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How to Survive an Audit as a Cash-Intensive Business

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How to Survive an Audit as a Cash-Intensive Business

 

It should come as no surprise that the accurate reporting of income and expenses by cash-intensive businesses is among the areas that have gotten extremely keen attention from the IRS and the California taxing authorities. It would be fair to say that the attention is well deserved because the General Accounting Office (GAO) estimates that the individual income tax “gap” lies in the hundreds of billions of dollars! Consequently, the IRS has developed an Audit Techniques Guide (ATG) to provide guidance to its agents on how to examine income in a cash-intensive business. While the ATG is not an official pronouncement of the law or IRS’s position and cannot be used, cited, or relied upon as such, it does provide valuable information on how the IRS audits cash-intensive businesses, including specific types of cash businesses.

A cash-intensive business is one that receives a significant amount of receipts in cash. This can be a business such as a restaurant, grocery, or convenience store, that handles a high volume of small-dollar transactions. It can also be an industry that provides cash payments for services, such as construction or trucking, where independent contract workers are commonly paid in cash, albeit this is very inadvisable as it can be construed as aiding and abetting income tax evasion if you do not include the cash wages on a W2 or 1099.

How IRS and the California Taxing Authorities Audit Cash-Intensive Businesses?

The IRS and the California taxing authorities, such as the Franchise Tax Board (FTB), the California Department of Tax and Fee Administration (CDTFA), and the Employment Development Department (EDD), are aware that the staggering individual income tax “gap” results from increasing underreporting of income by those taxpayers with the ability to determine their own reported income, such as businesses that receive most of their income in cash. Cash transactions are anonymous, leaving no trail to connect the purchaser to the seller, which leads taxpayers to mistakenly believe that cash receipts can be unreported and escape detection.

Cash businesses, such as restaurants, flea market vendors, beauty salons, etc., are more likely to be audited and face a particular problem when audited because it is difficult to verify income received in cash. There are three main ways to misappropriate cash from a business:

  • It can be skimmed from receipts before they are recorded;
  • It can be stolen after it has been recorded; and
  • A fraudulent cash disbursement can be created to a fictitious payee.

One of the most significant indicators that can alert the IRS, FTB, CDFTA, or EDD that income has been purposefully & willfully underreported is a consistent pattern of losses or low-profit percentages that seem insufficient to sustain the business or its owners over time. Other indicators of fraudulently unreported income include:

  • A lifestyle or cost of living that can’t be supported by the income reported.
  • A business that continues to operate despite losses year after year, with no apparent solution to correct the situation;
  • Application of the Cash Transaction examination method (Cash T) shows a deficit of funds;
  • Bank balances, debit card balances, and liquid investments increase annually despite reporting of low net profits or losses;
  • Accumulated assets increase even though the reported net profits are low or there’s a loss;
  • Debt balances decrease, remain relatively low, or don’t increase, but low profits or losses are reported;
  • A significant difference exists between the taxpayer’s gross profit margin and that of his industry; and
  • Unusually low annual sales for the type of business.
  • Use of a Zapper program is detected by a state or federal taxing authority.

Examination Techniques

From our decades of experience, we know that the examining agents are instructed to tailor their techniques to provide for the most accurate analysis of a specific taxpayer’s possible income stream. There are several techniques employed by state and Federal taxing authorities that are used when auditing cash-intensive businesses.

For example, first, a financial status analysis, including both business and personal financial activities, is done. This is a required minimum income probe. If it shows an imbalance in the cash flows indicative of underreported income, an examiner will ordinarily request clarification or explanation from you or your representative before beginning the use of an indirect method.

Indirect methods, such as a fully developed Cash T, percentage mark-up, source and application of funds, or bank deposit and cash expenditures analysis, can then be used to confirm the amount of any understatement. Please be aware that the authorities have instructed their examiners that the most critical aspects of successfully examining cash-intensive businesses are the examiner’s ability and skill in gathering information about how the taxpayer conducts business, documenting cash inflows and outflows, and conducting a detailed interview with the owner of the business relating to business and non-business cash receipts and cash expenditures. You can thus expect that your examiner will be very skillful and aware of all the tricks of the trade.

The IRS and California taxing authorities have repeatedly emphasized to their examiners the importance of interviewing the taxpayer thoroughly. The examiners know that taxpayers’ oral testimony may be the only evidence they will have 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.

If you know you cheated on your tax returns, you would be well served to hire a dual licensed Tax Defence Attorney and CPA to guide you through the process. During eggshell audits, the agents are looking for the possibility that you, as the subject of a civil audit, will, under pressure, crack under the pressure and inadvertently provide incriminating information, or worse yet, apologize and admit to the wrongdoing, that eventually leading to a referral for criminal tax investigation. As your dual licensed Tax Defense Attorneys & CPAs, our goal when advising you through an eggshell audit is the resolution of the audit without a referral by the civil examiner to the California or IRS’s criminal investigation divisions (CID).

If you are a cash-intensive business and find yourself in the unfortunate situation of receiving a federal or California audit or criminal tax investigation notice, and know for a fact that you cheated on the returns under audit, do not contact the original preparer under any circumstances. You are going to be bitterly disappointed if you think they are going to stand up in your defence and take one on the chin. On the contrary, they are likely to become government witness number one against you if the government even hints at seeking criminal tax charges fearing that they could be viewed as having aided and abetted your tax evasion. Additionally, the CPA’s duty of confidentiality goes out the window where criminal tax charges are at issue.

At the Tax Law Office of David W. Klasing, we are California Tax Attorneys & CPAs with a long record of successfully representing cash-intensive businesses in California and Federal civil audits and criminal tax investigationsAppeals & Litigation before the IRS, FTB, and Office of Tax Appeals (OTA). Equipped with nearly 30 years of business bookkeeping and accounting experience, including more than two decades of public accounting auditing experience, our David Klasing and his staff of California Tax Lawyers & CPAs can protect and advise your small or large business on all of the issues impacting your profits.

How Are Different Industries Scrutinized?

The IRS has specific audit techniques for all kinds of cash intensive industries, such as bail bond agents, beauty salons, car washes, coin-operated amusements, convenience stores, mini-marts, bodegas, and laundromats. We lay out some of the key ones below:

  • Bail Bonds: The auditors will 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: The agents will check income earned from services, sale of products, and station rental income from stylists who are independent contractors.
  • Car Wash: One of the indirect methods used by the agents to test income is analyzing expenses to reconstruct potential income. With respect to a car wash business, an 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 examiner will review money orders and money transfer systems like Western Union as some unrecorded cash may be used to purchase money orders. The examiner may also check for self-consumed items as they are often unreported in the books.
  • Laundromats: If a laundromat has no books and records, the auditors will reconstruct income by measuring the water, electricity, and gas consumption of the business.
  • Scrap Metal: Taxpayers should be aware that the agents will check the adequacy of their documents, substantiating their purchases. Taxpayers should keep proper receipts showing unit cost, total cost, metal type, and weight of scrap metal received as substantiation for cash purchases.
  • Taxicabs: The IRS has developed a formula called the taxi/cab formula to reconstruct gross receipts of taxicab drivers. The agents will 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 will be the driver’s total earned entry amount. Using the number of gallons used and the total business miles driven, the agents will figure out the rate the driver charges per mile. They will multiply the total business miles driven by the rate the driver charges per mile. To this total, they will add the total earned entry amount, tips and lease income, and any other income like wait time to calculate the total gross receipts.

No matter which industry you belong to, we have devised a fool-proof method of representing our clients as they undergo eggshell audits of cash intensive businesses. We are always on the lookout for signals to evaluate whether a civil investigation has turned criminal. In unfortunate circumstances in which a criminal investigation has already started, our goal is to lessen the possibility of referral for criminal tax prosecution, which is called a declination. It is important to note that once the criminal investigation division of the IRS complete an investigation, they have over a 90% historical conviction rate. That being said, we have achieved declinations in the past.

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Why Do You Need the Help of our Dual Licensed Criminal Tax Attorneys and CPAs?

The IRS has long proven itself extremely capable of investigating both civil tax fraud and criminal tax fraud. The investigation of tax fraud is one of the most important phases in the administration and enforcement of tax laws. Given that cash-intensive businesses are considered to contribute significantly to the tax gap, the taxing authorities have significantly increased their enforcement activities toward cash-intensive businesses in an effort to reduce it.

Increased information reporting to the IRS and the IRS’ expedited reporting with state and foreign governments will have a significant impact on the tax gap. As a result of their matching programs, the authorities can now better identify cash-intensive businesses that have underreported or not reported income or have otherwise failed to file income, sales, or employment tax returns. With Congress now involved, hunting for under-reporters and non-filers will likely become the trophy sport for the IRS. The criminal functions of the CDTFA, FTB and EDD are not to be dismissed lightly either.

High audit potential taxpayers have traditionally included high net worth individuals, attorneys, medical professionals, etc., and anyone involved in a cash-intensive business. The IRS is now “operating as a business” and has been successfully targeting cash-intensive industries, as it deems them to have a strong potential for significant audit adjustments.

We advise you to seek legal guidance from a dually California licensed Tax Attorney and CPA immediately if you or your business entity (S Corp, C Corp, LLC, Partnership, etc.) have received an audit notice from the IRS, FTB, EDD, or CDTFA concerning a tax audit or criminal tax investigation. You should be aware an audit could lead to an unexpected tax assessment, costly accumulated interest, and substantial civil penalties. If your case is not handled properly, there is always the possibility that your case will be referred by the civil examiner to the IRS’s criminal investigation division (CID) or the state of California’s criminal tax function.

David Klasing is a former public auditor and dual-licensed Tax Attorney and CPA who understands and can accurately anticipate federal and California auditing practices and methodologies. He uses his decades of experience and ever-increasing knowledge to develop responsive strategies to the civil and potentially criminal tax issues you may face. All of the Tax Lawyers and CPAs of the Tax Law Offices of David W. Klasing are experienced in federal and California tax controversies and will diplomatically fight for you in an aggressive and strategic manner.

If you run a cash-intensive business such as a restaurant, salvage yard, check-cashing business, pawn shop, jewelry store, or parking garage and are facing an IRS, FTB, CDFTA, or EDD audit, contact the experienced tax lawyers of the Tax Law Offices of David W. Klasing today. To speak to our Tax Lawyers who are experienced and thoroughly versed in IRS, California FTB, and California audit and criminal tax investigation techniques and the litigations and appeals processes, call 800-681-1295 or contact us online today to schedule a reduced-rate initial consultation.

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