How to Survive a Tax Audit When You Run a Cash Intensive Business
An array of businesses and commercial operations function on a cash basis due to the customers and clientele or simply because of the nature of the business. For instance, clients may pay an independent contractor in cash for work performed at their home. Similarly customers at a gas station, liquor store, convenience store or other business may also pay in cash. Other companies and businesses such as salvage yards, check cashing businesses, pawn shops, jewelry stores, parking garages, and restaurants also often have significant cash dealings.
Unfortunately for businesses of this type the IRS, California Board of Equalization, and California Franchise Tax Board (FTB) all recognize that cash presents a greater opportunity for wrongdoing and thus present a higher likelihood of abuse. In fact, aside from the tax enforcement agencies, both the North American Industry Classification System (NAICS) and Federal Financial Institution Examination Council also recognize many of the businesses discussed above as cash-intensive. Because of the potential for abuse, cash-intensive businesses are typically subject to much greater levels of scrutiny when selected for an audit.
What this means for owners of businesses of this type is that the agent or examiner may enter the audit expecting to find wrongdoing by the business owner. This heightened level of suspicion and more intensive audit techniques utilized often result in major problems for the business owner which may include a tax audit that goes off the rails and results in an examination by sampling or other statistical methods. In other words, audits of cash intensive businesses often result in significant tax liabilities and penalties and a heightened potential for criminal tax exposure. Therefore, they should only be handled by an experienced tax professional.
The Potential Problems with a Cash Business
The IRS and other taxing agencies recognize that the lack of a paper trail surrounding cash transactions enables greater latitude for abuse than credit card payments and other transactions that create an electronic paper trail. Chiefly, the main concern held by tax agencies and other regulators is the propensity for misappropriation by the business owner and other individuals who handle cash or who are in charge of the business finances. Misappropriation in a cash intensive business can occur in several manners ranging from low-tech skimming of cash receipts before they are recorded to high-tech fraud accomplished with “zappers” – electronic devices that can alter sales records. Other methods of misappropriation can include the theft of cash from the cash register and the theft of goods. Business owners may also make payments for goods never received to alleged vendors who turn out to be family members or aliases. These practices reduce taxable revenues and deprive the state and federal government of tax revenue they would otherwise receive. As such, tax enforcement agencies pursue and prosecute fraudulent criminal behaviors of this type aggressively.
How Do IRS and Other Auditors Identify Potential Tax Fraud?
Along with other audit and examination techniques IRS, FTB, and BOE agents also use what are known as badges of fraud to identify situations where there is a high likelihood of tax evasion or other forms of misappropriation. Badges of fraud often include the behaviors of the audited cash basis business owner. For instance, behavior that is combative or hostile towards the auditor is considered a badge of fraud. Likewise, the act of refusing to provide requested or required information to an auditor may also be viewed as a badge of fraud. Other badges of fraud include:
- The failure to maintain adequate records
- The destruction of financials or other records
- Concealing assets
- Excessive cash dealings
- Keeping a second set of books
- Structuring transactions only for tax purposes
- Concealing assets
- Unreasonable or implausible explanations or financials
Other signs of fraud the IRS references in its Cash Intensive Businesses Audit Techniques Guide include a lavish lifestyle that could not be sustained on the reported amounts of income, businesses that continue to operate despite stated losses in multiple consecutive years, an increase in cash balances despite reported losses, and unusually low sales for a business of this type.
The presences of badges of fraud places taxpayers in an extremely difficult position. The consequences of their presence when entering a federal civil tax audit can include the possibility of a civil fraud penalty set at 75% of the additional tax owed plus interest. Should the matter be referred for criminal investigation, the possibility for a five year prison sentence and up to $500,000 in fines exists.
What You Can Expect from an IRS Audit of a Cash Intensive Business
The auditor’s investigation into you and your business starts long before the actual examination of your books and records begins. All agents engage in a thorough, intensive pre-audit work-up process. The auditor will review your tax returns along with information from an array of sources. The IRS is likely to seek any financial information it can find including court records, state tax and regulatory filings, information from public utility bills, credit applications, newspaper articles, and information from landlords and current or former employees. The IRS also make use of private subscription services such as Lexis, Accurint, Robert Morris & Associates, and Dun & Bradstreet. As part of the work-up, the IRS will also determine whether your stated financial positions are reasonable through the use of vertical analysis vis-à-vis industry ratios, comparative analysis, inventory analysis, and other methods.
From this point, the IRS agent will conduct an initial interview. For a business owner who is unfamiliar with the audit techniques and processes this interview can be a potential minefield. A proper interview can take more than two hours during which your statements, appearance, body language (up to 70% of communication) and conduct will be thoroughly scrutinized. The taxpayer is expected to be able to explain every step in the businesses standard operations from funds entering the business as income, through their deposit to their disbursement. Discrepancies in what you may state or imply during the interview versus the information contained in your records can give rise to grounds that will support a more thorough and intrusive audit.
During the actual tax audit, the examiner typically first makes use of direct methods to determine whether the cash intensive company’s stated income is accurate. Direct methods of examination include analyzing the purchases made by the company, disclosures made as part of a past sale, or potential future sale, of the business, loan disclosures, and use of check cashing services.
One indirect audit technique frequently used by the IRS and California state tax authorities is the percentage markup method. In industries with fairly uniform gross profit margins such as bars, coin laundries, gas retailers, and packaged liquor stores a reasonable gross profit margin may be used to determine if the taxpayer’s gross profit comports with similar businesses. In other cases, the agent may make use of a unit or volume markup method to reconstruct the business’ gross profits. In any case, an auditor that resorts to indirect methods of examination can result in major problems accruing for business owners and managers. Should the auditor select an improper basis for the indirect audit, these businesses can face inflated tax bills based on non-existent sales and potential criminal exposure as well.
What to Do When Your Cash Intensive Business is Facing an IRS Tax Audit
If your business has been selected for an audit by the IRS or a state tax enforcement agency (especially a sales tax audit by the BOE), working with an experienced tax attorney is a critical step that can help your business avoid a worst-case scenario and mitigate the consequences of the audit. We understand the taxpayer’s bill or rights and will not hesitate to remind the auditing agent of your rights in an assertive but professional manner. In the hands of an experienced tax lawyer, the audit work-up process begins immediately. The attorney can review your records, assess the situation, and begin preparations regarding potential issues that may arise. Furthermore, the attorney is likely to reach out to the auditor to negotiate and set ground rules for the audit. By setting ground rules, the process can be controlled to a degree. Should the auditor find errors or inadequate information, you will know what to expect from the process. Furthermore, exercising some degree of control over the audit techniques, the attorney can negotiate strategically to protect your business from weak points in the records.
Many business owners are tempted to work with their original preparer or accountant. Unfortunately, this is a major error that can result in your accountant becoming government witness #1 against you and your business. When there is even a hint of concern regarding potential criminal penalties, you should only work with a tax lawyer. The attorney-client privilege is broadly recognized and robust. By contrast, the accountant-client privilege is not broadly recognized and furthermore, it will not offer protection should underlying criminal issues arise. In certain circumstances an accountant can assist on your matter, but they may only do so under the direction of an attorney through what is known as a Kovel letter.
How an Experienced Tax Lawyer Assists a Cash Intensive Business During and Following an Audit
At the Tax Law Offices of David W. Klasing, David Klasing is dual certified as a tax attorney and as a CPA. Therefore, he can provide guidance and advice from the perspectives of both professional roles. Additionally, the team of experienced tax lawyers and CPAs can provide on-point guidance before, during and after the audit process including during any necessary tax appeal or collection action. Furthermore, if you attempted to handle your audit alone and are less than satisfied with the IRS, BOE, or FTB determination our experienced tax lawyers can litigate the determination and seek a more favorable and equitable result for the taxpayer.
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 contact the experienced tax lawyers of the Tax Law Offices of David W. Klasing today. To speak to tax lawyers who are experienced and thoroughly versed in IRS, California FTB, and California BOE audit and criminal investigation techniques and appeal processes call 800-681-1295 or contact us online today to schedule a reduced-rate consultation.