Cash audit fever

guest commentary by David Potts

I’ve been reading an audit guide. It’s interesting. You may think that only a CPA would find an audit guide interesting. Not so. Many small business owners will find this audit guide interesting.

The Internal Revenue Service publishes a series of audit technique guides as a resource to help their agents conduct audits of people’s income tax returns. I think it is safe to assume that when the IRS publishes an audit technique guide, it covers an area where the IRS believes it should focus its exam efforts to enforce compliance. It might be predictive of which tax returns will be audited in the near future.

Last year the IRS published two new audit technique guides, the Construction Industry Audit Technique Guide and the Ministers Audit Technique Guide. (It seems preachers have a hard time giving to Caesar too). These were published shortly after the IRS began talking about closing the tax gap, the difference between taxes that should be paid voluntarily and taxes paid. The construction industry is one of those areas where the IRS believes voluntary compliance is low. In the IRS’s own words, here is an excerpt out of the Construction Industry Audit Technique Guide published last year.

“Latest estimates put the Federal tax gap at $345 billion and growing. The tax gap is equivalent to a noncompliance rate of 16.3%. Of this amount, $285 billion is attributable to underreporting of business income of which $68 billion is attributable to sole-proprietors (Individual Income Tax, Form 1040, Schedule C). This amount represents the single largest source of the entire tax gap and is a direct result of little or no information reporting. Consequently, matching of income received to income reported cannot be performed.

“In addressing the tax gap attributable to the construction industry, residential construction is of particular interest because this group of taxpayers accounts for 73% of the return filings but reports only 10% of the gross receipts. It is imperative that steps are taken to ensure that only the most noncompliant returns enter the examination stream and that appropriate issues, specifically underreporting of income, are examined in a quality manner. Of particular interest are cash intensive businesses. The Service is especially concerned with sole-proprietorships because they often lack internal controls and cash can easily go unreported.  In addition, records can be either non-existent or inadequate. For example, cash receipts may not be deposited into the business bank account.”

For this month the IRS has published their revised Cash Audit Techniques Audit Guide, the audit guide I have been reading. So why do I find this audit guide interesting and why might you?

Maybe it comes with a Democratic administration being in power, but the IRS is now interested in the little guy. In the recent past they favored the rich, but now they are more inclusive. In addition to the construction industry, the IRS is looking at increasing income tax revenues from bail bondsmen, beauty shops, car wash owners, pet groomers, check cashing businesses, vending machine owners, convenience stores, Laundromats and junk yards. But wait, there’s more. The people who sell used cars, take care of small children, clean houses, haul trash, trim trees and mow yards are included too. Whoops, I forgot people who sale items on Ebay to buy their kids a few nice things. All these lucky people have an honorable mention in the new Cash Audit Technique Guide.

Back in the Clinton days when budget deficits moved to budget surpluses, the IRS morphed into a nice IRS with the number of returns being audited falling. With this lack of enforcement action, people have forgotten what a potent force the IRS can be. With trillion dollar deficits now upon us, I think we soon will be reminded what the IRS can do. The audit guide talks about respecting your privacy, but if you are ever audited you won’t feel your privacy is respected. This isn’t because the IRS agent is evil, it’s just the nature of tax return audit. And if you decide to represent yourself and you aren’t cooperative with the IRS you might end up feeling like you were just stripped naked and forced to bend over.

You might be under the false assumption that if you don’t deposit your cash into a bank account you don’t need to report the cash as income, that the IRS will never know your received it. Read the Cash Audit Technique Guide. The examination of your return is a lot more involved than most people believe. It starts before they meet you and involves a lot more than looking at your bank account and asking you questions. The agent has probably already driven past your place of business, and probably your house to get a feel for your lifestyle. The IRS, if they think it’s necessary, can and will examine loan application files, asset locator databases and property tax records. They will examine how much your business purchased to see if it correlates with what you sold. They will talk with your customers, your vendors, and maybe your ex-spouse.

If you are in a business that deals with a lot of cash, you will find the newly published Cash Audit Technique Guide an interesting read. It will help you see what areas of your income tax return the IRS agent might focus. If you are under reporting a significant portion of your income, you might want to know your risks. You might even want to begin reporting all your income. If not, the IRS wants to help you become more compliant.

About Potts
David Potts is a certified public accountant also accredited in business valuation. Owner of Potts & Company, Certified Public Accountants for more than 25 years, his practice focuses on small and medium size businesses and their owners in the areas of taxation, accounting and bookkeeping, business valuation and business advisory services. He is a Fort Smith native and a graduate of the University of Arkansas. You can follow more of his thoughts at ThePottsReport.com. Although every effort is made to provide you accurate and timely tax information, it is general in nature and not specific to your facts and circumstances. Consult a qualified tax professional to discuss your particular case.

Also, feel free to e-mail topic suggestions or questions to [email protected]