While only about 1% of personal taxpayers face audits, that number is higher at 2.5% for small businesses. Yet, for cash intensive businesses, the odds increase.
The IRS watches those businesses where much of the revenue they gather is from cash because often those are businesses that might be skimming some cash and not reporting it.
So, what is a cash-intensive business, and would the IRS watch more closely this type of business? What audit techniques get used?
Read on to learn more about how the IRS looks at cash intensive businesses and the Audit Technique Guide for Cash Intensive businesses used by the IRS.
Definition of a Cash-Based Business
Different business models have different methods of collecting revenue. If you hire a painter to paint your house or go to the doctor for a physical, you’re likely to get billed and then pay with a check or credit card. When you go to the grocery store, you might use cash for a gallon of milk. Yet, if you’re buying a cart full of groceries, you’re more likely to use a debit or credit card or write a check.
All these methods end up with documentation.
Yet, when you go through the car wash and hand out cash or tip your hairdresser or server at a restaurant, the cash doesn’t have the paper trail.
A cash-based business is one where their main source of revenue for what they do as a business comes from cash.
Get Expert Tax Consulting For Your Cash-Based Business
Methods in Which a Cash-Based Business Might Misappropriate Funds
When a business collects cash for a service, it is really anonymous. There is not a written record often of where or who the cash came from. For some business owners, this makes them feel like they don’t have to report the income in its entirety or even at all.
There are a variety of ways a cash business might skim cash from their revenue stream and opt to not report it.
First, it can simply get skimmed before it is ever recorded into the business records.
Second, the business could take the cash through goods from the business or use the cash and not document where it went.
Finally, the business might say the cash got used for a purpose that didn’t really exist. Perhaps they take the cash and say they paid a bill for the business that didn’t really even exist. In this situation, they’d also be creating fraudulent receipts to cover it up too.
IRS Red Flags
The IRS recognizes that cash intensive businesses might make it easier to stack away some cash and not report it. So, there are some things they generally use as guideposts. If they see these things, it’s likely to raise their level of suspicion. These red flags include, but are not limited to:
One thing the IRS will do is to compare your business with other similar businesses. If the business in question has a gross profit that is much lower than other comparative businesses the IRS is likely to get suspicious.
What Is an IRS Audit Technique Guide?
When there’s suspicion about a business and the IRS audit begins, the IRS will use their Audit Technique Guides as a way to navigate through the audit. Looking at the Audit Technique Guide specific to your business can help prepare the business and even offer audit tips.
The cash audit form is specific to cash-based businesses and addresses several specific types of cash businesses. More on this shortly.
The Audit Technique Guides not only define the business but also spell out how the IRS is likely to seek information about your business.
The Audit Technique Guide for Cash-Intensive Businesses
The IRS has a specific Audit Technique Guide for cash intensive businesses too. It’s broken into chapters, 17 in all, and spells out the process an IRS auditor would use as they begin an audit on a cash-based business.
The last 11 chapters of the guide discuss specific types of cash businesses. The first 6 chapters specifically go through how the auditor will proceed to gather information from the cash-intensive business.
Chapter 1 provides background information. It lets the business know what the IRS might deem suspicious.
Let’s take a closer look at each of chapters 2 through 6 and what happens for each step of the audit process in the Audit Technique Guide.
The penalty of perjuries statement requirements are different if you are representing yourself or if an attorney is filing on your behalf. The person submitting the protest must sign below the written perjury statement.
Chapter 2 covers the initial interview. Chapter 2 covers the pre-audit information and the evaluation of the tax return. The IRS will begin gathering background information on the business in question.
Before much happens, the auditor will carefully work through the actual tax return. They will be looking for potential audit adjustments and fraudulent situations that raise suspicion.
The IRS will analyze external sources then do a comparative analysis between your business and others like it. Then they will use their investigative resources to begin looking and digging for information. They might look for immigration files, bank records or use the asset locator database.
Chapter 3 involves the initial interview with the taxpayer or business owner. The auditor will do an initial meeting to ask beginning questions. They will ask for information that shows the:
They will issue an official summons and set up a time and place for the full examination.
Chapter 4 covers how the IRS will begin to evaluate income for cash intensive businesses. They use an analytical test to see if the income reported makes sense or if it’s likely income has not been reported.
They will begin to look to see if there’s a cash imbalance from the books, what’s reported and what they believe should be there.
At this stage, the auditor will visit the business, observe the processes the business uses and observe how the business operates. They will also interview the business owner with more depth.
Here the IRS will more closely evaluate the internal systems used by the business to document the cash that is a part of the business. This will help them to evaluate both if cash has gone unreported or underreported and how their business might have covered what’s missing.
Evaluate the Evidence
Now that the IRS has gathered an array of evidence related to the business, they will begin using their extensive resources to evaluate the accuracy of the information they’ve gathered.
Focus of The Cash-Intensive Audit Technique Guide
When the IRS considers cash-based businesses, there are certain businesses they will likely focus on. The IRS expects all cash-based businesses to have an accounting system for the business they bring in.
This becomes part of the audit if the IRS gets suspicious the business isn’t actually reporting all the cash that comes in. So, what cash intensive businesses does the IRS typically focus on?
As part of the Cash-Intensive Audit Technique Guide, the IRS specifically addresses certain cash businesses in chapter 7 through 17.
So, what are cash intensive businesses? Let’s take a look at cash intensive businesses listed as examples that get addressed specifically in the audit guide.
1. Digital Cash
Think about all the purchases made on the internet. Digital cash is one area the IRS monitors for cash businesses. It includes e-money, electronic cash, or digital currency.
You might think most digital cash could be tracked because it goes through a computer. Yet, the IRS knows there are some businesses that have a large flow of digital cash and may not account for it all.
2. Underground Business
An underground economy is all of the money earned by an individual or business that is not put in the books. Something is paid for by cash and not recorded into the books. This underground economy can be legal or illegal or even black market goods, including drug sales, money laundering, and warehouse banking schemes.
Many underground economy transactions are single entrepreneurs who take cash for goods or services. The goal is often to avoid paying taxes on these transactions.
3. Bail Bonds
Bail bonds by the nature of what they do and who they work with tend to be cash-intensive. They take in cash so they can write a bond. The audit guide focuses on the bail bonds industry and their work with insurance or surety companies.
Often the bail bonds don’t have quality internal controls on the cash coming in and that’s what the audit would look for in this type of business.
4. Beauty Shops
Salon workers have several avenues for income. They can work for a salon and collect a W-2 at the end of the year. They could be an independent contractor who rents space in a salon. They might own the salon and rent the space to others.
No matter the configuration used, often their revenue is cash-based. They collect tips and the more clients they see, the more revenue and tips that come their way.
No matter how they have set up their work, the trick is in the internal recording of the cash that comes to them via tips.
5. Car Washes
A car wash is a popular cash business. You pull up to the car wash, tell them the type of wash you want and hand them the cash. It’s not uncommon to see a car wash employee collecting money for the washes with a thick stack of cash in hand.
The cars roll on and on and the cash is collected. The IRS will question how and if all the cash that was collected was documented and reported.
6. Coin Operated Amusements
This business will include video games, pinball machines, jukeboxes, pool tables, slot machines, and other machines and gaming devices. All of these are typically played with either tokens, paid for from a machine with cash, or with actual cash into the game.
The IRS will want to see how the amusements are run and how money is collected from the machines. They will want to understand how the cash is documented as part of the business.
7. Convenience Stores
Convenience stores often make a large number of small sales from coffee and drinks to grab and go snacks. The IRS will want to see the cost of goods and records for the volume of goods sold.
They’ll want to know the volume of the sales that are done in cash and how the cash is recorded into business records.
Laundromats are run with machines that collect coins. The part that makes the cash tricky is there are no receipts issued. The user comes in, deposits coins, uses the machine, and leaves.
The IRS will question volumes of usage and if the volume of usage matches up with the reported income from the cash-based machines.
9. Scrap Metal
Approximately 56 million tons of scrap iron and steel are recycled each year. The sale of scrap metal is often paid out in cash.
The IRS will question volumes. They will also want to know does the volume of scrap metal matches with the cash reported.
Taxicabs remain a cash intensive business both through the payment for a ride and through tips. If the taxi driver is an independent driver, they often don’t retain good internal records that show their drives and the money brought in from them.
The IRS auditor will want to look at the volume of rides provided by the taxicab and how those rides were paid for. How often does the driver receive tips and for how much?
Cash Intensive Businesses and the IRS
Audits of cash intensive businesses are not uncommon, as businesses are faced with the challenge of bringing in cash as their revenue stream and then finding quality methods to document the cash and keep the IRS from getting suspicious.
If you run an all-cash business and are facing an audit, we can help. Our team of tax attorneys wants to help you handle the IRS and a potential audit. Contact us today to get your questions answered and the help you need.