Page 16
— Retail Properties Quarterly — November 2015
I
n the rapidly changing retail
world, executives have a lot
to think about – the impact of
multichannel sales, shrink-
ing profit margins as a result
of real estate and labor expenses,
increasingly intense competition,
and constantly shifting consumer
preferences and loyalty. Adding an
audit to the list of concerns means
something else undoubtedly will
suffer. The good news is that with
careful consideration and prepara-
tion, retailers often can avoid audits
or, at least, survive them.
What triggers an audit?
Several
things may prompt taxing authori-
ties to select a particular business
for an audit. First is some sort of
statistical prompt. At the federal
level, the U.S. Internal Revenue Ser-
vice has its infamous statistical pro-
gram: the computerized “discrimi-
nant function” technique. Using DIF
scores, the IRS ranks and selects
returns having the greatest audit-
problem potential. With the IRS
approach as a guide, many states
and cities have fashioned their own
models.
Another example of statistical
modeling is trend analysis. By aggre-
gating returns by industry, state
revenue departments often can use
trend analysis to spot specific tax-
payer anomalies and assign audits
accordingly. The technique particu-
larly is helpful in cash-intensive
businesses, such as convenience,
discount or specialty retailers where
trend analysis can highlight irregu-
lar relationships between sales,
inventory and cost of goods sold.
Audits also may be prompted
by routine information exchanges
between govern-
ment entities.
Departments of
labor exchange
wage and unem-
ployment informa-
tion and secretar-
ies of state provide
data on bankruptcy
filings. Counties
and cities may
share information
on the issuance of
building permits.
In any event, fol-
lowing the com-
mon sense rules of filing returns
accurately and promptly remains
the best strategy to prevent an audit.
Prevention planning must begin
long before a business is selected for
audit with accurate and complete
recordkeeping, good internal control,
and a competent and knowledge-
able accounting staff.
What to do when the auditor shows
up?
First, control the flow of infor-
mation. Auditors can look at just
about anything they please. But the
fact of the matter is that auditors
always ask for more than they want
or ever intend to examine. So help
them out by giving them limits.
An initial meeting with an auditor
should include a discussion regard-
ing the scope and depth of the audit.
Retailers should create a “docu-
ment request” form to track what
is requested and provided at what
time. With such a form, businesses
can keep track of exactly what the
auditor has and has not seen. This
may help to understand a position
the auditor is taking. In addition, it
may keep the auditor from request-
ing additional
documentation for
items that already
were substantially
supported.
Second, put lim-
its on time and dis-
tance and, if appli-
cable, audit sample
size. Auditors
should commit to
a timeframe for
the examination.
Many auditors will
respect the season-
ality of the retail
business and may work around end-
of-year sales. Also, consider “isolat-
ing” the auditors. That is, do not
invite them to work at a desk next
to the company’s accounts-payable
clerk, one of the audit contacts or
the company president.
Third, be professional. In dealing
with auditors, some interpersonal
relationship rules should apply:
• Be friendly, but do not be a
friend.
• Do not be an enemy; hostility
does not pay.
• Be cooperative without being a
pushover. At the least, be noncon-
frontational. Inevitably, you and the
auditor will disagree. Thus, starting
with a professional demeanor is
always a good strategy.
• Limit comments about fiscal
reform, politics, the chances of a
flat tax or what you would do if
you were in charge of the world. An
auditor who has been around for a
while has heard it all and isn’t inter-
ested.
What do we do when the auditor
leaves?
Generally, the auditor will
plan a closing conference. If not,
retailers should request one. In pre-
paring for the closing conference,
follow these four steps.
First, review the assessments and
the underlying work papers. Check
for math or formula errors in the
worksheets. Auditors tend to reuse
their audit work paper templates so
errors can creep in. Whenever pos-
sible, try to make adjustments at the
audit level.
Second, identify and review with
the auditor the problem areas, and
make sure that the positions taken
by the auditor and the reasons for
those positions are clear. Ask for
explanations of the adjustments
and substantiation for the positions
taken, including relevant statutes,
regulations, policy positions, case
law, etc.
Third, discuss the billing process,
protest procedures and interest
rates, and be sure they are under-
stood. If you are contemplating an
appeal, this is where the process
really starts. Procedural matters now
become critical. Do not rely on the
auditor or anyone else to get it right.
Rather, get written copies of the var-
ious due dates, appeal procedures,
etc., directly from the statutes and
regulations.
And fourth, do not miss deadlines.
Finally, keep things in perspective
and move on. If an audit occurs,
work hard to get it dealt with as
quickly as possible. The challeng-
ing nature of the retail industry
requires constant attention and
strategic decision-making. Getting
distracted by a prolonged audit can
be deadly.
s
A
ll parties involved face
the standard hurdles in a
contract process, which
many approach with
trepidation from the start.
However, retail purchase
transactions with environmental
issues present all parties with new
complications. As brokers, we’re not
experts in liability, costs or risks.
However, with the right knowledge,
persistence and assistance from
a reputable remediation expert,
there’s hope to navigate the “dirty
deal” to the closing table.
In the Denver metropolitan area,
common contamination discover-
ies are asbestos, subsurface indus-
trial solvents and gasoline, and
dry cleaner solvents – commonly
tetrachloroethene, or “perc,” used in
the cleaning process and disposed
of irresponsibly. Although these
are most common, the spectrum of
potential contamination issues are
overwhelming, both above ground
and subsurface, rare and exotic.
It is becoming a rarity to close a
deal without some investigation
into possible contamination and its
full effect on the property. The first
step is to research past uses and
recorded instances of contamina-
tion on or surrounding the property.
This can cost $1,000 on the low side
and reach upward of $50,000 for
more complex properties.
If there are existing or discovered
concerns, it is customary to follow
with a second step. Fortunately,
there often is an automatic exten-
sion for this incorporated in the
contract and it
is negotiated up
front. Phase two
usually involves
soil and ground-
water testing, air
sampling or sam-
pling of building
materials existing
on the property.
This process can
take more than 30
days and incurs
a significant cost
ranging from a
few thousand dollars to well over
$100,000.
There are no standards on how to
proceed with a required phase two.
Its cost is never good news for the
deal and frequently is a deal killer.
However, while the actual remedia-
tion can take years, this is not nec-
essarily the time to give up. Often
there are options available to those
patient and committed to keeping
their deal alive.
If a buyer moves forward follow-
ing the discovery of environmental
contamination, the first step to is to
look at whether the subject proper-
ty or another nearby parcel was the
responsible party. If it is determined
to be the result of the subject prop-
erty, the next step is to look at costs
and the time involved in getting a
no further action letter. The source
of contamination will affect this
process drastically as many subsur-
face issues have access to a state-
run superfund for the management
of the remediation process and
costs if the responsible party cannot
be found or does not have the funds
or insurance. However, when deal-
ing with other contaminants such
as perc from dry cleaners, there are
fewer options because the operators
responsible for the contamination
seldom have the funds to cover the
remediation and it rarely is covered
by insurance.
If the buyer decides to move for-
ward, a suitable lender needs to be
matched with him. There are some
conventional banks that will lend
on these properties, but they are
few and far between; if the bank
does not sell off its loan portfolios,
there may be a chance it is willing
to accept the risk internally. The
best bet is to focus on smaller, local
banks or credit unions because the
type of banks big enough to get a
bailout is not going to bailout your
deal. However, most buyers and
sellers are forced to look for pri-
vate lending in which unfavorable
terms can be expected. To overcome
the drastic change in interest rates
and cleanup costs the seller should
expect a significant price reduction.
From a listing broker’s perspec-
tive, whether contamination was a
known complication at the time a
property was listed or discovered
after, there is hope to get to the
closing table. Marketing the prop-
erty with the right terms and to
the correct buyer pool is essential.
While the buyer pool is reduced
drastically, with a patient seller that
is clearly coached in what to expect,
most of these dirty deals can close
in a decent market. The key is to
research lending options prior to
receiving offers and coaching the
seller in what to expect in capi-
talization rates for contaminated
investment properties. In my expe-
rience with contaminated invest-
ment properties, these CAP rates
usually are 0.5 to 2 percent higher
for comparable clean properties, but
every deal will be evaluated differ-
ently, of course.
Fortunately, there are local com-
panies and buyers who focus on
buying contaminated properties,
although a larger discount than
most other options can be expected
because their profit is in the sale
of the clean property following the
risky cleanup investment that can
be higher than originally antici-
pated. When listing a contaminated
property the best-case scenario is to
find a long-hold focused buyer who
is willing to accept the risks and the
value-add cleanup process without
a lender, whether that be cash or a
1031 tax exchange transaction.
The fact of the matter is with risk-
adverse lending requirements on
investment and user-owner loans,
we cannot ignore and must plan
ahead for these potential issues
in all deals. Buyers, sellers and
brokers have options, but getting
to the closing table is increasingly
difficult, but not impossible, when
they are discovered. As Benjamin
Franklin once said, “Energy and per-
sistence conquer all things.”
s
Bruce Nelson,
CPA
Tax director,
EKS&H, Fort
Collins
Gannon Roth
Senior broker,
Unique Properties
Inc., Denver
RJ McArthur,
CPA
Tax partner,
EKS&H, Denver
Investor Insight
