Income Tax Compliance

I hate income taxes. Hate is a strong word, but I don’t care. My first tax professor, Eugene Croarkin, told his class, “If you can read, you can file an income tax return.” Then I guess my strategy would be to unlearn how to read.

I worked at one of the Big Eight accounting firms when I graduated. My, I was a glutton for punishment because I signed up for a summer-time tax optionee program (my firm called it TOPs, and it was hard to get accepted). I wanted that work because it meant I’d be billable every week of the year except for my four weeks of vacation. It was also one of the most miserable experiences I’ve ever encountered professionally. The people were wonderful, but the tax code made no sense.

I have a deeper problem with any compliance work, even though the laws of governance are established for our well-being, mostly, but not always. One of my personal taxation issues is that parts of the Internal Revenue Code (IRC) are not logical.

The tax law was not created like accounting principles promulgated some 100 years ago. For every pound of logic, we find in the tax code, we’ll find another pound or two driven by politics. Take a look at your itemized deductions on a personal return. Many of those were driven by partisan give-and-take.

Tax laziness slowly crept into my brain during a ten-year time period because the business I worked in had its in-house tax department. That meant I didn’t have to know much about taxes. I would quiz Brian Habermehl periodically on the tax consequences of certain transactions I was working on, but I didn’t have to know what he did.

Ultimately, I started a consulting practice, and my tax views would change forever.

A Short Non-Profit Story

“Mark, I’m on the board of directors at our Ronald McDonald House. These people are amazing, but they need help in the back office,” said my friend, Jake.

Their back office needed leadership. Not Alan Mulally’s leadership or John Maxwell to give them a pep talk. They needed direction and tactics, and Jake knew my work in systems thinking and processes through his brother’s business and other clients that he referred to me.

“Give me a name and number to contact, and I’ll touch base immediately.” That was one of my favorite calls I’ve ever made. Melody and Beth were the people I wish I could work with daily.

Melody was amazing because she was the Executive Director. She was incredibly smart, but she was transparent and humble. She knew she needed help in her back office of three people. None had accounting degrees. But they possessed a trait far better than administrative skills. They had the drive and the willingness to learn.

That’s where Beth comes into the picture. Beth ran the accounting department even though they outsourced the bookkeeping to a local firm. That told me the outsourced firm was indifferent to the administrative shortcomings of their client.

Their problem was that no one had shown them how to organize work and create a simple financial operating system. They were habitually late on compliance reporting, including their form 990 reporting, a bad thing since major donors wanted access to their most recent filings.

I started their cleanup process by getting the 990 prep work done immediately because they were already running behind. Incidentally, in cleanup work, I never do the work. I identify what needs to be done and help the other person achieve mastery by figuring out how to accomplish the work.

Beth had a marketing degree. In school, we joked that marketing majors were the people who couldn’t make it in finance and accounting classes. Beth was no idiot. She was intelligent and wanted to learn. She just needed a guide.

That was scary because I had never looked at a 990 before. I knew that they were an information return, but I had no idea what was included in the return.

That meant Beth and I would play the game of common sense.

Beth, Please Get a Divorce

Dang, Professor Croarkin was correct. If you can read, you can compile a return. “Beth, print out last year’s return. We’ll use it as a starting point.” Surely two intelligent people could tame this monster that looked intimidating with all those boxes and figures.

Next, we three-hole punched it and put it in a binder (this was nearly 15 years ago, so it wasn’t uncouth to work with physical paper). After that, we read the first page. For every number, we identified the source for the number. We did that for the entire return. We only had two questions for the CPA. Not bad for two people who had never read a 990 before.

Looking back, my favorite observations from that exercise were that we had zero formal training on this specialized form of compliance reporting. We did this work in about two hours. The reason it took that long was that we were documenting on post-notes the source for each number or checkmark we encountered.

Next, Beth did not need to be told the importance of taking ownership of the 990. Their CPA prepared and submitted the return. The real value should have been a roadmap on how to be 990-ready 15-20 days after the calendar year. As I stated earlier, the CPA firm was indifferent. They were great at sending emails to Melody and Beth stating they were late turning in their workpapers. I’ll never understand why they didn’t go the extra mile to ensure we’d never be late in the first place.

When Beth and I wrapped up the 990 preparation for the current year, I gave her a homework assignment. While we had a great manual system, I wanted her to create a spreadsheet where we could enter numbers with explanations of the source of the data. I asked her to be liberal with documentation. I didn’t even provide a format. The following week, I looked at her work. She nailed it. Plus, she looked like a little kid opening gifts at Christmas.

What I sensed more was peace of mind from both Beth and her boss, the executive director. In short, we simplified what we thought was complex–it wasn’t, just nuanced.

The following year, her back office turned in their 990 workpapers on or about the 20th day of January. They were never late again.

Beth was a joy to work with. She proved that anyone can pick up a return and figure out what needs to go in every box. Her husband works in ministry, and I nearly cried the day she said he got a calling to take on ministry work in Pennsylvania. I told her God gave me a calling to tell her to get a divorce because she couldn’t leave.

She didn’t believe me because she was gone two months later. And this is why we document the heck out of work because when people come and go in the back office. minimal training is needed for the next person taking over and there are few, if any, disruptions in back-office workflows during times of turnover.

Small Business Tax Compliance

Beth’s story is important to me because I’ve encountered bookkeepers, accountants, accounting managers, and even controllers who would never want to put in the work that Beth did when it comes to business returns. Here’s what I’ve been subjected to over the years:

Mark, the accounting firm, is not asking for the tax workpapers you create for them. They want the trial balance, and that’s all. If they have questions, they email us.
Mark, I’m too busy. You are asking for too much. Plus, my boss does not think this is important.
Mark, I don’t know how to do this.

As I think about Beth’s story, I would love to have her provide feedback on each of these excuses.

You do not have to agree with me, but here are some of my strong beliefs related to small business corporate governance and compliance:

Even if we outsource the tax return, we own it. The CPA is not responsible for the accuracy or completeness of the return; we are. They are the final referee in completing and filing the return.
Tax planning is not a passive activity. We should meet with our partner at least three times annually for guidance, planning, and new regs being addressed on capital hill.
Our firm, without asking, always provides supporting schedules in addition to the return after they wrap up their filing. If you have to ask twice, you have the wrong firm in your corner.
We’re tax ready 60 days before any filing deadline. That’s radical when it comes to the March 15th deadline. If this is not the case, your back office has serious deficiencies. In my case, this is non-negotiable.
Trust and verify. Within 48 hours after a return has been completed, reconcile it. This is also a non-negotiable in my world of corporate governance.

Connie, Meet Beth

Connie (not her real name) is the best accounting manager I’ve ever known. If you look up David Maister on a Google search, add the work professional or professionalism. Even though he’s retired, his blog still exists. His writing on professionalism is the best I’ve ever studied. Connie is the embodiment of everything he teaches on this topic.

Incidentally, Connie does not have an accounting degree. She’s self-taught. She would say she has average intelligence. Her drive is off the charts. She never complains, and she’ll do far more than what you ask.

I hired her for a complicated ag client nearly 20 years ago. She kept making the same mistakes repeatedly, even with my easy-to-follow checklists. Her issue was that accrual accounting was a huge abstraction. I encouraged her to get certified in bookkeeping but thought nothing of it then.

About two months later, I got an email with an attachment. I still have that message with two words, “See attached.” It was a certificate from the AIPB.

Here’s the best part. She didn’t tell her boss. Her boss would have gladly paid for the time and the books. Furthermore, I was the only person she told about this certification. That’s because she’s a professional in the eyes of David Maister.

Connie has moved on to greener pastures. I would have no problem having Connie as a controller for any small business under $20 million. I say that because we had to up her game with job number two that I found for her.

As the business of her old boss was winding down, I had another client who badly needed an accounting manager. Connie’s boss also knew this client very well, so I recommended Connie as long as she could help her old employer for about one hour a day. We’d bill him for it, and he was okay with that.

Connie started the new position around tax season, “Connie, let’s talk about Beth.” Connie would have to become a tax expert very quickly, and that’s training she did not receive from the AIPB.

Tax Recons Are Simple, Or Should Be

Let’s get two absolute truths out of the way.

Any given business has ‘book’ earnings. Those are the earnings your company earns before income taxes.

For tax compliance purposes, we also taxable earnings. To be more specific, there are several names for taxable earnings:

On the 1120-S, we find ordinary income (loss) on page 1
On the 1120, we find taxable income on the first page
On the 1065 for partnerships, the same term is used as s-corporations
On Schedule C of a personal return, net profit or loss is used

Accordingly, I’m using the term taxable earnings for clarity and simplicity.

Balance sheets are also included in every return once a certain dollar threshold is hit. Similar to ‘book’ reporting, there is an equity section on the tax return. Depending on your tax entity, the balance sheet will be on either page 4 or 5.

And by now, you should probably already know that the numbers will rarely, if ever, match. There are two reasons: 1) temporary timing differences and 2) permanent differences. Explaining the differences is beyond the scope of this essay. However, the differences will become readily apparent as we push onward.

Before starting this recon work, I’d obtain the tax trial balance and the fixed asset supplemental schedules first. My CPAs always provide these. If not, you have the wrong firm in your corner.

Below is an excerpt from a trial balance workbook. The page you are looking at shows the adjustments the CPA firm made for tax reporting purposes. For more complex returns, these tax workpapers are critical. But I’ve found that smaller firms are more than happy to provide these. Getting the trial balance and adjustments in advance will cut your recon work down to minutes.

With this primer out of the way, the next part is simple once you start. Download the trial balance you provided to the CPA in a spreadsheet. Then, start tying out each number to the tax return. There’s a shortcut to reconciliation, but we’re taking the long approach to augment your learning process.

Accordingly, the longer way is to start with your P&L and start tracing the numbers to the return on page 1, and this applies to corporate and partnership returns.

Even if I didn’t point this out, the first page and the balance sheet on the tax return may have a note stating, See Statement. In all cases, find that page near the back of the return to obtain the detail supporting the number on the return.

Most returns will have from a handful to more than a dozen statements that provide detail for summarized totals on pages 1 and 4/5 (the balance sheets). Those detailed numbers in the statements will tie out to your and/or the accountant’s trial balance.

Connie’s first recon looks like the excerpt below. Don’t let the small numbers fool you. This is a complex business with hair growing in places you’d never expect. There is no right way or wrong way to create these recons. I do mine differently, but the method below is still complete and accurate:

The goal of the tax recon is to tie out two pairs of numbers: earnings and equity. Start with EBT or book earnings. Start identifying the differences noticed between book and tax (section 2). Those differences will tie out to taxable earnings on the corporate return. Then tie out capital on page 4 or 5 of the return.

In section two above, you can enter every adjustment the accountant provides you, which is what Connie did. She did a second recon by comparing her unadjusted numbers on the tax trial balance to the CPA’s. That trial balance has a final column that ties out to all the numbers on the return.

On a side note, do you see the error above in the reconciliation? I’ve seen three errors in my consulting career. In all cases, the accountant never said sorry or that they screwed up. I can live with the error, but humility means a lot to me. Instead, they shrugged it off. This reveals another reason we take these recons seriously. We own the numbers, not the CPA firm.

Common Reconciling Items

I’m not a tax expert. I can converse with a tax partner, but I’m still a tax luddite, even though I use that term incorrectly. I like the sound of it.

However, I can tell you pretty quickly where book and tax will part when it comes to looking at the bottom lines of both.

Unless you book tax deprecation in your general ledger (don’t do that), your number and theirs will always differ. Also, the tax return will include Section 179 deductions (the full write-off of certain or all fixed assets) that you will not do in your regular books.

Meals and entertainment also drive tax reporting differences. Passthrough entities such as partnerships and s-corporations will include differences for owner benefits, charitable donations, and interest income.

When you get to the balance sheet, you shouldn’t have any issues. If you get stuck, ask your CPA. I’ve had to do this several times, and they never mind explaining a number or a difference I’ve flagged.

The first time I did this, I was on my own. There was no owner’s manual. I kept hearing Professor Croarkin’s message in my small brain, “Mark, you know how to read.”

The Reason We Reconcile the Return

I’d love to see a poll of financial controllers who reconcile their numbers to the tax return. Good luck in Googling for a recent survey. You either won’t find one, or it’s buried on page 638 of the search results.

I fear the count is small and probably next to zero for firms with revenue under $20 million.

Why reconcile? Do you reconcile cash? How about inventory if you have it? How about vendor invoices from large suppliers? Are there other assets you own where trust and verification are required?

And so it goes with the tax return. Every business needs a strong tax accountant. But as business owners, we need our accountants to step up to verify the accuracy and completeness of these numbers.

Tax Reconciliations Versus Audits

Not only do I hate tax compliance reporting, I hate financial audits too. They are worthless and serve no purpose. Even in acquisitions, they provide little, if any, value. If interested, you can read more about this topic in another essay.

A well-constructed tax reconciliation can help you downgrade your expensive audit to a full-disclosure audit. Let me explain.

If a business owner wants to fudge their financials, are they more than likely to do that with their internal numbers or on the tax return? Most bankers in private conversations tell me they trust the tax return more than the external financials. That’s because they know and understand the myth of audits. Audits are not for catching fraud. However, many owners dread the possibility of being audited. Hence, tax numbers will typically be more accurate and complete (I realize this could easily be debated).

The bigger point is that many bankers we work with trust tax returns due to the inherent conservatism baked into the numbers. Every banker I work with gets a clean and professional version of the tax reconciliation, but we also go over it in person or on a Zoom call.

Go through this cycle more than once, along with the quarterly financial meetings you have with them, don’t be surprised if they give into a downgrade on the external reporting requirements, which are triggered by your revolving line of credit.

Advice for Larger Accounting Departments

In my second CFO/controllership position, I had a small 10-person team, including myself, for a $23 million newspaper and commercial printer.

Todd was one of my staff accountants, and not only did he reconcile the return when it was completed, but he also completed a draft of the return before sending it to Kate, our senior manager of the firm she worked with. Our workpapers were complete and easy for them to complete the return.

So when I say we should own the return, I mean it. Todd was not a full-time tax accountant. But he knew the code well, and his work was phenomenal in this respect.

If you are a much bigger business, I highly recommend that you invest in tax software along with trial balance software because compliance reconciliation becomes far easier. My first and only recommendation is the software from Thomson Reuters. If you can only afford spreadsheets for now, that’s fine too.

Frequently Asked Questions

You can, but most of the time, my teams do it after the filing. For bigger businesses where you are doing a draft in-house, as Todd did in my discussion, it makes sense to review the CPA’s draft first. CPAs are busy during tax season. That’s one more friction point for them before they can hit ‘send’ in their software to the IRS.

There’s a practical answer, and there is a correct response. I’ll stick to the first. I’ve found three errors in my career, and we never amended them. We let the error correction reverse itself the following year. Obviously, if the error is significant, that’s another story.

I don’t have a format since I have a way of cheating and doing a backdoor reconciliation method. My excerpt above was from Connie’s file, which worked for her. She liked starting with book earnings and listing the differences she received in the AJE listing from the CPA. Function should always trump form. Plus, Connie’s version is perfect for showing to a banker.

What did your CPA say? That’s your answer. Remember, I have nothing on you and your skills. You can read just as well as I can. If you are stuck, it’s because there’s probably something tricky on that return. It has nothing to do with your skills or abilities.

I’ll answer that question differently. You should already take about 80 hours of informal CPE (self-learning on interesting topics). You should be taking 40 hours of formal CPE training annually. About 4-8 of those hours should be in tax. In the first year, take an introductory course. In subsequent years, step up your courses. Your CPA can provide you with classes to attend. One of my firms even conducts in-house training that clients can attend.

Let’s Test Your Knowledge

You’re a master, right? Let’s do a quick assessment to gauge the gaps in your understanding. Remember, you must do a reconciliation first, no matter how messy or confusing the process is. I was once in your shoes, and I found that common sense went a long way in getting numbers to tie out.

By the way, most of the questions are heavy on concept vs. technique.

Do you or your department need to complete a tax reconciliation? Why or why not? If you are now starting to add this to your annual to-do list, why?
Your small business CPA uses the cash basis for reporting taxes. Your business, as all should, uses the accrual method. What is your process for reconciling the two trial balances?
In the reconciliation, is your goal to figure out how the CPA arrived at your numbers or to tie your accrual numbers to the cash basis numbers on the tax return (this applies to the accrual basis for tax)?
Your small business tax CPA clicks the cash basis number on your QuickBooks P&L. Are those P&L balances cash basis? Why or why not?
Do you record all of the reconciling differences in your general ledger?

I mentioned this earlier; if the content behind the questions above is confusing, please invest in a couple of tax-centric CPE courses. My growth CEOs are always happy to pay for those training courses because they take financial management systems seriously. I do too.