Don Bruce
Credit: Photo: David Johnson Don Bruce
Barry Kemons, owner of Archadeck in Charlotte, N.C., endured a five-month-long IRS compliance audit.
Credit: Photo: Compoa Barry Kemons, owner of Archadeck in Charlotte, N.C., endured a five-month-long IRS compliance audit.

In the spring of 2004, at least five Chicago-area contractors were audited by the Illinois Department of Revenue as part of the department's crackdown on companies that weren't paying “sales and use” taxes on products purchased out of state. “The audit program is our state's biggest money maker right now,” says Michael Holmes, who with his wife, Linda, owns Creative Carpentry Remodelers, in Aurora, Ill. Creative Carpentry Remodelers wound up paying around $1,000 in back taxes and penalties — and another $1,500 in accountant's fees — to settle its liability for a computer bought from an out-of-state supplier.

Illinois is one of 45 states staring at staggering budget deficits, and many state governments are shoring up revenue shortfalls through aggressive auditing programs. On top of these, the U.S. Internal Revenue Service over the past few years has been zealously executing the Bush administration's expressed mandate to enforce compliance with a federal tax code that's now 61,224 pages and counting.

Although most contractors say they aren't rattled by the prospect of having their books or business practices examined, several of those interviewed for this article admit that their companies may not be completely prepared for an ordeal that can take anywhere from a few days to several months. “The biggest problem in this industry is that companies don't know their own books,” observes Doug Sutton, whose Springfield, Ill., company, Sutton Siding and Remodeling, has been audited several times over the past two decades. “You have people out there who don't even do job costing.”

The integrity of their recordkeeping and filing is just one area where home improvement contractors can prove vulnerable when tax agents come knocking. How companies manage subcontractors, compensate their owners, and purchase building materials and equipment are all red flags that consistently draw the attention of the IRS and state auditors.

Several contractors declined to discuss this topic at length for fear of calling attention to their companies. “I'm of the opinion that if you're out of sight, you're out of mind, and I believe in flying under the radar,” says Merle Petz, general manager for Lenexa, Kan.-based window and door installer Alenco (and Petz has a degree in finance). Others insist, sometimes defiantly, that honesty remains their best defense. “No one wants to get that phone call, but I don't fear it [because] we pay our taxes in a timely fashion, usually before they are due,” says Jim Lett, owner of A.B.E. Doors and Windows, in Allentown, Pa., which has never been audited in its 31 years in business. “My CPA and I go over the books together once a month, and he'll ask us to do an extra inventory if he sees any discrepancies,” Lett says. “I can't afford not to report everything, and I don't have anything to hide.”

But contractors who have endured audits point out that honesty may be beside the point, and that nothing beats preparation for getting through an investigation. America's Best Home Remodelers in Golden, Colo., went through a state tax audit five years ago. Owner Rick Duggan says he now manages his company from the point of view — purely practical — that it could happen again at any time. “My thinking is not if we're going to get audited, but when,” he says. Duggan and other contractors say the audits their companies were subjected to — which mostly resulted in relatively minor tax payments — gave them new insights into the process (see “Words From the Wise”).

Don Bruce, owner of Amer-ican Home Design, in Nashville, Tenn., sums up the one lesson home improvement company owners invariably learn from such an experience. “Play by the rules and document everything,” he advises. “We take every advantage we can, but we have paperwork for everything we do. Plus, we have good accountants and attorneys.”

Subcontractors at Issue Most home improvement contractors interviewed for this article couldn't say for certain why their companies were singled out for audits. But there is no question that state and federal taxation agencies continue to look closely at just how “independent” subcontractors are when remodeling or home improvement companies regularly use their services. “This is a huge issue for the IRS,” says Tom Ochsenschlager, vice president of taxation for the American Institute of Certified Public Accountants in Washington, D.C.

“Wage and hour rules are misunderstood by most contractors, and IRS agents never fail to find fractures in” their employment arrangements, observes Dave Yoho, president of Dave Yoho & Associates, a consulting firm in Fairfax, Va., with many home improvement companies among its clients. Bruce points out that because “there are so many subs out there that aren't paying their employees' taxes,” the IRS tries to attach those laborers to home improvement companies which are financially more stable, in order to collect the taxes owed.

Contractors can't plead ignorance here. Section 530 of the U.S. Tax Code clearly explains the procedures employers must follow to prove that a worker isn't an employee. A worker or business can ask the IRS to determine this by filing form SS-8, which tax agents often use in their audits. And in its most recent “Construction Industry Guide,” published in October 2004, the IRS laid out how its agents differentiate independent contractors from employees. The criteria revolve around behavioral control, financial control, and the relationship between the parties. For example, if the worker/subcontractor expects the relationship to go on indefinitely, “this is generally considered evidence of an employee-employer relationship,” the guide states.

Filing 1099 forms with the IRS for every subcontracting company that works for you is critical to the paper trail you must establish. To further eliminate any confusion and to document that subs are employed by separate business entities, The Clear Choice, a window and bath replacement contractor in Pleasanton, Calif., draws up new contracts for every project it undertakes, according to president Donn Reinin.

“We don't furnish [subs] with tools, trucks, or uniforms, and we don't tell them what time to show up for work or what hours they need to put in,” Duggan says. He also says he prefers dealing with subcontractors who own their own homes because “that implies a certain amount of responsibility. I try to screen out those guys who aren't paying their taxes.”

Such actions might provide contractors with cover in the event of an audit. On the other hand, they won't automatically prevent one from happening.