Tax workpaper procedures.

The term "workpaper" can have many different, equally valid meanings. This article covers normal practices within a corporate tax department, and the common practices in public accounting firms for the preparation of individual income tax returns.

Individual Tax Return Workpaper Organization

An excellent discussion on return workpapers can be found in the AICPA's "Tax Practice Management" service. That discussion begins by noting, "Tax return workpapers should provide a trail from the source materials to the final figures on the return. Most firms have adequate workpapers for the preparation of business returns. Often, however, workpapers for individual taxpayers are neglected. Under the crush of the tax season workload, preparers may try to cut corners with workpapers." Fortunately, in comparing the workpaper requirements found in the internal procedure manuals of two different firms (one a small local firm, the other a medium-size firm, each in a different part of the U.S.), the practices were almost identical. The workpaper requirements common to both firms stated that the workpapers for the current year's tax return should contain the following items:

1. The engagement letter;

2. The completed and signed-off checklist (finding even one major item by using the firm's individual tax return checklist will forever prove its value);

3. Computer system byproducts (e.g., diagnostic messages, carryover schedules, etc.);

4. Interviewer's notes and comments;

5. The client's completed tax organizer;

6. Copies of all K-1s, retirement distribution information, basis information, etc.;

7. Copies of any tax research performed regarding issues within the return;

8. Copies of W-2s. (Note: There was a difference in practices as to retaining copies Form 1099s. The medium-size firm did not retain copies if the client had completed the tax organizer and the tax accountant had checked off the item "Agreed to Form 1099" The local firm retained copies of all Form 1099s, based on its experiences with the IRS's CP-2000 program. The CP-2000 program does a computerized comparison between the tax return as filed and the data received by the Service from Form 1099 filers. This comparison is done long after the tax returns have been filed; for example, taxpayers received CP-2000 notices concerning their 1996 tax returns in 1998. Frequently, the CP-2000 system misses corrected Form 1099s or W-2s that have been filed, resulting in taxpayer notices that do not reflect the changes. If the tax accountant has the corrected document in the client's file, the response to an erroneous CP-2000 notice can be swift and effective.)

Corporate Tax Workpaper Organization

The organization of tax workpapers for large corporations involves different challenges than those for accounting firms. The key factor centers on the fact that workpaper organization is customized to fit the corporate taxpayer's specific issues and events; the workpaper organization is directly dependent on how the corporate tax department is structured. Usually, a large corporate tax department will be divided by state tax, Federal tax, sales tax and legal responsibilities; under this structure, there are separate files for each area of responsibility. If the department is structured in a corporate entity approach, the workpapers are usually organized with an entity focus. The size of the return has a direct impact on file organization. For example, an inactive subsidiary return filing in five states should be combined into one file, as relevant information of inactive returns does not mandate separate state files. In the following discussion, the workpaper organization is structured under an entity approach.

Because a large corporate tax department usually files a large consolidated return involving multiple subsidiaries, a separate workpaper file is established for each subsidiary; depending on the complexity of the organization, there may be many files. The tax director usually implements the procedures for proper workpaper organization. The keys to workpaper organization are documentation and flexibility. Workpapers need to be organized and properly labeled. When a critical lead schedule needs to be found, a lead sheet should properly identify its location. Workpaper numbering can be done in many ways. The most efficient way is to allow insertion of additional pages without renumbering an entire file; as additional documentation is inserted into the file, no additional numbering of workpapers should be necessary. Usually, an alphanumeric system that allows this flexibility is used. For a large corporation with multiple state filings, there are usually three files--a research file, an IRs issue and correspondence file and a yearly workpaper file. These files are either labeled with different color labels or the entire file is distinguished by its color.

In the research file, documented memos are organized by date. The memos usually identify the relevant Code sections and provide a summary of facts. The facts, issue and conclusion foundation of memos may be changed in corporate tax structures. The memos any focus on specific categories related to specific Schedule M items; these memos would be cross-referenced to the tax lead schedule. The research file will provide a summary of points and conclusions. Any items addressed on a point sheet that were researched should be dearly identified. A quick index of research issues should be at the front of the file.

Because the audit rate of large corporate taxpayers is high, an IRS issues and correspondence audit file will usually be established. This file organizes any information document requests (IDRs) in a neat and orderly fashion. The file should be organized according to IDR number, with copies of all information supplied to agents. All phone communications should be documented. Additionally, a database of all IDRs for the entire audit year should be established; this allows quick access to critical information (such as the date information is supplied, the date the IDR is received, etc.). The IRS file is a critical file that can be used to a taxpayer's advantage; for example, a documented closing letter and determination that a taxpayer is not under audit can provide critical information to the tax director as to when an accounting method change should be filed. Proper segregation of correspondence relating to IRS issues may enhance a claim of communication privilege by a tax practitioner.

The yearly workpaper files are the substantiation to support a tax return. Depending on the complexity of the return, the state and Federal files may be separated. The Federal file contains a checklist of all proper procedures in filling a return, but also ensures that all information has been reviewed and categorized. The workpaper focus is usually on the Schedule M adjustments, with a summary of book-to-tax income analysis as the lead schedule. This schedule should also contain a column of previous-year adjustments (to allow a comparison with the current-year tax adjustments and a calculation of a variance amount); this can provide the reviewer with a quick check as to the reasonableness of the adjustments. A note section should be clearly identified and a summary of tax issues should be made. Also, a copy of the final tax return should be in the file, along with all IRS notices of nonaudit issues (e.g., employer identification number confirmation, payment receipts, etc.) The detail behind the lead schedule differs for each line item; spreadsheet summary, schedules, hand-written workpapers and interdepartmental responses to tax package inquiries are some of the various support documents included in the detail workpapers for the tax adjustment support.

The state file contains information similar to that kept for the Federal return. A state note section and state workpaper adjustment section can be organized along the same lines as the Federal workpapers; state notices and state tax adjustments are classified in similar fashion. A critical factor in the state file organization depends on whether the company files a consolidated return for the respective state or a separate company state return. If separate returns are, filed, a summary schedule to consolidated Federal adjustments may need to be prepared, to account for any adjustments made at the consolidated level (e.g., eliminating entries, charitable contribution limitation tax adjustments, etc.).

The workpaper organization of a large corporation is a critical part of tax compliance. If these workpapers are not clearly understandable, serious consequences can result. Violation of record retention agreements or lack of substantiation could cause additional audit adjustments, as well as IRS claims of unreasonable tax positions.

From Leonard W. Williams, CPA, Leonard W. Williams professional Corporation, Sunnyvale, CA, and Larry Jaffe, CPA, Fort Lauderdale, FL

Editor's note: Mr. Holub chairs the AICPA Tax Division's Tax Practice Management Committee. Mr. Williams and Mr. Jaffe are members of 'that committee. The authors wish to thank T. Chris Muirhead, CPA, Porter, Muirhead, Comia & Howard, Casper, WY, for his assistance.

If you would like additional information about this article, contact Mr. Holub at [phone].

Steven F. Holub, CPA Pender, Newkirk & Company Tampa, FL