Tax Audits of Cash Intensive Businesses
Cash intensive businesses are a prime target for tax examinations because they receive a significant amount of receipts in cash, which are more difficult to trace. Cash intensive businesses include restaurants, grocery stores, and gas stations. They also include businesses like construction and trucking companies that tend to pay independent contractors in cash. Due to the elusive nature of cash, the IRS has prepared an Audit Technique Guide (ATG) that explains to IRS examiners how to audit a cash intensive business.Minimum Income Probes
According to the ATG, unreported income is one of the main issues the IRS has identified when auditing cash intensive businesses. Therefore, the ATG instructs auditors to conduct minimum income probes to determine whether a taxpayer accurately reported income. Minimum income probes include the following:
- An analysis of the financial status of a taxpayer to determine whether the reported income is sufficient to support the taxpayer’s lifestyle. If an expense is not disclosed on a tax return, the IRS uses Bureau of Labor Statistics information to estimate personal living expenses.
- An interview of the taxpayer. The ATG explains interviews are very important especially when auditing cash intensive businesses due to the lack of tangible records.
- A tour of the business to observe how the business operates and the type of payments received. The ATG informs IRS auditors that some owners of cash intensive businesses will reduce prices when they learn their business will be audited. Therefore, the IRS examiner may record the prices of some items during the tour.
- An evaluation of the taxpayer’s policies and procedures for gathering and maintaining accurate financial information.
- A reconciliation of income to books and records by duplicating the taxpayer’s steps for calculating income.
- An analysis of the taxpayer’s business and personal bank accounts, including investment accounts.
- A horizontal business ratio analysis which identifies changes in items such as sales, cost of goods sold, expenses, and net income over time. The IRS considers a difference of 5% or more to be significant enough to merit further inquiry.
- A vertical business ratio analysis that identifies differences between a taxpayer’s business and the industry standards for a particular year. The IRS uses this comparison to determine whether the taxpayer’s reported gross receipts and net profit are reasonable according to the IRS’ information on the industry.
The ATG emphasizes to IRS examiners the importance of interviewing the taxpayer. It explains that the taxpayer’s oral testimony may be the only evidence provided because cash intensive businesses tend to have few physical records. IRS auditors are informed that the interviews should be as thorough as possible and may take at least two hours. Taxpayers generally must be present during the interview and tour of the business. However, taxpayers who do not want to speak with an IRS examiner may appoint qualified representatives like the tax attorneys at the Ben-Cohen Law Firm to handle every aspect of the tax audit.
Taxpayers should be aware that the IRS has the authority to issue summons to third-parties, like banks and accountants, who may have records that are relevant to the audit. The IRS also has access to information held by other government agencies. Such sources may help an IRS auditor corroborate or refute information gathered from a taxpayer or a taxpayer’s representative. For example, if a taxpayer claims over $10,000 of cash is not income but a gift or loan from a relative overseas, the IRS agent may corroborate this information by searching through the government’s database for a FinCEN Form 105. FinCEN Form 105 must be filed by anyone who transports monetary instruments of more than $10,000 in or out of the U.S. Failure to file a FinCEN Form 105 may result in a fine of up to $500,000 and/or imprisonment of not more than ten years. In addition, any money that should have been reported on FinCEN Form 105 may be seized by the government. Therefore, taxpayers may want to consider retaining a tax attorney or CPA who knows how one piece of information is connected to another, and to manage the flow of information provided to the IRS.
As most IRS examiners may be unaware of how a certain business operates, the ATG provides additional information on the following relatively prevalent cash intensive businesses and common audit issues related to each:
- Bail Bonds: The ATG explains that IRS auditors should examine build up fund accounts for unreported income, premium income, reimbursed expenses, double deductions due to payments made from build up fund accounts, and deducted bond costs that should have been slowly amortized over time.
- Beauty Shops: IRS agents are instructed to check income earned from services, sale of products, and station rental income from stylists who are independent contractors.
- Car Wash: As cash intensive businesses tend to have few financial records, IRS agents must rely on indirect methods to test income. One of the indirect methods used by IRS agents is analyzing expenses to reconstruct potential income. With respect to a car wash business, an IRS auditor may measure the amount of water, soap, and chemicals used to determine how many cars were washed.
- Convenience Stores, Mini-Marts and Bodegas: The ATG directs IRS examiners to review money orders and money transfer systems like Western Union as some unrecorded cash may be used to purchase money orders. IRS examiners are also instructed to check for self-consumed items as they are often unreported in the books.
- Laundromats: If a laundromat has no books and records, the ATG directs IRS auditors to reconstruct income by measuring the water, electricity, and gas consumption of the business.
- Scrap Metal: According to the ATG, two of the main issues in the scrap metal industry is unreported income and substantiation of purchases. Taxpayers should be aware that the adequacy of their documents substantiating their purchases is incredibly important. In Bobry v. Commissioner, T.C. Memo. 1997-27, the taxpayer provided receipts showing unit cost, total cost, metal type, and weight of scrap metal received as substantiation for cash purchases. The IRS still disallowed 83% of these cash purchases because the taxpayer did not provide the identities of who the taxpayer purchased the metal from. The Tax Court disagreed with disallowing 83%, but still denied 5% of taxpayer’s cash purchases deductions for inadequate substantiation. In addition, the taxpayer was subject to a 20% accuracy-related penalty for any underpayments that resulted from the disallowance.
- Taxicabs: The IRS developed a formula called the taxi/cab formula to reconstruct gross receipts of taxicab drivers. The cab formula involves the following steps:
- First, calculate the total amount a taxicab driver earns for entry by multiplying the average number of customers per day by the number of days per year the driver works and by the driver’s entry rate. This is the driver’s total earned entry amount.
- Second, divide total fuel expense by the average cost per gallon to obtain the number of gallons used.
- Third, multiply the number of gallons used by the vehicle miles per gallon to calculate the total miles driven. Subtract non-business miles from this total to obtain the total business miles driven.
- Fourth, multiply the total business miles driven by the rate the driver charges per mile.
- Fifth, add to the total from step four the total earned entry amount (from step one), tips and lease income, and any other income like wait time to calculate the total gross receipts.
IRS audits of cash intensive businesses can be burdensome, and subject taxpayers to severe civil and criminal penalties. Pedram Ben-Cohen, Esq., CPA knows how to defend against the IRS’ audit tactics as he has represented taxpayers against government taxing authorities for over 20 years. He is also a Taxation Law Specialist certified by the State Bar of California. Contact us now to schedule an appointment with Mr. Ben-Cohen.