Statistical sampling may create opportunity for M&E analysis.
Meal and entertainment (M&E) expenses are often ignored when considering potential tax planning Tax planning
Devising strategies throughout the year in order to minimize tax liability, for example, by choosing a tax filing status that is most beneficial to the taxpayer. strategies. The amount a company expends on M&E is generally minor in comparison to its other operating expenses Operating expenses
The amount paid for asset maintenance or the cost of doing business, excluding depreciation. Earnings are distributed after operating expenses are deducted. and often deflects any serious examination. Further, a wide misconception mis·con·cep·tion
A mistaken thought, idea, or notion; a misunderstanding: had many misconceptions about the new tax program. is that all M&E expenses are subject to the Sec. 274(n)(1) 50% limit. However, some expenses commonly considered as subject to this limit are, in fact, fully deductible as ordinary and necessary business expenses under Sec. 162. Often, companies are unaware of these exceptions, which inadvertently leads them to misreport mis·re·port
tr.v. mis·re·port·ed, mis·re·port·ing, mis·re·ports
To report mistakenly or falsely.
An inaccurate or wrong report. a potentially large number of expenses.
Until recently, the only method thought available to correct misreporting was a thorough review of each expense record, a proposition not likely cost-effective. However, for companies with relatively large M&E accounts, a new method may be available. An IRS An abbreviation for the Internal Revenue Service, a federal agency charged with the responsibility of administering and enforcing internal revenue laws. memorandum (released March 14, 2002 to the industry directors of large and mid-size businesses) provides acceptable standards for using statistical sampling in preparing a return. Although these guidelines offer audit direction, they are not intended to serve as a technical position. However, they are planned for future release as a revenue procedure.
The memorandum proposes that through the use of statistical sampling, an estimate generated from analyzing only a portion of a taxpayer's M&E account may be used to project the expected amount of incorrect bookings made to a large M&E account. This could potentially create an efficient way to fully deduct expenses that would otherwise be subjected to the 50% limit.
The memorandum provides guidance for determining when the use of sampling is proper. First, agents should determine whether a taxpayer has appropriately used a probability sample to support or stand as the primary evidence of tax amounts. Appropriateness is a facts-and-circumstances determination.
The key elements examined in a given situation include the cost of analyzing the volumes of data available, the cost of analyzing the sample, and the availability of any other records that have a greater probative value probative value n. evidence which is sufficiently useful to prove something important in a trial. However, probative value of proposed evidence must be weighed against prejudice in the minds of jurors toward the opposing party or criminal defendant. . Based on these criteria, sampling would be appropriate if there is a compelling reason for its use and taxpayers cannot reasonably obtain more accurate information.
Second, agents are to examine the validity of the resulting estimate obtained from the statistical sample. Three conditions must be established to support its validity. First, the taxpayer must maintain adequate documentation of the sampling techniques performed. This includes a written sampling plan, generally including information such as the plan objective, definitions of the population (including reconciliation to the return) and the sampling flame and unit, the source of the random numbers and the method used in selecting them, the sample size and documentation of how the size was arrived at, the methods used to associate the random numbers to the frame, the steps taken to ensure that the serialization se·ri·al·ize
tr.v. se·ri·al·ized, se·ri·al·iz·ing, se·ri·al·iz·es
To write or publish in serial form.
se of the frame is carried out independently of the drawing of random numbers, the steps to be taken in evaluating the sampling unit and the appraisal method for the sample.
Second, the estimate must be based on a probability (i.e., statistical) sample, in which each sampling unit has a known (nonzero non·ze·ro
Not equal to zero.
Not equal to zero. ) chance of selection. Finally, the estimate for a ample must be computed at the least advantageous 95% one-tailed confidence limit. The memorandum contains samples of the specific sampling plans and formulas that would be permissible to create a valid statistical sample. However, using a sampling technique does not exempt a company from complying with the substantiation requirements of Temp. Regs. Sec. 1.274-5T(c)(2).
This guidance appears to validate the argument that a company with a large M&E account could use statistical sampling to find incorrectly classified transactions. Even in a middle-market company, M&E accounts can have thousands of entries posted in a year, making any attempt to verify the correct reporting of each expense a nightmare and most likely not cost effective. Due to the subjective nature of many of the laws governing deductibility of the various expenses that may get posted to a M&E account, it would also be extraordinarily difficult to establish an accounting system that could reliably classify each expense properly. This would seem to fit within the memorandum's guidelines, allowing companies to use the sampling technique.
Although the Service issued this memorandum in March 2002, the IRs can still scrutinize scru·ti·nize
tr.v. scru·ti·nized, scru·ti·niz·ing, scru·ti·niz·es
To examine or observe with great care; inspect critically.
scru this method, by evaluating the facts and circumstances of each case. For example, in Field Service Advice (FSA FSA Financial Services Authority
FSA Food Standards Agency (UK)
FSA Farm Service Agency (USDA)
FSA Financial Services Agency (Japan) ) 200209028, it denied the use of sampling, declaring that sampling of any kind was invalid on the basis that it was only "a form of a close approximation," when "each and every item covered under section 274(d), requires an expenditure-by-expenditure determination."
The FSA's facts appear to meet the "appropriate" test, as the company estimated that over 50,000 entries were posted to its M&E account in one year, making the cost to analyze each item ineffective. In support of its position, the company also used Litigation An action brought in court to enforce a particular right. The act or process of bringing a lawsuit in and of itself; a judicial contest; any dispute.
When a person begins a civil lawsuit, the person enters into a process called litigation. Guideline Memorandum (LGM LGM Last Glacial Maximum
LGM Little Green Men (Astronomical: first used as the designation for pulsars)
LGM Lembaga Getah Malaysia (Malay: Malaysian Rubber Board)
LGM The Lone Gunmen ) TL.97 (9/9/92), Use of Statistical Sampling Techniques in Examination of Tax Returns, which instructs Service personnel to support taxpayers' use of sampling.
Although the FSA seems to be in complete disagreement with the suggested increased acceptance of sampling, it may not have disclosed all the facts involved in its decision; it did not specify the reasons for denial. The FSA does focus on the substantiation requirement in its argument against statistical sampling, but does not delineate why the sample is insubstantial. In the instant case, the sampling plan may have been invalid, or the taxpayer may have been attempting to use the sampling technique to avoid the normal substantiation requirements.
In conclusion, although using statistical sampling to substantiate To establish the existence or truth of a particular fact through the use of competent evidence; to verify.
For example, an Eyewitness might be called by a party to a lawsuit to substantiate that party's testimony. returns may still be considered a new or risky technique, the IRS's internal guidelines for acceptance of this technique indicate that it is increasing its acceptance of properly designed statistical samples for obtaining tax information when a detailed analysis is impractical.
As with any position, consideration must be given to ensure appropriateness. Thus, the facts and circumstances of each case determine not only whether sampling is appropriate, but also whether the result is a valid estimate that can be used for tax purposes.
FROM SHARON L. COOK, CPA (Computer Press Association, Landing, NJ) An earlier membership organization founded in 1983 that promoted excellence in computer journalism. Its annual awards honored outstanding examples in print, broadcast and electronic media. The CPA disbanded in 2000. , AND DAVID J David J. Haskins (b. April 24, 1957, in Northampton, England) is a British alternative rock musician. He was the bassist for the seminal gothic rock band Bauhaus. Life and work . HOLETS, SOUTH BEND South Bend, city (1990 pop. 105,511), seat of St. Joseph co., N Ind., on the great south bend of the St. Joseph River, in a farming and mint-growing region; inc. as a city 1865. , IN