IRS Adds Income Section to Business Consultant Audit Techniques Guide
The IRS has updated its Business Consultant Audit Techniques Guide (“ATG”) to include an income section addressing issues that may arise during examinations. The new section discusses Income Assignment and Substance Over Form issues as well as related audit techniques.
Income assignment involves the shifting or assigning of income earned by one entity to another entity to reduce the earning entitys income and taxes. Income assignment can be addressed under IRC § 61 or IRC § 482, but courts have ruled that IRC § 482 more readily applies than IRC § 61. The question to be raised under IRC § 482 is whether parties would have entered into their financial relationships had they been unrelated parties dealing at arms-length. See, e.g., Keller v. Commissioner, 77 T.C. 1014 (1981).
According to the ATG, closely held or one-man personal services corporations, including business consultants, have assigned income to another entity in order to reduce their income and evade self-employment taxes. After this illegal shifting, the taxpayer may take a small salary from the assignee entity in proportion to the amount of income shifted. The IRS emphasizes that particular scrutiny is necessary when an individual incorporates an existing service profession and the corporation’s only business activity is effected solely through the individual as an employee of the corporation.
Substance over Form
The ATG income section also discusses the doctrine of “Substance Over Form,” which states that a transactions substance dictates how the transaction is taxed. This rule follows the notion that “taxation is concerned with actual command over the property taxed and the actual benefit for which the tax is paid.” Gregory v. Helvering, 293 U.S. 465 (1935). A transaction is viewed as a whole from the beginning of negotiations to completion. The true nature of a transaction cannot be hidden by an outward appearance that exists to alter tax liabilities.Commr v. Court Holding Co., 324 U.S. 331 (1945).
In applying the doctrine of Substance Over Form, courts look to the objective economic realities of a transaction rather than to the particular form the parties used. Gregory v. Helvering, 293 U.S. 465 (1935). When a step in a transaction is a mere “ritualistic incantation” in order to meet the words of the statute, that step will be ignored and the final result achieved will govern the tax consequences. Ericsson Screw Machine Products Co., 14 T.C. 757 (1950). The effect is to tax true taxable income regardless of how a taxpayer disguises it.
During the pre-audit phase of an examination, examiners determine whether the taxpayer reported all of the income required to be reported and that the income was reported in the proper period by the proper entity. The examiner looks for the following:
- A lack of internal controls;
- The types of books and records the taxpayer maintains;
- The taxpayers use of bartering;
- The shifting or assignment of income by a taxpayer to a related entity;
- The taxpayers use of the Internet;
- The taxpayers use of a fiscal year end in order to defer income.
During an audit, an examiner reviews the taxpayers consulting agreements or contracts for the following to determine whether income was assigned:
- To whom the client/customer is contracting the services;
- Whether the consulting fees per the contract are traceable to the Taxpayers books and records;
- For significant shareholders or partners (greater than 20% direct or indirect ownership), an examiner evaluates tax returns for:
- Examination potential;
- Proper treatment of related transactions with the corporation or partnership; and
- The likelihood of diverted funds.
The ATG stresses that a careful examination of the financial arrangements entered into will be required in order to ascertain whether an adjustment is necessary, either to reflect actual income or to prevent tax avoidance.
Read the full Business Consultant Audit Techniques Guide here.
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