sales totals); evidence that the retail “business” is indeed a business engaged in for profit, and not a hobby; proper use of deductions; and what happens to items that are not sold. More warnings for the small retailer.

Additionally, the examiner may look to cash wages paid to employees for employment taxes properly paid. To say nothing of the income taxes that may or may not be paid on such wages. Did you ever wonder about small doughnut shops or small restaurants, where the only “employees” appear to be members of one (frequently foreign born) family? Do they report any payroll at all? Or do they all just “chip in” to help run the family business? And what do they all live on? Doughnuts?

There you have a brief summary. If it doesn’t apply to you — pass it on to a retailer friend it can help. We must emphasize one of the IRS comments about “bank deposits.” One of the unfortunately common ways the IRS catches some retailer (or anyone else in a “cash” business) is to compare their bank deposits for the year with the reported income from the cash business. Incredibly — many times there is a major discrepancy that cannot be explained — and (strangely) the cash deposits are always higher than the reported income from the business. You cannot believe how often this happens! Sometimes, there is a legitimate explanation that the individual just never recorded and cannot remember two years later! Remember this: the IRS can absolutely tax you on unexplained cash deposit discrepancies as additional income. The Courts have upheld them time after time.

This leads us back to our oft-repeated advice: Identify every deposit in your personal and/or business accounts! Then, when questioned by the IRS, the difference in deposits and reported income can be explained to the penny by bank and other borrowings, sales of securities, gifts, transfers from other accounts, loan repayments collected by you, insurance collections, etc.

This “Survivor” Didn’t Survive the IRS

The Justice Department has announced that a federal jury found Richard Hatch guilty of tax evasion. He did not report $1,037,000 he won from the Survivor television series and he also failed to report about $391,000 of other income. According to the testimony, his accountant warned him that he should report all that income but he ignored that advice. See — you’d better listen to your accountant!

Laddering

Here is a simple investment strategy, to even out your monthly income. It simply means that you open multiple C.D. accounts with different maturity dates and/or buy bonds with different interest payment dates. EXAMPLE: You buy the first bond that pays interest in January and July. A second that pays interest in February and August. A third that pays interest in March and September, etc. Thus you receive an interest check every month of the year. Similarly you can time the maturities of C.D.s. (I personally intended to adopt this strategy, but after buying the first bond, I ran out of money!)

How to Screw Up Your Will if There are Multiple Beneficiaries

If you are leaving everything outright to your spouse, you don’t have to read this section. However, if you are doing so without using a marital trust (or the so-called A and B trusts) — you have probably already thrown away a lot of money in needless taxes — since you wasted your own estate tax exemption, which is not needed for spousal bequests. (That’s not the discussion here, but run back to your estate attorney if this applies.)

Here is the strange fact to remember. A dollar in one kind of asset does not equal a dollar in another kind of asset. So if you leave equal dollar values to different beneficiaries, they may not end up with the same amount of money.

If you are leaving anything to charities, religious organizations or similar, it always should be part or all of a regular (not Roth) IRA, or of any other retirement plan. Why? Because if you leave such retirement plans to any individuals (even your spouse) — they must pay income taxes on those funds as they withdraw them — and at regular income tax rates (up to 35 percent federal, plus any state taxes).

Follow the same concept if you have annuity policies, or similar items that will produce future taxable income such as loans outstanding on which you are owed interest, installment sales and similar. All such items, including the retirement plans, produce (taxable) “income in respect of a decedent (IRD)” and as much of them as you can get rid of by charitable bequests (if you are so inclined), do so first.

Charity aside, you may already suspect that a dollar is not a dollar tax-wise. If you have stock you paid $200,000 for and also cash of $200,000, they may not represent equal bequests. The stock is valued at market value at the date of death (the “stepped-up” basis). So if it’s really worth $300,000 at that time, one beneficiary has received $300,000 in stock and the other $200,000 in cash. In many cases when the will was drawn up, the stock and cash were of equal value — but not today! In this example, the easy solution is to leave each of the two beneficiaries half the stock and half the cash.

Another common problem is the home of the decedent. Many times one beneficiary wants to live in the house and wants to exchange part or all of his/her inheritance with other beneficiaries. But what is the house really worth if it’s not actually sold? The best solution seems to be to get at least three professional appraisals, and then either average them, or use the highest one.

Then, in some cases, the one occupying the house asks the other beneficiaries to hold the mortgage on that home. Potentially, this is a great way to break up a family relationship. What do you do in the event of late payments — or even a default? How tough are you going to be? Sometimes the occupant of the home needs a guarantee from another family member in order to obtain a mortgage. Another great way to possibly split up a family!

A basic concept to remember: In all cases where certain assets are difficult to precisely value — simply split them between all intended beneficiaries. Typical examples are partnership interests. Even if you could get appraisals that state they are of equal value (unlikely) — what may be the future potential of each interest? One may later appreciate at twice the rate of another. Don’t waste your time, just split away. About the only easy thing to value is cash.

Some final advice: In the event of a divorce, the same “splitting” concept is frequently the only way to protect both parties. Split the partnership interests, sell the house and split the proceeds. Split the stocks and other securities, etc. Trading off one asset for another in the event of a divorce almost always ends up with one party the loser. So if you are headed for splitsville — split away!

Medical Expenses — Some “No-Nos”

There are many lists and articles about deducting medical expenses. Here is a contrarian’s list of some of the items you cannot deduct:

• Surgery for purely cosmetic reasons.
• Teeth whitening.
• Funeral expenses.
• Medical insurance premiums included in your auto insurance policy.
• Bottled water.
• Diaper service.
• Health club dues.
• Travel for general health improvement.
• Medicines bought without a prescription.
• Maternity clothes.
• Weight-loss expenses not for the treatment of obesity.

When is Social Security Taxable?

We get this question very often, as many taxpayers are stunned to know that up to 85 percent of the social security can be taxable — and at ordinary income tax rates. It’s a complicated calculation that our computer program does automatically (probably in 1/100th of a second). In simple form, here is how it works.

Add half your social security to all your other income. Then, add all your tax-exempt income to that total. Then subtract your exclusion, and if there is any balance left, it’s taxable. Or, if not, not.

The exclusions that you subtract from the above are:

• Married, filing jointly — $32,000
• Single, head of household, qualifying widow(er), or married filing separately and you lived apart from your spouse for the entire year — $25,000
• Married filing separately and you lived with your spouse at any time during the year — Zero

If your benefits are taxable, generally the higher that final amount (as calculated above), the greater the taxable part of your benefits (up to 85 percent). How simple.

More on Scientology

A few readers have asked for information about the ruling on religious school tuition and Scientology. In 1989 the U.S. Supreme Court in Hernandez held that the record did not support payments to the Church of Scientology as tax-deductible charitable contributions for what it calls “auditing and training.” However, in 1993 the IRS stipulated that pursuant to a closing agreement with the Church of Scientology, all such payments were deductible as charitable contributions, and this IRS ruling stands to this day. That’s all I know.

Al Capone

As a native Chicagoan, I proudly report that the personal auto of Al Capone has been sold at auction for just over $610,000. It’s a 1928 Cadillac V-12. Besides bulletproof glass, one of the more interesting features is a back window that opens completely — so that you can stick your Tommy Gun out and spray lead on any pursuing auto. (This feature would be most helpful to me most any afternoon on the 405 freeway in Los Angeles, as I try to get home.)