Focus on corporate governance to keep the IRS away

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by Brian C. Bernhardt

During the last 12 months, the IRS has decided to get into the corporate governance business because it believes that a well-governed business is a tax-compliant business. As a result, the IRS is often asking questions that are less tax-related and more business orientated. And although the IRS has limited its corporate governance review to nonprofits and charities so far, business owners should not ignore their own governance policies. Some of the areas to examine include:

Governing documents.  When was the last time you reviewed your articles of incorporation or organization, bylaws, operating agreement, or partnership agreement?  Do they accurately describe your business purpose and reflect how you operate your business? Businesses should review or, better yet, have an outside third-party review, their organizational documents at least once every five years.  This review will help ensure that the documents continue to meet the needs of the business and comply with current laws.

Draft a code of ethics.  What happens if one of your employees does something that you consider morally wrong, even if it does not violate the law? Can you fire the employee? Or are you stuck until the conduct becomes a pattern? A code of ethics requires a company’s employees to abide by stated ethical standards and enables these ethical requirements to permeate the business. By making compliance with a code of ethics a job requirement, businesses can make sure employees follow the law, as well as a higher ethical standard. 

Draft a whistleblower policy.  What happens if an employee wants to report a supervisor’s misconduct but fears retaliation? A whistleblower policy enables employees to address complaints, unethical conduct, suspected financial improprieties, misuse of business resources, and report potential violations of law.  Properly drafted, it will prohibit retaliation, demotion, or other adverse action against a reporting employee. To accomplish these goals, however, the policy needs to maintain the confidentiality of the reporting employee. Businesses often include a whistleblower policy within their code of ethics.

Create a document retention policy. How long do you keep old records? Do you know why you are keeping those records, or why you are not keeping them? What are you doing with electronic documents, such as emails? A written document retention policy will establish standards for document integrity, retention and destruction, while also addressing electronic files, backup procedures and archiving. This type of policy will not only protect business records for the appropriate period of time, but will also prevent a business from keeping documents longer than necessary, both of which could cause problems. 

The policy should specify the length of time specific types of documents must be retained; when it is permissible or required to destroy specific types of documents; and procedures for both paper and electronic records (such as emails).  The policy should be circulated to all employees on regular basis, and someone in the business should be charged with overseeing its implementation and ensuring it is followed. It does bear mentioning — no matter what the document retention policy provides, in order to avoid charges of criminal obstruction, all document destruction should be halted immediately upon notification of a pending or ongoing investigation by a law enforcement agency.

Note on code of ethics, whistleblower policy, and document retention policy.  Keep in mind that a code of ethics, a whistleblower policy and a document retention policy are only as good as their creation. Businesses should involve their employees in developing, drafting, adopting and implementing the code of ethics to ensure buy-in from all interested parties. Similarly, businesses should make sure the whistleblower policy and document retention policy meet their stated goals.

At the same time, these documents are only as good as their enforcement.  Ignoring them or applying them haphazardly will set the business up for disputes, and possible litigation, by disgruntled current and former employees.  And of course, unless businesses provide training to employees regarding the employees’ obligations under these policies, the policies are doomed to gather dust.

Financial examinations.  Does your business have a budget? Does it have financial statements audited each year? Can you easily access your cash-flow information? Setting an annual budget may be time-consuming, especially when unexpected events cause the budget to fly out the window. But taking the time to create the budget will force the business to take a close look at its revenue, expenses and cash-flow, rather than flying by the seat of its pants. In addition, having an independent auditor conduct an annual audit in accordance with generally accepted accounting principles will help the business better understand where its revenues are coming from and where its expenses are going, find problem areas and better budget in future years. 

Moreover, creating an audit committee separate from the business owners and directors to review the audit will help ensure negative financial implications are not swept under the rug.  Lastly, although using the same auditors every year enables them to more easily and better understand the business, it also leads to complacency. Consider changing auditors, or at least the lead auditor, every three to five years.

In conclusion.  Although it is not necessarily true that a well-governed business is a tax-compliant business, it is often true that a poorly governed business — one that does not keep track of its goals, does not operate using best practices, and fails to set and keep financial management goals — is often a tax problem waiting to happen. And while the list of issues described above is not an exclusive list of potential problems, it does focus on some of the more common areas businesses frequently ignore in their day-to-day operations. Addressing these long-term issues will help short-term business operations and help keep the IRS away.

Brian Bernhardt is a partner in the Richmond office of McGuireWoods LLP. He practices in the areas of Federal tax controversies, Federal tax litigation, and nonprofit and tax-exempt organizations, focusing on their administrative relationships with the Internal Revenue Service.

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