How The IRS Audits a Cash Business

October 7, 2010
Written by: steve

No matter what type of business you may have, the IRS knows all the tricks. Chances are, you are not going to fool the IRS. If you have a cash business and you are under audit or have a fear that the IRS is going to audit your business, you may want to call Fresh Start Tax at 1-866-700-1040. We are former IRS Agents who use to audit cash businesses. Call us today should this become problematic for you.
The IRS Cash Audit Techniques Guide. These are the methods the IRS Agent will use during the tax audit:
1.Examination Techniques for a Cash Business
2. Purchases can Reveal Sales
3. Sources
4. Hidden Family and Employee Transactions
5. Check Cashing Services
6. Indirect Methods
7. Percentage Markup Method (and Unit Volume Method)
8.  Fully Developed Cash T-Account Method
9.  Source and Applications of Funds Method
10. Bank Deposit and Cash Expenditures Method
11. Net Worth Method
12. Key Points to Audit of Books and Records
Since many businesses in this industry are cash oriented, have weak internal controls, lack an audit trail, and have inadequate books and records, the  IRS examiner’s audit will focus on probing for unreported income.
It is the responsibility of the business owner to maintain the documents needed to verify their reported income. When the source documents are available, there will be more than one way to test income and other transactions, because different documents will have the same information (a bill of lading and a sales invoice, for example) to check for consistency. When the source documents are not available the examiner must look for ways to discover if all income is reported.
The most likely method for a cash intensive business that does not report their full income is to skim cash prior to its entry in the accounting system. This can be done by failing to deposit all of the funds, by failing to use a cash register to record sales or by failing to report an income stream. The result is that the books will reconcile to the return and the bank deposits, but income will be missing. Skimming can be discovered through excess expenditures or when markup percentages are corrected.
Someone with access to incoming checks can remove a check before it is recorded. Later the check can be added to a cash register in exchange for cash in the same amount. If a check for $500 is taken from the mail, it can later be substituted into the cash register for $500 in cash. This way the total receipts will match the amount deposited. However, when the examiner checks the amount of cash received and the cash deposited, a discrepancy will be evident. The examiner should follow up with the person who worked the register and ask about the check included in that drawer. If necessary, follow up with the payer and find out how it was delivered to the business.
Purchases can Reveal Sales
A quick first step is to look for a purchase that will reveal sales. For example, when a smog certificate is required on each vehicle sold, the number of smog certificates purchased will equal the number of vehicles sold. Once the examiner knows the correct number of items sold, either the taxpayer can produce the missing data or sales can be determined by multiplying the number by the average of the reported sales.
When workers wear uniforms the uniform service invoices can be inspected. They usually list the number of pants and shirts laundered and include the worker’s name embroidered on the shirt. Compare the names on the uniform invoices to the names on the W-2’s to determine if there are more people wearing uniforms than working. (Also, anyone who has ever worn a uniform for work knows the employer doesn’t pay for that- so be sure to check payroll deductions for the amount paid by the employee.)
When a vehicle is towed to a repair shop, the shop initially pays the tow truck, and then passes the cost on to the customer. Use the tow receipts as a sample to ensure each vehicle’s repairs are reported on a sales invoice. If necessary the examiner can locate the customers and contact them to provide their work invoices that were never reported in the shop’s sales.
Another avenue to pursue when the taxpayer does not produce contracts, but it is unlikely the particular industry would do business without them, is to summons the deposit slips, deposit sources and canceled checks to reveal customers and suppliers. The suppliers, identified through the taxpayer’s canceled checks, can be contacted to obtain their invoices. In the building industry, the invoices will reveal the delivery addresses and can identify specific homes that were built.
There are times when it is easier to find unreported income. Following are a few examples:
Selling the business – When a business is being offered for sale the new owner and possibly a lender will be looking at the financial records. It is in the taxpayer’s interest to give these sources the correct business information, first because the healthier the business the better price it will garner, but also because the potential buyer may be in the same business and will recognize problematic records. They may think if the records are shoddy, what else is wrong. If the examiner learns of purchase negotiations, it would be helpful to speak with the potential buyer. If there have been potential buyers in the past it would be helpful to interview them.
Getting a loan – When a business is looking for funding or to expand, they will need to supply the lender with healthy financial statements. Similarly, if the sole proprietor, majority shareholder or partner is seeking personal loans, banks will want to see the business financials. These financial statements are usually accurate. When an application is made for a loan, the taxpayer is required to list income and expenses, and attests the information is true by signing and dating the application. Loans funded and loans applied for can be summonsed.
Divorce – A disadvantaged spouse can attest to the amount of money flowing into the household by verifying what was spent. The spouse may also have knowledge of hidden assets or unidentified sources of income, such as sideline sales or another cash business.
Former Employees – especially mistreated employees can discuss business practices they have observed over time. They can say who handled cash and what procedures were overridden. Employees may also be able to prove they were paid in cash to avoid payroll taxes.
Hidden Family and Employee Transactions
When employees or workers in the business are extended family members or fellow immigrants, there can be diverted profits in the form of unreported benefits. A convenience store owner, who pays very little to employees, may also allow the worker to remove inventory for personal use. The examiner should be alert to store owners offering workers:
* free or low rent in their residential rental properties
* payment of personal expenses
* removal of inventory for personal use
When a cash intensive business makes payments in cash and there is no information reporting made or it is not required to be made
Check Cashing Services
A check cashing service may refer to a large or small company that will cash personal or payroll checks for a fee. The check cashing service earns its income by charging a percentage of the amount of the check.
Some convenience stores will offer this service, typically charging a 3-5% fee. For example, cashing a $1,000 payroll check at a local convenience store may cost between $30-$50.
As with a bank, the check cashier will require identification, and may not accept certain types of checks, based on their experience. A business that has been in operation for several years will not usually have losses from check cashing. Whenever losses or bad debts are claimed, the examiner must determine that sufficient efforts were made by the business. Contact should be made with the customer to ensure the funds were not repaid to the business in cash and the collection was not recorded.
Other methods have been successfully applied in the following cases:
* Gas retailers (fuel volume from the wholesaler times average price equals gross receipts);
* Drinking establishments (liquor purchases divided by average drinks per bottle times average price per drink with allowance for spillage);
* Package liquor store (purchase of liquor times average markup); and,
* Coin laundries (water consumed divided by average water consumed times price per load equals gross receipts).
Business mark-up standards can be obtained from sources such as:
* Robert Morris & Associates (RMA)
* Bureau of Labor Statistics
* Association and Industry Publications and Websites
* Practitioners Publishing Company (PPC) manuals and other similar industry guides
Percentage CompuFor, a bank deposits analysis, the revenue agent will be able to demonstrate that:
* Every bank statement, deposit slip, and canceled check has been reviewed
* All deposits made into all of the taxpayers’ accounts have been totaled
* All possible transfers of funds between accounts have been searched for and credited to the taxpayer. When a revenue agent only obtains a one-month sample of deposited items, which casts doubt on the effectiveness of the Service’s independent review to ascertain if there were any transfers between accounts. All nontaxable sources of income have been eliminated.
Net Worth Method
The net worth method is founded on the basic accounting theory of the Balance Sheet:
Assets less Liabilities = Net Worth
* Include all assets and liabilities, business and personal.
* The increase in Net Worth is the difference between beginning net worth and net worth at the end of the period.
* Add: Non-deductible expenditures (checks and cash).
* Subtract: Nontaxable income.
* Equals: adjusted gross income (taxable income for Forms 1120 and 1065).
This method is best used when income records appear to be false, incomplete, or missing, and there are substantial assets.
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