The Birth of an Audit
If You Think the IRS Is Becoming Too Lenient, Think Again
When preparing your tax information annually, does the likelihood of an audit cross your mind?The IRS feels that businesses and individuals may have become slightly lax in their record keeping due to a decreased presence of auditors. They believe this lack of compliance has led to a significant tax ‘gap,’ i.e., the difference between the tax the IRS estimates is due and the amount actually paid by taxpayers.
In response, the IRS has increased its number of audits. Many of these audits are under various ‘tax-audit initiatives,’ which are intended to provide data for the National Research Program (NRP) study of tax compliance.
One area of focus is cash-intensive 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 generally paid in cash.
The IRS has posted 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 the IRS’ position (and cannot be used, cited, or relied upon as such), it does provide valuable information to practitioners and taxpayers on how the IRS audits cash-intensive businesses, including specific types of cash businesses.
The ATG notes that the income-tax gap is thought to be in the hundreds of billion of dollars. In part, this may be because there is an 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 may lead some individuals to believe that cash receipts can be unreported and escape detection.
The ATG observes that there are three main ways to misappropriate cash from a business:
• it can be skimmed from receipts before it is recorded;
• it can be stolen after it has been recorded; and
• a fraudulent disbursement can be created.
The ATG states that the most significant indicator that income has been underreported is a consistent pattern of losses or low profit percentages that seem insufficient to sustain the business or its owners. Other indicators of 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 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 business type.
The ATG stresses that examination techniques must be tailored to provide for the best analysis of a specific taxpayer’s possible income stream. There are several techniques that can be used successfully when working with cash-intensive businesses.
First, a financial status analysis, including both business and personal financial activities, should be done, the ATG advises. This is a required minimum-income probe. If it shows an imbalance in the cash flows indicative of underreported income, an examiner is told to request clarification or explanation from the taxpayer before beginning the use of an indirect method.
Indirect methods, such as source and application of funds or bank-deposit and cash-expenditures analysis, can be used to confirm the amount of any understatement.
The ATG says that the most critical aspects to successfully examining a cash-intensive businesses is the gathering of 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.
In addition to their focus on cash-intensive businesses, auditors are focusing on several other items, which in recent years were frequently not considered in audits. These include:
• Adequate substantiation of meals and entertainment expenses, including a record of who the expense was with, their business relationship, business conducted immediately before or during the meal or event, and supporting documentation.
• Establishing the business purpose of ordinary expenses, including airplane travel, vehicle expenses, membership dues, and external office expenses. The substantiation requires more than bank statements, credit-card statements, and canceled checks. For example, the IRS has long required that written records be maintained to document the business use of vehicles. They are now routinely requesting these auto logs, gas and repair receipts, and calculations of reimbursements.
• Employment tax compliance. This will mark the first such study conducted by the IRS since 1984. The IRS is expected to focus on the following five employment tax issues:
• worker classification (employee vs. independent contractor);
• fringe benefits;
• officer’s compensation;
• reimbursed expenses; and
The initiative is intended to help reduce the size of the tax gap.
In many instances, the IRS is quick to assess accuracy-related penalties in addition to penalties for late payment of tax when items of income are erroneously omitted and unsustainable deductions claimed.
So gather up your receipts and other documentation, keep good notes, and resurrect that auto log. If you need assistance in clarifying the substantiation requirements for any expense or the proper use of an auto log, be sure to speak to your accountant or tax adviser. The little bit of pain you endure now in keeping good substantiation will save you the pain of writing a significant check to the IRS in the future.
Sean Wandrei is a tax manager with Meyers Brothers Kalicka, P.C. His technical concentrations are in multi-state taxation as well as real-estate entities; (413) 536-8510.