Published June 15, 2012
No one likes to be the center of an audit, but small businesses that deal primarily in cash may find themselves under the IRS’ scrutiny more often than other companies. The IRS realizes that a considerable amount of cash income is not reported on small businesses’ tax returns. In turn, it has developed techniques to uncover hidden stores of cash. Here is what they look for:
Initially, the auditor performs a thorough pre-audit analysis, and will take a look at the tax return and consider the following lifestyle tells:
These seven tasks are accomplished before you ever meet the auditor face to face. When the auditor arrives to dissect your books, the first thing she will look at is how you record your sales and she will check to see if all of the sales are deposited into the bank.
A sampling of Z tapes (if you have a cash register) or sales invoices will be matched against bank deposits. She will check to see if the invoices are numbered. And of course, the auditor will total the bank deposits to compare against the sales that were declared. If bank deposits for the year total $200,000 and you list $75,000 in sales on the tax return, the auditor will expect documentation to support the unreported $125,000 difference.
An estimation of inventory turnover cross-checked against vendor invoices will be measured against sales for consistency. So if your inventory was reduced by 100 units, but your sales for the same period reflect only 50 units sold, you’ll have some ‘splaining to do, Lucy.
The agent will also measure consistency of inflows and out flows. For example, is the profit low but massive amounts of debt have been repaid or new equipment was put into service without financing or personal expenditures were excessive, especially for vacations or luxury items? How was this facilitated? An auditor can tell a lot by looking at the balance sheet and comparing it to prior years for radical changes in entries that reflect the items listed above.
The examiner will also cast an eye to what she thinks the business should be earning. She will consider the location of the business – is it accessible to a large market? She will attempt to determine if there are specialty items for a select clientele. She will count the number of employees and find out what the duties are of each, count the number of cash registers, trucks, chairs, etc. she will look at pricing and age of the business to determine the value of established goodwill.
Then there’s the issue of “other income.” The auditor will consider the following:
As you can see, an audit, especially of a cash-based business, may involve more than matching up the income and expenses declared on your books. The auditor becomes Sherlock Holmes in an attempt to discover unreported cash sales.
Bonnie Lee is an Enrolled Agent admitted to practice and representing taxpayers in all fifty states at all levels within the Internal Revenue Service. She is the owner of Taxpertise in Sonoma, CA and the author of Entrepreneur Press book, “Taxpertise, The Complete Book of Dirty Little Secrets and Hidden Deductions for Small Business that the IRS Doesn't Want You to Know.” Follow Bonnie Lee on Twitterat BLTaxpertise and at Facebook.