ARCHITECTS MAKE BIG TIME WITH IRS

It's a dubious distinction, but architects, as an industry group, have in one way made the big-time with the IRS. With the IRS' issuance of the MSSP Guide for auditing architects, architects can now find themselves in the company of other industry groups targeted by the IRS such as attorneys, real estate developers, and used auto dealers, to name a few.

MSSP GUIDES: WHAT ARE THEY?

The "Market Segment Specialization Program" is to provide guidance for IRS agents in specialized industries by developing a "cook book" approach to the audit process. The "cook book" or the audit guide for each of the 111 industries expected to be issued, will assist the IRS agents in "collecting the proper amount of tax revenue at the least cost". In essence, the more they know about architects and the nature of their business, the easier it will be for them to collect additional taxes.

WHAT DOES THE IRS KNOW?

Right away, it is very clear from reading the MSSP that the IRS' profile on the typical architectural firm is very thorough and revealing. Certain of the highlights are as follows:

• Most working drawings won't be approved without the signature block.
• Other services such as planning and construction supervision are typically provided.
• Changes in the scope of services as the job progresses are normal.
• The AIA standard contract is used by many.Diversified firms tend to fare better.
• Many projects get put on hold due to lack of financing.
• Fees for small jobs are about 10% of project costs and 4% to 5% for larger jobs.
• Progress billings tied to completion of phases is typical.
• Fee disputes more often arise towards the end of a job.
• Cash basis method for tax purposes is almost always used, with many firms using accrual basis for financial statement purposes.
• 80% to 90% of the work has been billed and collected prior to the construction phase.
• Most architectural corporations are "personal service corporations", (PSC).
• Larger firms use software specifically designed for the industry.
• All firms maintain some kind of client job file which would contain the contract, invoices, remittance advices, and reimbursable info, etc.
• Well kept files can help the architect's defense if litigation arises.
• Most use outside reproduction companies.
• E & O insurance is tied to revenue levels.
• A list of jobs on an annual basis is normally kept as well as copies of completed plans.
• Payments to subcontractors or outside consultants are probably the largest non-payroll deductions on the return and, payments to them are typically tied to collecting the related receivable from the client.
• "Employees" are often treated as independent contractors in business downturns.
• Due to the nature of the business and the mindset of today, litigation and large legal fees are to be expected.

In knowing what the IRS knows about them, architects will be better prepared to do battle when the time comes and to anticipate the IRS' strategies.

IRS AUDIT TECHNIQUES

Much of the MSSP guide for architects focuses on trying to detect unreported income as follows:

• If there is a large percentage write-off on the job, there may have been an unreported non-cash form of payment.
• Local government's permits or excise tax info is often computerized and the IRS will want to try to trace it to the architects client files.
• Incomplete or sloppy client files will alert the IRS agent to the possibility of unreported income.
• All remittance advices in the client files should be traceable to the bank statements.
• Total deposits for the year per the bank statements will be reconciled to the tax return's gross receipts.
• 1099's may show more income than was reported.
• US Govt. Form 8596 may show more income than was reported.
• Customer or receipts info provided to the E & O insurance firm will be traced back to billing and receipts info.
• Subcontractor lists and payments to them will be traced back to the related billing and receipts info.

Other areas of interest for the IRS are as follows:

• Architectural firms doing interior design work may not be using a client advance account properly. See special note on Reimbursable Expenses below.
• Individuals paid via a 1099 may be employees and related payroll taxes may be understated.
• Legal expenses may be prepaid and might include personal expenses.
• Retirement plan contributions might be overstated or paid late.
• Corporate PSC's may not have elected properly to keep their non-calendar fiscal year end.
• Corporate PSC's may not be properly deferring deductions for employee/owner compensation.
• Corporate PSC's with non-calendar fiscal year ends may be incorrectly carrying back a net operating loss to a prior year.
• Corporate PSC's may have calculated their tax using a federal rate lower than the required flat 35% rate.

While the MSSP guide for architects did not specifically focus on meals & entertainment, travel, club dues, business gifts, and auto expenses to name a few, please rest assured in knowing that supporting documentation for many of them will be requested in a normal audit proceeding. Any changes in stock ownership during the year may also be examined.

SPECIAL NOTE ON REIMBURSABLE EXPENSES

The IRS' accounting theorists believe that the normal reimbursable expenses that architects pay for and then bill to their clients are in effect " loans to their clients" and that "an asset account should have been created".

In creating the asset (or loan/advance) account, the IRS is technically saying that the typical cash basis architect is not supposed to deduct the expenses when paid and, consistently, the IRS is also saying that when the architect collects the reimbursable expenses from its client - it's not income. The IRS will eventually allow a bad debt deduction if the architect is never able to collect the "advanced" reimbursables. This particular IRS position has been unfortunately well supported in contested dealings with attorneys and other industry groups where costs are typically advanced on behalf of clients. So, it seems that the IRS wants the typical cash basis architect to keep part of its tax books on the accrual basis method. Wonderful! If this is their position on reimbursable expenses, what would their position be on outside consultant costs, to the extent they had been "advanced" by the architect? It's not addressed in the MSSP, so there will be uncertainty on this.

After raising an unsettling issue for the average cash basis architect, the MSSP then goes on to say, "However, since most costs are usually reimbursed within a short period of time, it may not be material enough to warrant adjustment". On the one had, reading this, maybe we should be relieved. On the other hand, however, there is still enough loosey-goosey in the statement to provide the IRS auditor a lot of subjectivity and that's a big concern. In fifteen years of representing architects, we have not had to respond to IRS questions in this area. That may be all changed now. Time will tell.

ARE YOU READY FOR THE IRS?

There's no doubt about it! The IRS has done its homework and, by the time you've finished reading this article you will have done quite a bit of homework yourself. Someone once said that a good offense is a great defense. There's no better time than now to take a quick look into your books and records and gauge how you might fare in an audit. Remember, you really (and I mean really) don't want the auditor camped out in your office just this side of forever. If your books and records are a wreck and don't allow the auditor to perform the normal tests and procedures easily and in a timely manner, you'll feel as if your least favorite in-law has moved in and won't take a hint to leave.

Today you should feel as if you've got the upper hand. After all, you now know what they will want to look at. Keep the momentum in your favor. Clean up those loose ends and get yourself organized. You won't regret it.

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