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:: Retail Industry Audit Technique Guide (ATG) - Chapter 3: Examination Techniques for Secific Industries (Electronic Business Online Retail)   Table of Contents (Electronic Business, Online Retail) Introduction Internet Investigative Tools Audit Techniques & Interview Questions Income Cost of Goods Sold Expenses Potential Tax Issues Glossary Exhibit 1: E-Business Introduction Electronic business (E-Business) encompasses a wide range of emerging and evolving concepts and technologies. Generally, e-business consists of business transactions conducted over open computer networks.   To most people, e-business implies online shopping, but web shopping is only a small part of the e-business picture. E-Business also refers to other business transactions including online stock and bond transactions, Business-to-business purchases (EDI), and electronic telemarketing.  In retail businesses the examiner is likely to find that retailers make a substantial percentage of their purchases of goods and supplies online Retail e-business sales for 2003 were $55 billion, according to the U.S. Department of Commerce.  2004 has again seen a dramatic increase in online retail sales increasing to nearly $69 billion. There are a significant number of Small Business/Self-Employed taxpayers involved in online retail, including Catalog and Mail Order Sales of Automobiles & Parts, Specialty Items, Music, Videos, Books & Magazines, Electronics & Appliances, Computer Hardware & Software, and Clothing.  With the increased awareness and popularity of the Internet, individuals and businesses, both large and small can participate in e-business. The Internet is changing the way that many retailers conduct their business. Retailers are now involved in multi-channeling to a greater extent; whereby a portion of the business is still conducted at the traditional “brick and mortar” establishment and also business is conducted on the Internet becoming “click and mortar” businesses.  Many retail and service businesses use the Internet for advertising for their traditional businesses in which the sales transaction of the product or service cannot be or is not consummated online.    As the influence of the Internet grows, conducting business-to-business commerce on the Internet will expand greatly, and become more of a routine part of commerce than it is today. Even small businesses are increasingly utilizing the Internet to conduct business transactions. This increase in rate of electronic business promises to be faster than any other technological innovation to date and its implications far more profound. Online Retail Sales have shown a significant growth of 243 percent for the period 2000 through 2004, with sales of $28.3 billion in 2000, rising to $68.9 billion through 2004.  (Source:  U.S. Department of Commerce Census Bureau.) Back To Top Internet Investigative Tools How does the examiner know if the taxpayer is involved in e-business or has a web site? There is no definitive means of determining whether or not a taxpayer is involved in e-business. Here are some suggested audit techniques to help make that determination:   Ask the taxpayer if he/she has a web site. Use a search engine. Most businesses want high visibility to reach customers and will register their site with the major search engines. Look in the yellow pages to see if the taxpayer advertises a website. Business cards will often have the name of a website on it or an e-mail address. If the domain name included in the e-mail address is similar to the taxpayer's business name, then it is very likely the taxpayer has a business web site. Look for deductions that are common for e-business: Website development costs paid for software used to create a website or to an application service provider. Larger than normal depreciation deductions for web servers, networking equipment, and payments to Internet access providers.   The examiner of a retail business should always consult the Internet for possible websites or links to the business under examination or to unknown businesses belonging to the taxpayer. Inspection of the taxpayer’s website is every bit as important as the inspection of the place of business.  Internet Investigative Tools are available to assist examiners in their examinations.  What can these tools do for the Revenue Agent?  After the agent has determined an Internet presence for the business or promotion the agent will be able to identify possible third-party contacts to be made and related websites and other possible businesses and relationships. Ask the taxpayer. This question must be asked during the Initial Interview. Perform Google searches for the Domain Name based on the business and individual names. Save the current website content using Internet Explorer.  Saving the website content before the taxpayer closes it down or places security on it such as “members only” registration is important to the development of an unreported income case involving online retail sales. Perform a LinkPopularity search to determine linked websites, related websites and other websites under the control of the taxpayer to determine other possible sources of income for summons action. Use Whois to locate the Registrar and summons records. Use Whois to locate the Responsible Party and summons records   Search the Internet Archives Wayback Machine.* (*The Internet Archive is a database of archived webpages dating back to 1996.  The search interface for the Internet Archive is the Wayback Machine.  Using the Wayback Machine, it is possible to search for the taxpayer’s website.  The results displayed will show all archived copies of the website available.  This search will allow the examiner to determine what the website contained during the year of examination as well as historical information.  Did the online business really start in 2004 or was there activity prior to that year?  What were the product lines that were being sold online during the year of audit?  Are those product sales included in income?)   Back To Top Audit Techniques & Interview Questions E-Business Online Retail & Services Interview Questionnaire   Do you have an Internet presence? (web site, web page, e-mail, banner for business purposes) Do you conduct business transactions over the Internet? (Accept orders and/or payments over the Internet?) (What types of records are maintained for these transactions?  All electronic?  Paper documents?) What products, services or memberships may be purchased on your web site or through the use of email? When was the web site "opened" for business? Did the business exist prior to creation of the web site?  Is the business conducted over the Internet separate or distinct from the taxpayer's historic line of business? What domain names have been registered either by you or on your behalf? What domain names do you have control over?  Please include the date of registration and the name of the registrant. How is the fee for Internet connection services determined? How was your Internet web site developed, i.e. outside consultant, internal staff, web site design software?  Details regarding all consulting fees, employee salaries, design software, etc. should be requested. How many employees are engaged in the Internet-based business activity?  Secure a list of the employees, job titles, compensation, etc., responsible for web site design and web site hosting.  How much has the taxpayer paid to outside vendors including non-employee compensation, for web site development and web site hosting? What type of credit cards does your financial institution(s) accommodate? What is the name of the financial institution(s) that clears your credit card receipts? Was an application or merchant services sign-up form completed for the credit card clearing services? Does your ISP or the entity that is providing you server space process your credit card transactions? Have you used any other financial institutions in conjunction with your web site? Does your financial institution(s) provide: charge authorization transaction capture settlement charge-back handling reconciliation reporting, or Prepaid card issuance and acceptance? What type of purchase payment enabling software do you use?  Make note of the vendor name and address.  If the taxpayer does not know the name of the software, ask if the ISP hosting the web site is providing the software. How are credit sales handled and how are they recorded in gross receipts? How are non-credit sales handled and how are they recorded in gross receipts? How is information for approved or authorized credit card product purchases processed? What is the sequence from order entry to shipment? How are products shipped and which shippers are used? Who are your major suppliers and vendors? From where are shipments made? Do you have any paid referral or advertising contracts with other Internet web sites? If the answer is yes, obtain copies of the contracts. Do you swap (barter) links, banner space and server space with any other businesses? Do you have any foreign operations? Do you have direct or indirect control over any foreign corporations, foreign partnerships, foreign trusts or any other foreign business enterprises? Do you have any direct or indirect control over foreign bank or other offshore accounts? Identification of E-Business Cases: When you are first assigned a return for examination, you may not immediately know  a taxpayer has an e-business.  The return, however, may have some E-Business indicators.  The most obvious indicator on a tax return may be the business name.  If one of the gTLDs (e.g. .com, .net, etc.) is a part of the name or if the name is preceded by www, the business is likely to be in e-business. Another indicator may be found in the explanation of the Business Activity (Product or Service).  Internet businesses may use words such as Internet Service Provider, web host, web design, web master, or online in the descriptions.  Review the instructions for the preparation of Forms 1040 Schedule C, 1120-S, 1065, and 1120 with respect to the “Business Code” line item for each form.  This code is referred to as “Codes for Principal Business Activity and Principal Product or Service” and is indicated to be based on the North American Industry Classification System (NAICS).  E-Business returns may be identified using NAICS.   Forms NAIC Code Explanation of Business or Products 1120, 1065, 1120S, 1040/C 425110 B2B Electronic Markets   454110 Electronic Shopping & Mail Order Houses   511210 Software Publishers   516110 Internet Publishing  & Broadcasting   518111 Internet Service Providers   518112 Web Search Portals   518210 Data Processing, Hosting & Related Svcs   541511 Custom Computer Programming Services   541512 Computer Systems Design Services   541513 Computer Facilities Management Svcs   541519 Other Computer Related Services 1040/C-Only 519100 Other Information Svcs (News, Synd, Lib)   454112 Electronic Auctions   454111 Electronic Shopping Back To Top Expenses contained in the Other Deductions line item may provide indicators of Internet activity.  Below is a list of expenses that a business with a website might deduct:    Web site design costs  Domain name registration fees  Web maintenance costs  Internet service provider fees  Cable modem access  Web page hosting fees  Web consulting fees  Domain name cost  Network service fees             Many tax returns contain a supplemental depreciation schedule.  Assets included on the depreciation schedule may also indicate that the business is involved in the Internet.  These assets may include the following:   Servers Significant computer purchases Computer Software Modems Routers  Telecommunication equipment Phone Lines   Domain name Web site design costs Switches                     An unusually large amount deducted for Rental/Leasing Expense and/or Utilities may also be indicators that the company is involved in Internet activity.  Many taxpayers do not have the capital necessary to fund the initial investment for equipment and peripherals needed for Internet activity.  These taxpayers rent or lease the equipment and peripherals as an alternative. More and more traditional brick & mortar” businesses in the retail and services trade are turning to the Internet as another market and becoming what is referred to as “click and mortar” businesses, combining their traditional business activities with the virtual world of the Internet.  This may not be obvious to the examiner upon review of the return during the pre-planning stages. If there are no indicators on the return or if the indicators are not conclusive, other references may also indicate that the taxpayer is involved in e-business.  A Yellow Pages ad, for example, may list a web address.  A company with a web site will usually include the address in their advertising, brochures or pamphlets, signs on the building, business cards, company letterhead, vehicles, and receipts or invoices.  A Google search for the business is also an excellent pre-planning tool to determine whether the taxpayer is involved in online sales or services.  More advanced searches are recommended to identify all websites used by the taxpayer and business. Once the audit has started, the most obvious way to find out if the taxpayer is involved in e-business is to ask.  It is important to ask even if there are no indicators of an online presence for the taxpayer.  See the recommended Interview Questionnaire and the Explanation for the questions in the chapter Appendix. Back To Top Income The potential for omitted income is greater in E-Business, due to the borderless and paperless feature of the organization. Another large segment of E-business transactions is internet bartering.    The examiner should question the taxpayer for the procedure when a sale of a product is conducted on the taxpayer's website, for example, can the order be placed on-line and payment submitted on-line?  What type of payment is the taxpayer accepting if sales are occurring on the Internet? How can the examiner verify that all sales are being reported? The examiner must determine if the business offers its clients the opportunity to purchase directly from a web-based catalog.  “Walk me through various types of transactions.” It is important for the examiner to review the taxpayer’s web-pages for E-payment sources such as PayPal, Visa and MasterCard, then tie those sources to the Books and Records and then on to the Tax Return.  This is an important audit technique for online retail.  Look for those items of income that should be there but are missing.  Evidence of an unreported online business can also be found by tracing credit card payments or following up on invoices providers. Any business that operates a website will receive advertising income for banner ads and pop-up ads that appear on their website.  Additionally, each time a site visitor clicks onto the ad, another fee is paid to the site owner.  Be sure to ask how this income is accounted for.  Many times there is a counter on the site that indicates the number of visitors to the site that would give the examiner an idea of the amount of traffic the web site receives.  If the examiner can determine the “click-through” rate charged, a good estimate of this income can be made.  (Often this rate is between 5 and 10 cents per click.) With online retail, the reconciliation of shipment costs with both COGS and Income is another quality audit technique.  The examiner should consider the average mark-up based on purchases reported and not reported to identify any unreported income.  The Percentage Mark-up Technique for the determination of Income based on Cost of Goods Sold Purchases should be considered and employed when appropriate.   Point-of-Sale software issues (ZAPPER) and the fact that taxpayers have the ability to edit tax and accounting records in most versions of commercially available software are discussed elsewhere in this guide.  Needless to say, examiners must be vigilant for any indications of income or expense record manipulation by the taxpayer. Back To Top Cost of Goods Sold Cost of goods sold will not differ significantly for businesses involved in e-business.  Since there is no fixed location, shipping costs will be evident and the examiner should question the taxpayer regarding the method (FedEx, USPS, UPS, etc.).  Another clue to business-to-business internet purchasing is when the ‘ship to’ address is different from the ‘purchaser address’.  This is indicative of a more complex business structure that could involve a possible Offshore aspect to the examination.  Any Offshore issues involving Online Retail should be referred to the E-Business & Emerging Issues staff for assistance. Back To Top Expenses Some expenses of an online retail business will be different, but the same tax laws apply as those for a traditional retail establishment. Online Purchases and Expenses present a challenge as usually there is no evidence other than the electronic document, which can be easily manipulated.  Electronic records should be tested for accuracy and any adjusting entries scrutinized. If the books and records appear questionable and Internal Control is lacking, the examiner should consider third-party contact for significant and/or reoccurring expense items.  Back To Top Potential Tax Issues Not a trade or business – When a taxpayer has claimed losses over several years from online retail activity which was used to shelter ordinary income from other sources, a determination should be made whether this activity is a business or a hobby.  These losses often stem from abusive deductions for expenses such as auto expenses, travel, and in home office allocations.  Allowance of these items is questionable under several IRC Code sections including sections 162, 183, and 262. (Home-based business)  Tax Shelter – Similar to the above scenario, except that we have identified a systematic scheme to obtain losses and credits that are not allowable under IRC sections 162 and 44. (ADA Credit for Website Improvements) Cost of Goods Sold - Revenue Procedure 2000-22 excepts qualifying taxpayers with average annual gross receipts of $1,000,000 or less from the requirements to account for inventories. However, if a taxpayer decides not to account for inventories, the taxpayer is required to treat what would have been treated as inventory as a material or supply that is not incidental under Treasury Regulation section 1.162-3.  The result is that the deduction is deferred until the material or supply is consumed or sold.  This is a potential issue for online retail. Failure to Report or Failure to File – Information available indicates that the taxpayer has an online retail site, but the examiner cannot ascertain how the proceeds were reported.  There is no Schedule C, Partnership, or Corporate filing that has been identified or the taxpayer is a nonfiler. An examination must be conducted to determine tax liability using Indirect Methods and Third-party Contacts and Summonses. Omitted Online Retail Sales for an established “brick & mortar” business. One easy way to understate income is to not recognize an entire income stream such as the online retail segment of an established traditional retail business.  Segregated income streams are easily concealed by diversion.  This is an example of the importance of using Internet Investigative Tools to determine whether a traditional retail business has expanded into an Internet presence.  Techniques discussed earlier in this chapter will be required to develop the case. Use of Limited Liability Companies and Trusts structures and no 1040 returns filed.  This scheme has been identified in the field involving online retail and online services businesses.  An LLC is formed as the business entity for the online retail business, with Grantor Trust Partners creating a TEFRA partnership at the LLC level.  The individuals involved in the business do not file 1040 returns. The tax treatment of the following items may result in potential tax issues.  Many of these potential issues boil down to capitalization versus expensing and timing of deductions. The tax treatment of these items is still under consideration by Counsel and issues involving the tax treatment of these items and online retail should be referred to the E-Business & Emerging Issues staff for assistance. Business Start-up Costs (Internet Business) Acquisition of Domain Name(s) and Website Development Costs Acquisition of Hardware Acquisition of Intangibles, including Costs of Production of Literary Content, Graphics, Sound or Video Acquisition of Software and Software Development Costs Lease Expense Catalog Costs Research & Experimental Expenditures and Credit Back To Top Summons Resources for Online Retail Case Development  During the course of an examination of an online retail taxpayer, it may be necessary to issue summonses to third parties.  Suggested summons language for Responsible Parties, Registrars, Internet Service Providers, Internet Access Providers, Credit Card Companies, PayPal and Other E-Payment Providers is available on the E-Business & Emerging Issues website. Back To Top Glossary ARIN  American Registry for Internet Numbers B2B Business to business transactions, such as making online purchases from supplier. B2C Business to consumer transactions, such as when a consumer makes an online purchase from a business website. Bridge  A device linking Local Area Networks (LAN) together or two segments of the same LAN. Broadband  A type of transmission where a single medium (typically fiber optic) can carry several channels at once. FTP  File Transfer Protocol. Gateway  A device linking LANs that may be using different networking protocols to communicate HTML  HyperText Markup Language ICANN  Internet Corporation for Assigned Names and Numbers IP  Internet protocol Terminal Server  A point of access to a network.  Also called remote access servers. WWW    World wide web. Back To Top EXHIBIT 1: E-Business Explanation for E-Business Online Retail & Services Interview Questions Do you have an Internet presence? (web site, web page, e-mail, banner for business purposes) Explanation – It is important to determine the extent of the taxpayer’s involvement with the Internet.  Keep in mind that a web presence does not necessarily mean that the taxpayer is involved in e-business. A business may have a web site that is purely for advertising purposes with nothing sold online.  For example, a national restaurant chain might have a web site that contains their menu and a listing of their locations.   Do you conduct business transactions over the Internet? (Accept orders and/or payments over the Internet?) (What types of records are maintained for these transactions?  All electronic?  Paper documents?) Explanation – The examiner will need to determine the nature of business transacted as well as the volume and types of records maintained for examination.   What products, services or memberships may be purchased on your web site or through the use of email? Explanation - The interview process often provides leads that are very valuable to checking and verifying reported income later when you are examining the actual books and records. For example the taxpayer may describe a list of products a, b, c, d & e. Yet when you are looking through inventory records you may only see a, b, & c on hand. Maybe you are auditing the 2003 tax year and the taxpayer did not start selling d & e until 2004, or maybe they omitted the sales of these particular items from their tax return.   When was the web site "opened" for business? Did the business exist prior to creation of the web site?  Is the business conducted over the Internet separate or distinct from the taxpayer's historic line of business? Explanation – How you audit a business depends in significant part on what was the driving force behind the expansion of the business. Is the Internet-based business an extension of an existing business or does it represent a completely new endeavor?  An important first step in this regard is to establish the date that the web site became operational.  The date the taxpayer obtained their domain name may coincide with the date the web site opened for business.  Invoices from paid consultants or purchases of software, and service dates on bills from the taxpayer’s Internet Service Provider (ISP) are all indicators as to when a web site became operational or there was a significant upgrade in the capabilities of the web site to offer interactive business services.   What domain names have been registered either by you or on your behalf? What domain names do you have control over?  Please include the date of registration and the name of the registrant. Explanation - The domain name is the web site address used to find the site on the Internet.  As a revenue agent, you already know the importance of conducting a tour of a business.  If you were auditing the XYZ chain of bookstores, you would look to see the addresses of the separate bookstores, how many cash registers each had, etc.   Each web site is just like a separate bookstore in the physical world with a separate cash register.  In the world of electronic business, each domain name gives the taxpayer a storefront with its own unique cash register.  Identifying the number of web sites a taxpayer has is no different than trying to identify all the possible business sites or cash generators on your tour of a more earthbound business. Domain name information can be obtained from InterNic. InterNic is the directory service under contract with U.S. Government to register and track domain names. InterNic’s registry includes the name, address and phone for the registrant, the billing and technical contact points, the host site name and its Internet Protocol (IP) address.   Domain names may be acquired from domain name brokers.  Third party domain name brokers gang register domain names with InterNic for a nominal fee on the speculation that the name may appreciate in value.  The resale value may exceed several hundred or even several thousand dollars.   These names are tentatively believed to be capital in nature with the cost being amortizable.   How is the fee for Internet connection services determined? Explanation - The stock reply from the taxpayer is "From the bill." However, the answer we are looking for is not so obvious.  The fee charged by the ISP might be either connection or volume based. A connection-based fee is based on the simple fact that the taxpayer is paying for basic point of presence (POP) on the Internet.  A volume-based fee is based upon what is known as bandwidth and storage volume. You can have either or both together. Bandwidth refers to the ability of a site to handle access volume.  For example a million simultaneous hits might be more then most servers could sustain without crashing. As access to a site grows, the host must expand its ability to service multiple users.  This is accomplished by expanding bandwidth.  Therefore, a large bandwidth implies a high volume web site. Storage volume is associated with the sophistication of the web site.  The web site is resident on the host company’s computer as a sub directory.  The sub directory consists of separate text, graphic, video, and sound files.  The larger and more graphics-heavy the web site, the more storage space is required when someone accesses the web site. In addition to bandwidth and storage, volume-based billing may also include charges for other ancillary services.  These may involve special routines such computer graphics interchange (CGI) routines, Perl Scripts and server side applications.  The billing for these extras is not necessarily volume based, but is generally associated with high volume sites. In summary, the higher cost of a relatively more sophisticated web site implies a higher