Monthly Archives: January 2013

Restaurant Owners–What Are Your Numbers Really Telling You?

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Successful restaurant owners are focused on providing high quality food at reasonable prices and with very good service.  This is obviously a very important focus for restaurant owners.  Successful restaurant owners also know that there is a numbers side to the business—how profitable is the restaurant?

It is helpful for restaurant owners to know how their financial numbers look compared to their competition.  When restaurant owners compare their numbers to industry norms, interesting questions tend to arise.  They begin to take closer looks at certain aspects of their restaurants to make sure they are operating the restaurants as profitably as possible.

Our firm has access to real-time databases and we were able to gather information on privately held restaurants in Michigan with sales of $1 million and under.

We found the following information (percentages of sales):

Average Cost of Food    42.57%

Average Gross Profit      57.43%

Payroll                        22.22%

Rent                            5.92%

Advertising                   4.16%

Example: JoJo’s Restaurant has the following Profit & Loss Statement:

Sales                      $1,000,000

Cost of Food                600,000  (60%)

Payroll                        280,000  (28%)

Rent                          100,000  (10%)

Advertising                   50,000  (5%)

There are some things to note:

JoJo’s cost of food is slightly higher than the average.

This can be caused by:

  • Underpricing the competition
  • Paying higher food costs than the competition
  • Buying higher qualify food than the competition
  • Inventory walking out the back door
  • High inventory waste or spoilage
  • Over-portioning
  • Inventory being eaten by the owners/employees and it’s still being counted as food cost expense

JoJo’s cost of labor is higher than the competition

This can be caused by:

  • Scheduling too many employees during shifts
  • Paying employees a higher wage/salary
  • Employees are moving slowly
  • Having too few employees and paying some employees overtime
  • Employees clock in early and clock out late

Going through the numbers on a regular basis may not be the most interesting thing to do, but it will reveal things about your restaurant that could surprise you.

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How a Restaurant Should Price its Menu

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Restaurants have fairly tight profit margins.  How they price their menu items can have a large impact on its profits.  This post will describe three ways to price your menu items profitably.

The Prime Cost Method

A restaurant’s prime costs are its food, beverage, and labor costs.  These costs are referred to as prime costs because, in the short term, they are the only costs a restaurant owner can manage.  The Prime Cost method is based on the menu item’s cost and the desired food cost percentage of the restaurant.   On average, restaurants have a 38% to 42% food cost margin—for example, a restaurant with $10 in sales will have a $3.80 to $4.20 food cost.

Under the Prime Cost method, the food cost of the item is divided by the desired food cost percentage.

Example:

Pomo D’oro Bros wants to price an entrée consisting of 4oz of chicken, a baked potato, green beans, and a salad.  The total food cost of the items is $6.  If Pomo D’oro Bros is aiming for a 40% food cost, it would divide the food cost of $6 by 0.4 and come up with a $15.00 menu price for the entrée.

The Peanut Butter Method

This method takes a restaurant’s projected labor, non-food expenses, and desired profit and divides the amount by the number of meals the restaurant estimates it will serve during a year.  It then adds this amount to the cost of each food item.

This method only works if a restaurant has menu items that are similar in cost, otherwise each menu item will have the same markup.

Example:

Projected Labor Costs                                    $60,000

General Expenses                                          $40,000

Desired Profit                                                $10,000

Total                                                         $110,000 (1)

Meals to be Served during the year                    30,000 (2)

Required Markup Per Meal                                   $3.67   [divide (1) by (2)]

The restaurant owner adds $3.67 to the cost of each menu item to determine the menu price. 

Again, this method works best when all menu items have a similar cost.  Under this method, a hamburger with a cost of $2 with have a $5.67 price for a 35% food cost (good) and a steak with a cost of $6 will have a $9.67 price for a 62% food cost (not so good).

Multiply Food Costs by 3

This method is the same as the Prime Cost method above if the target food cost is 33%.  If your menu items cost $4 and you multiply this by 3, you would get a $12 menu price.  This is a 33% food cost ($4 cost divided by $12 price).

A few points to consider:

  • If you have menus printed only once a year, you may want to increase the menu prices for inflation over the next year.  For example, if you come up with a $15 menu price, you may want to figure in a 3% (give or take) inflation rate and increase the menu price to $15.45
  • The price you come up with must be compared with what your competitors are charging.  If your competitor’s prices are slightly less than the amount you came up with, you may want to beat her price.  If your competitor has substantial cost advantages like a low-cost lease you may not be able to beat her prices.  In this case, you may want to stick with the higher price and focus on differentiating your restaurant from the competition.

 

If you need accounting or tax help with your restaurant,

sign up for a FREE tax analysis.

 

Buzzkill Disclaimer:  This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

Reducing Theft in Restaurants

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fraud trianble

Internal controls are the procedures a business puts into place to ensure that assets are safeguarded, fraud is minimized, and procedures are actually followed.   Any discussion of internal controls usually begins with the Fraud Triangle.

The Fraud Triangle focuses on three factors that help predict whether a person will steal.  These three factors are:

  • Opportunity to Steal
  • Motivation/Financial Pressure to Steal
  • Personal Integrity/Ability to Rationalize Theft

Motivation/Financial pressure to steal can be caused by:

  • Large debts and/or pending bankruptcy
  • Low income
  • Living beyond one’s means
  • Extensive gambling
  • Addiction to drugs/alcohol
  • Frustration with job
  • Resentment of supervisors

An employee’s personal integrity is very important because many employees may have the motivation and opportunity to steal, but do not do so because of moral character.

Employee thieves:

  • sympathize with thieves
  • are more vulnerable to peer pressure to steal
  • often think about and talk about different ways to steal
  • are able to rationalize theft

An employee’s ability to rationalize theft can be caused by envy of the employer’s success.  It may also be caused by the employee witnessing the employer cutting corners.  Employees who witness their employers cutting corners may rationalize their behavior by thinking, “if it’s OK for him, then it’s OK for me.”

Once an employee is hired, an employer has little control over the employee’s motivation to steal or the employee’s personal integrity.  The employer does have control over the employee’s opportunity to steal by implementing strong internal controls.

An extensive discussion of internal controls covering all aspects of a restaurant’s operations can’t be done in a page and a half blog post, but I’ll include some examples of how an employee can steal cash and the internal controls that can implemented to help prevent these thefts.  It is important to note that internal controls will never absolutely 100% prevent theft or fraud, but internal controls can substantially reduce the likelihood of such events.

 

8 Quick Ways to Steal Cash

1.       Short-ring: charge the customer the actual price, underring the sale on the cash register, and pocket the difference

2.       Voided Sale / Phony Walkout: cashier voids out the entire check (or certain items) and pockets the money for the voided items / cashier collects the money from the customer, but claims the customer walked out without paying

3.       Fictitious Payouts: cashier claims money in the register was used to pay for food deliveries, to buy supplies at a nearby store, or to pay for other miscellaneous expenses

4.       Charge customer full price, but ring sale up at a discounted child or senior citizen price

5.       Cashier steals coupons, collects the full sale price from the customer, includes a stolen coupon with the customer payments, and steals cash equal to the coupon discount

6.       Double Drop: waiter reuses an old guest check for a customer and does not ring up the current sale

7.       Alter the breakout of tip and check amounts on credit card receipts to overstate the amount of tips and understate the check amounts

8.       Cashier records sales on training key which does not feed into the daily counts

Internal Controls That Will Help

  • Each cashier has his drawer counted at the end of each shift
  • Manager conducts surprise counts of employees’ registers at random
  • Manager conducts a daily cash reconciliation to reconcile cash received, sales, cash payouts, credit card sales, and other cash items
  • Cash payouts require a vendor invoice or store receipt
  • Bank reconciliations are done monthly
  • Spotters (people sent in by management to act as customers and report back to management) are used in the restaurant to observe employee behavior
  • Video cameras observe the registers
  • Comparing the Cost of Food margins on the Profit & Loss statements with industry averages

 

If you need accounting or tax help with your restaurant,

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Buzzkill Disclaimer:  This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

IRS Requires Annual Tip Report from Certain Restaurants

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A problem restaurant owners run into frequently is trying to get their employees to report their tips.  Employees hesitate to report the full amount of their tips because tips are subject to FICA and income taxes.  Restaurant owners aren’t thrilled with tips either—the employer has to pay FICA and other payroll taxes on tips.

All tipped employees who earn more than $20 per month (in other words, all tipped employees) are required to report their tips to their employers at least monthly.  Practically speaking, restaurant owners cannot force employees to report all tip income.  Some courts have held that the employer is only responsible for distributing IRS Form 4070 to tipped employees and instructing them to fill it out and return it.  However, if the IRS performs a tip audit on the employer and finds unreported tips, the employer is responsible for the 7.65% employer portion of FICA.  The employer will then have to amend federal and state payroll tax returns to report the additional tips.  As a silver lining, the additional assessed FICA tax on tips qualifies for the Tip Tax Credit.

Restaurant’s Responsibility to Submit Annual Tip Income Report

Certain restaurants must report sales and tip information to the IRS annually on Form 8027.  This form is required for restaurants that meet the following criteria:

  • Tipping is customary—this generally includes most restaurants, but usually doesn’t include fast-food restaurants, cafeterias, and restaurants that assess a service charge greater than 10%
  • Food or beverages are sold
  • More than 10 employees are normally employed

The number of employees refers to all employees, not just tipped employees.  More than 50% owners are not counted as employees.  The number of employees is based on the average number of employees in two months—in the slowest month and in the busiest month of the year.

Restaurants that operate in multiple locations must file a separate tip tax return for each location—even if the multiple locations operate within the same corporation or LLC.

Even if there are 10 or fewer employees and the tip tax return is not required, employees must still report their tips.

There are a few things to note about this form:

  • Gross sales are reduced by sales tax
  • The form requests credit card sales, credit card tips, and total tips and total sales—based on this information the IRA can compare the tip percentage on credit sales and compare it to the tip percentage on cash sales.  If credit card sales are tipped at 15% and cash sales are tipped at 3%, there is likely a problem.
  • The form multiplies total sales by 8% and compares this amount to the total reported tips.  If the 8% of sales is larger than reported tips, employers are required to increase reported tips and allocate the increased tips to tipped employees

It is important to keep track of sales that are not tipped such as carryout sales, sales to employees, sales from nonfood items such as T-shirts or posters, sales for which a service charge was added, and customer walkouts.

 

If you need accounting or tax help with your restaurant,

sign up for a FREE tax analysis.

 

Buzzkill Disclaimer:  This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

 

New Tax Law Benefits New & Expanding Restaurants

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In 2010, Congress passed a law favorable to restaurants that allowed restaurants to more quickly deduct the costs of buildings and improvements to buildings.  This was done in three ways:

  • The costs of qualified restaurant property was allowed to be depreciated (deducted) over 15 years rather than the normal 39 years
  • Additionally, up to $250,000 of the costs of qualified restaurant property was allowed to be deducted in the year of purchase under the increased Section 179 deduction
  • Finally, if qualified restaurant property also qualified as qualified leasehold improvement property it would qualify for 50% bonus depreciation

The law expired on December 31, 2011; however, as part of the Taxpayer Relief Act of 2012 passed at the beginning of 2013, the law has been reinstated for 2012 and is extended through 2013.

What is Qualified Restaurant Property?

Qualified restaurant property includes:

  • a building, or
  • improvements to a building
  • if more than 50% of the building’s square footage is devoted to the preparation of, and seating for on-premises consumption of, prepared meals.

Shorter Depreciation Period

Qualified restaurant property is the only category where Section 179 expense is allowed on the building itself, rather than solely on the improvements.

Example:  Tomato Brothers Restaurant buys a building for $300,000.  Under old law, the building would be deducted over 39 years at $7,692.31 per year.  Since a restaurant building is qualified restaurant property, it can be deducted over 15 years at $20,000 per year.

This favorable provision also allows costs of leasehold improvements to be deducted over 15 years rather than over 39 years.

Increased Year of Purchase $250,000 Section 179 Deduction

Restaurant buildings and leasehold improvements also qualify for the increased $250,000 Section 179 deduction.  A major drawback of the Section 179 deduction is that it is limited to the restaurant’s taxable income for the year.  Any disallowed Section 179 expense is carried forward.  A second drawback of this special provision is that the deduction cannot be carried forward after 2013.  Any unused deduction is treated as placed into service on January 1, 2013 and is deducted over 15 years.

Example:  In 2012, Paradise Coney Island incurs $200,000 in qualified restaurant improvement expenses.  Before taking in account the $200,000 Section 179 expense, Paradise Coney Island has $150,000 of taxable income.  Paradise Coney Island’s allowable Section 179 expense is limited to its taxable income of $150,000.  The remaining $50,000 of Section 179 expense is carried forward to the next year.  If Paradise Coney Island has at least $50,000 of taxable income in 2013 it can deduct the remaining $50,000 in 2013.  If Paradise Coney Island does not have income in 2013, the $50,000 unused loss is treated as placed in service on January 1, 2013 and is deducted over 15 years.

Qualified Restaurant Property May Qualify for 50% Bonus Depreciation

If qualified restaurant property also meets the definition of qualified leasehold improvement property, it will qualify for 50% bonus depreciation.  Since the building itself will not qualify as leasehold improvement property, only the improvements to a restaurant building (and not the building itself) may qualify as qualified leasehold improvement property.

What is Qualified Leasehold Improvement Property?

Qualified leasehold improvement property means any improvement to an interior portion of a nonresidential building if

  • such improvement is made pursuant to a lease by the lessee, sublessee, or lessor of such improved portion
  • such portion is to be occupied exclusively by the lessee or sublessee
  • such improvement is placed in service more than 3 years after the date the building was first placed in service

Qualified leasehold improvement property does NOT include:

  • an enlargement of a building
  • any elevator or escalator
  • any structural component benefiting a common area
  • the internal structural framework of the building

A lease between related persons (e.g., a lease between a taxpayer and his 80% owned business) does not qualify.

If you need accounting or tax help with your restaurant,

sign up for a FREE tax analysis.

 

Buzzkill Disclaimer:  This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

Successfully Managing Inventory in Restaurants

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Food costs of a restaurant tend to be around 40% of revenues.  It is one of the largest expenses a restaurant incurs, and it is therefore critically important that a restaurant effectively manages its inventory.

Restaurant owners must balance two competing forces when managing inventory:

  • keeping enough inventory on hand to meet customer demands and
  • keeping inventory levels low enough so less cash is tied up in inventories

Lower inventory levels have the following advantages:

  • they require less effort to monitor since fewer items need to be counted and tracked
  • they can help reduce theft—it is easier to notice one bottle of scotch missing when you had three in inventory rather than twenty in inventory
  • they reduce spoilage
  • they reduce waste—high inventory levels may cause employees to over-portion

Setting a Par Level of Inventory

The par level of inventory is the amount of inventory needed to meet customer demand and provide a cushion in case of an unexpected spike in demand or a delay in delivery.  This cushion is referred to as safety stock.

Setting the par level requires:

  1. forecasting customer demand
  2. estimating delivery schedules
  3. considering perishability
  4. periodically reviewing current par levels to determine their adequacy

Inventories must be divided into high-turnover inventory and low-turnover inventory.  High-turnover inventory such as meat, seafood, and produce, must be ordered frequently to maintain freshness.  Low-turnover inventory includes spices and dry goods.  Low-turnover inventory tends to be less expensive and isn’t as critical as high-turnover inventory.

As a formula:

Par Level = (Weekly Inventory Use + Safety Stock) DIVIDED BY Deliveries per Week

 

Example:  A restaurant uses chicken in five menu items.  It uses 10 cases of chicken per week and wants to maintain a safety stock of 20% (2 extra cases).  The supplier delivers on Monday, Wednesday, and Friday.  Based on these figures, the par level of chicken is 4 cases—

Weekly Inventory Use (10 cases) + Safety Stock (2 cases) DIVIDED BY Deliveries per Week (3)

As a general rule, the higher the turnover, the higher the safety stock requirement.  Generally, the safety stock should be around 20% to 30% of the weekly inventory use.

You must also be guided by your experience—the formula is an estimate of the par level inventory.

 

When Inventory Levels Can Exceed Par

There are a few situations when a restaurant should maintain inventory in excess of the par level.  These situations include:

  • Minimum Order Quantity—when the order to replenish inventory to par level is less than the supplier’s minimum order quantity the restaurant must order inventory in excess of par
  • Special Price Opportunities—if the restaurant owner can get a good discount on a higher quantity order or if prices will rise in the near future it may be beneficial to purchase extra inventory
  • Delivery Interruptions—holiday, weekends, bad weather may cause delivery delays
  • Special Occasions—Mother’s Day, Valentine’s Day, and other special events will require extra inventory

 Counting Inventories

The regular counting of inventory sends a clear message to employees that inventories are being closely monitored.  This can help reduce theft as well as reduce over-portioning.  It will also help the restaurant owner properly rotate inventory so older inventories are used first.

Generally, it is best to count food and supplies monthly and to count liquor weekly.

Counting inventory can be a bit tedious, but the following steps may make it less painful:

  • Organize the storage area
    • A neat and orderly storage area adds greatly to the efficiency of an inventory count.  Items should be maintained in the same location and similar items should be located near each other.  When a carton has been opened, the contents should be removed and stacked.  This makes it easier to count the open items.
  • Use preprinted inventory count sheets
    • Items should be listed on the sheets in the same general order that they are located in the storage room.  Preprinted count sheets may point out inventory that should be in the storage room, but for some reason is out of stock.  It may also point out inventory in the storage room that was never officially ordered.
  • Use two people to perform the count
  • Focus on key items on monthly counts, and count all inventory items annually

 Learn More About Restaurant Accounting and Tax Services We Provide

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The New & Simplified Home Office Deduction

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On January 15, the IRS announced a new optional method of calculating the home office deduction.  Normally, home office deductions such as utilities, repairs, homeowners insurance, depreciation, mortgage interest, and real estate taxes are allocated to the home office and the rest of the home based on the square footage of the home office.

Beginning in 2013, the home office deduction can be calculated by multiplying $5 by the square footage of the home office.  The maximum square footage of the home office under this method is 300 square feet, and the maximum home office deduction will therefore be $1,500.  Of course, taxpayers still have the option of calculating the home office deduction under the actual expenses method if it results in a larger deduction.

Taxpayers who use the simplified method may still fully deduct mortgage interest, real estate taxes, and casualty losses as itemized deductions.  Additionally, businesses expenses such as advertising, wages, and supplies are still deductible.   Depreciation may not be claimed.

Other requirements of the home office deduction must still be met.  These include the home office’s regular and exclusive use as:

  • a principal place of business
  • a place where you meet with customers or clients
  • a place that is connected with your business if your home office is in a separate structure

The home office deduction is still limited to the income from the business for which the home office is used (i.e., home office deductions cannot reduce income below zero and generate a loss).  Under the actual expenses method, disallowed deductions are allowed to be carried forward.  However, under the simplified method, disallowed deductions may not be carried forward.

Taxpayers may alternate between the simplified method and the actual expenses method on a year-to year-basis.  However, any disallowed losses in a year that taxpayers used the actual expenses method may not be used in a later year where the taxpayer uses the simplified method.

If you need help with small business taxes,

sign up for a FREE tax analysis.

Buzzkill Disclaimer:  This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

Any tax advice contained in the body of this post was not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. Any information contained in this post does not fall under the guidelines of IRS Circular 230

 

Extended-First Year Expensing of Real Property Improvements

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In 2010, Congress passed a law that allowed a $250,000 Section 179 deduction on qualifying real property.  The law allowed Section 179 deductions on real property placed in service during 2010 and 2011.  The law expired on December 31, 2011; however, as part of the Taxpayer Relief Act of 2012 passed a couple weeks ago, the law has been reinstated for 2012 and is extended through 2013.

The qualified real property must be used in the active conduct of a trade or business, and can’t be certain ineligible property (e.g., used for lodging, used outside the U.S., used by governmental units, foreign persons or entities, or certain tax exempt organizations).

There are three types of qualifying real property:

  • Qualified leasehold improvement property
  • Qualified restaurant property
  • Qualified retail improvement property

Qualified Leasehold Improvement Property

Qualified leasehold improvement property means any improvement to an interior portion of a nonresidential building if

  • such improvement is made pursuant to a lease by the lessee, sublessee, or lessor of such improved portion
  • such portion is to be occupied exclusively by the lessee or sublessee
  • such improvement is placed in service more than 3 years after the date the building was first placed in service

Qualified leasehold improvement property does NOT include:

  • an enlargement of a building
  • any elevator or escalator
  • any structural component benefiting a common area
  • the internal structural framework of the building

A lease between related persons (e.g., a lease between a taxpayer and his 80% owned business) does not qualify.

Qualified Restaurant Property

Qualified restaurant property includes:

  • a building, or
  • improvements to a building,

if more than 50% of the building’s square footage is devoted to the preparation of, and seating for on-premises consumption of, prepared meals.  Qualified restaurant property is the only category where Section 179 expense is allowed on the building itself, rather than solely on the improvements.

Qualified Retail Improvement Property

Qualified retail improvement property means any improvement to an interior portion of a building which is nonresidential real property if:

  • such portion is open to the general public and is used in the retail trade or business of selling tangible personal property to the general public, and
  • such improvement is placed in service more than 3 years after the date the building was first placed in service.

Qualified retail improvement property does NOT include:

  • an enlargement of a building
  • any elevator or escalator
  • any structural component benefiting a common area
  • the internal structural framework of the building

The Taxable Income Limitation

The amount of Section 179 expense is limited to the business’ taxable income for the year.  Any disallowed Section 179 expense is carried forward.

Example:  ABC Corp incurs $200,000 in qualified restaurant improvement expenses.  Before taking in account the $200,000 Section 179 expense, ABC Corp has $150,000 of taxable income.  ABC Corp’s allowable Section 179 expense is limited to its taxable income of $150,000.  The remaining $50,000 of Section 179 expense is carried forward to the next year.  If ABC Corp has at least $50,000 of taxable income in 2013 it can deduct the remaining $50,000 in 2013.

Disallowed Section 179 expense for real estate cannot be carried forward past 2013.  Any Section 179 expense carryforward that cannot be used in 2013 will be treated as property placed in service at the beginning of 2013.

Example:  Same as Example 1 except that ABC Corp has $0 taxable income in 2013.  The Section 179 expense of $50,000 will not carryforward into 2014, but will be treated as property placed in service on January 1, 2013 that will be expensed over its useful life (15 to 39 years depending on the type of property).

Example 2:  XYZ Corp incurs $200,000 of qualified retail improvement property in 2013.  XYZ Corp has $80,000 of taxable income before the Section 179 expense.  XYZ Corp can deduct $80,000 of Section 179 expense in 2013.  The remaining $120,000 of qualifying retail improvement property will not carryfoward into 2014, but is treated as being placed in service on January 1, 2013 and will be expensed over its useful life (15 years).

Section 179 expense on tangible personal property can still be carried forward indefinitely.

Section 179 Expense for Real Property Reduces Section 179 Expense Available for Tangible Personal Property

Prior to the Taxpayer Relief Act of 2012, the Section 179 limit for 2012 was $139,000.  The Section 179 limit had been $500,000 in 2011.  The Act reinstated the higher $500,000 Section 179 limit for 2012 and extended it through 2013.

It is important to note that the $500,000 expense available for tangible personal property is reduced by Section 179 expense used for real estate improvements.

Example:  John buys $600,000 of business equipment and spends $300,000 on qualified leasehold improvements.  If John uses $250,000 of Section 179 expense on the leasehold improvements, he may use $250,000 of Section 179 expense on the equipment.  Alternatively, for example, John could use $200,000 of Section 179 expense on the leasehold improvements, and the remaining $300,000 of Section 179 expense on the equipment.

If you need help with small business taxes,

sign up for a FREE tax analysis.

Buzzkill Disclaimer:  This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

Any tax advice contained in the body of this post was not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. Any information contained in this post does not fall under the guidelines of IRS Circular 230

When the IRS Requests a Copy of Your QuickBooks File…

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More and more businesses are using electronic accounting software, such as QuickBooks, to keep track of their business activity.  The IRS is well aware of this and is beginning to request backup copies of electronic accounting records.  There
is quite a bit of uneasiness about this because years of information are contained in the backup file, and the IRS potentially has access to years not under audit.  This isn’t as much of a concern when the IRS requests paper documents because only documents during the audit year(s) are handed over to the IRS.

WHY DOES THE IRS WANT ELECTRONIC RECORDS?

In a recent FAQ article posted on the IRS website, the IRS lists three reasons why it is requesting electronic records:

  • A backup copy of a file contains most of the accounting records for the audit period so the IRS can simply request the backup copy rather than request numerous items in an information request
  • the taxpayer will not have to print out numerous requested documents
  • the efficiency of the audit is increased because the IRS can “drill down” to the underlying data and documents to further investigate items.

UNDER WHAT AUTHORITY CAN THE IRS REQUEST MY ELECTRONIC RECORDS?

Under Internal Revenue Code Section 6001 and Regulation 1.6001-1, taxpayers are responsible for maintaining sufficient books and records to support the income and deductions claimed on their tax returns and for presenting this information to the IRS when requested to do so in an audit.

Internal Revenue Code Section 7602(a)(1) grants the IRS authority to examine any books, records, papers, or other data that may be relevant to an audit.  Section 7602(a)(2) grants the IRS authority to summons the books and records.

As the IRS can request paper records, it can also request electronic records.  If taxpayers refuse to produce paper or electronic records, the IRS may summons those records.

DO I HAVE TO GIVE THE IRS MY PASSWORD?

It is best to temporarily change the password to your accounting file to something like “IRSaudit”, make the backup copy to give to the IRS, and then change the password back to your normal password.  The temporary password must have administrator access.

THE IRS SHOULD ONLY REVIEW THE PERIOD UNDER AUDIT

An electronic accounting file will contain many years of information.  The IRS should review data only for the year(s) under audit.  If the IRS decides to expand the number of years under audit, the IRS will notify taxpayers and then access the additional information in the file.

Comfortable with this?  Me neither.

One option is to archive or condense data prior to the audit period.  This way, the IRS cannot readily access the archived information.    However, if the IRS expands the scope of the audit, the information must be restored from archive.

While the IRS can only access years under audit, they can review information for the month prior to and the month after each year under audit.  The IRS does this to ensure proper cutoff of income and expenses for each year (i.e., to make sure income and expenses are recorded in the proper years).

THE IRS MUST PROTECT CONFIDENTIAL INFORMATION

The IRS is prohibited from unauthorized disclosure of taxpayer information during the course of an audit.  IRS employees receive annual training on protecting taxpayer information from unauthorized disclosure and are reminded that they could face disciplinary action for such disclosures.

The IRS has procedures in place to protect electronic files.  Once the IRS no longer has a need for the electronic file, examiners can return the data to the taxpayer or dispose of it following internal procedures.

Comfortable with this?  Me neither.

Certain information may be privileged and does not have to be handed over to the IRS.

 

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Buzzkill Disclaimer:  This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

Any tax advice contained in the body of this post was not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. Any information contained in this post does not fall under the guidelines of IRS Circular 230

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