Chapter 1 - Return Selection Process
Returns Selected for this Project
Contractors were selected from the list of licensed Farm/Labor Contractor's, provided by the Bureau of Labor & Industry, Wage and Hour Division. A data base of the licensed contractors owning businesses in Salem, Woodburn, Mt. Angel, and the surrounding area was developed. AIMS was researched to locate social security numbers and addresses of the licensed contractors. Once a social security number was obtained, a transcript was ordered to determine if the contractors were filing Federal tax returns. Copies of selected contractors' returns filed with the State of Oregon were secured from the Department of Revenue under our information exchange agreement.
The returns examined were selected based on prior knowledge of the types of expenses common to the reforestation industry and whether or not the items reported on the return appeared either large or unusual. The returns selected for examination were either individual Forms 1040, Subchapter S-Corporations, or C-Corporations.
The group examined 9 prime contractors, 3 second-tier subcontractors, and 20 individuals who filed Federal returns Form 1040. The State of Oregon revenue agent examined the Corporate Income Tax Returns for three S-Corporations and one C-Corporation. The second-tier contractors were selected by expanding the "package audit" during the examination of the prime contractor. In other words, when a prime contractor was audited, the examiners reviewed certain documents (such as cancelled checks, invoices, and Forms 1099) pertaining to subcontractor payments. The subcontractors who received large payments were identified and again transcripts were requested to determine if they filed Federal and State tax returns. We selected subcontractors that were filing employment tax returns and also subcontractors that were not filing either income tax returns or employment tax returns. During the classification process and the examination process, the group identified audit issues which appeared to be common within this industry. The following is a list of the audit areas that were identified:
1. There were large numbers of nonfilers.
2. Circumvention of employment tax liabilities and worker's compensation premiums by failing to file employment tax returns, paying wages in cash, and classifying all payments to workers as subcontractor payments.
3. Employees in this industry are issued Forms 1099 for the above reasons. These individuals offset their Form 1099 income with expenses -- either paid by them or their employer, and subsequently qualify for a earned income credit.
4. Sums of large amounts of income. Internal control is usually poor and leads to underreporting of income earned from Federal and State agencies, from other contractors, private companies, or other unrelated business activities.
5. Poor accounting records lead to unsubstantiated expenses. Reforestation contractors contend that they do not have the expertise to maintain quality books and records.
6. Returns are being prepared by unlicensed preparers. A preparer reported that he was being paid for bookkeeping services, not for preparing tax returns, and, therefore, was not required to sign the returns.
Suggested Sequence of Selecting Contractors for Examination
Step 1: Identifying the Prime Contractor
Reforestation contractors working in Oregon are required to obtain a
Farm/Labor Contractor's License. To secure a listing of licensed Oregon
contractors you need to contact the State of Oregon, Bureau of Labor and
Industries, Wage and Hour Division. Oregon is the only known state that
requires the contractors to have a license; however, the Bureau of Labor
and Industries in your state will be able to give you more information on
their policies.
Another possible resource for locating reforestation contractors is PSPB
or the Department of Revenue in your state. PSPB and the Department of
Revenue have the capability of running a listing of returns with specific
Principle Industry Activity Codes, (PIA Codes). This may be something that
your Disclosure Officer can secure for your area. Finally, you may be able
to request a list of contractors from the Forest Service or the Bureau of
Land Management. These agencies are required to maintain a current mailing
list of contractors who wish to receive the current announcements of
solicitations. Chapter 2 of this handbook, lists addresses, and telephone
numbers of Oregon and Washington regulatory and licensing offices where
you can secure information about reforestation contractors.
Step 2: Selecting Second-tier Contractors for Examination
While completing the expanded "package audit" the examiner should concentrate on those subcontractors with the highest dollar volume. A good starting point is to review the Forms 1099. In addition, the disbursements journal should be reviewed for other large volume contractors who were not issued a Form 1099, since, 1) the prime contractor may not be issuing a Form 1099 to all subcontractors, and 2) Forms 1099 are not required to be issued to corporations, and contractors are sometimes organized as corporations to circumvent the Form 1099 filing requirements.
Step 3: Identifying Disbursements to the Selected Subcontractors
In preparation for reviewing the key documents (cancelled checks), disbursements made to the subcontractors selected in Step 2 must be identified by check number, date, and amount. It has been our experience that the contractors do not maintain summaries of their cash disbursement journal so it will be helpful to create a data base of payments made to individuals and the checks issued to cash. This information will be invaluable for the following reasons:
1. The list will give you a starting point when analyzing a subcontractor's bank deposits since the contractor may be cashing payments received from the prime contractor at the prime contractor's bank.
2. Prime contractors may be issuing checks to cash and paying the subcontractors in cash.
3. The prime contractor may file a Form 1099, but exclude certain payments made to the subcontractor.
Step 4: Inspect Cancelled Checks
The next step is to pull the checks for each selected contractor and to review the endorsements. The examiner will be looking for checks that were cashed in unusual ways. For example, they may have been converted to cashier checks, cashed at the payor's bank, cashed at a check-cashing business, deposited to a bank account located in another city, or endorsed to another individual. Because contractors normally operate as closely held family businesses, with few accounting controls in place, failure to deposit normal business receipts is a good indication that the income is not being reported for tax purposes.
Step 5: Select Subcontractors for Audit
After completion of Step 4, the examiner will have identified one or more contractors whose audits will spin-off. He or she would be well advised to request the payment detail for these contractors for the subsequent year as well. Requesting information in the early stages is advisable since it may become increasingly difficult to obtain documents as the audit progresses.
Step 6: Secure Documents for the Subcontractor File
The information to be accumulated for each contractor that will be spun-off should include as much of the following as is available:
1. Forms 1099
2. Front and back of all checks issued to the subcontractor
3. Any identification information that the prime contractor may have on the subcontractor, such as past and current addresses, telephone numbers, business names, invoices, and social security numbers.
Step 7: Other Sources of Information for Locating Subcontractors
If the address or social security number retained by the prime contractor does not help you in locating the subcontractor, you can call the Corporate Commissioner to obtain the address of the business and the names and addresses of the registrants. We have found that it is common for individuals to register an assumed business name with the Corporate Commissioner and give the name and address of several registrants. (For information on Oregon businesses you can call (503) 378-4166). The Department of Insurance and Finance can be a helpful source for locating subcontractors. This agency maintains a list of individuals and businesses who currently have worker's compensation coverage. If the subcontractor currently has coverage, you can obtain his or her home address. The Department of Insurance and Finance can also give you information about a business and tell you whether or not the business has registered for coverage as a partnership, corporation, or as a sole proprietor. (In Oregon you can call (503) 378-4954).
As previously mentioned, the Bureau of Labor and Industries, Wage and Hour Division will have names and addresses of all licensed contractors. (In Oregon you may call (503) 378-3292).