IRS examiners told to carefully observe operations of cash intensive businesses

The IRS has traditionally scrutinized cash businesses very carefully for tax evasion, and a recent update to its Audit Techniques Guide for cash businesses reinforces the agency's proactive approach. The IRS reminded its examiners that their focus should be on probing the business for unreported income.

Cash intensive business

The IRS views a cash intensive business as one that receives a significant amount of receipts in cash. Examples are restaurants, convenience stores and hair styling salons, which all handle a high volume of dollar transactions. In some industries, for example construction, cash may be commonly used to pay workers.

Red flags

The IRS told its examiners to look for certain signs that may indicate that cash is being misappropriated from a business. These include:

• A lifestyle that cannot be supported by the income reported by the taxpayer;
• A business that continues to operate despite losses year after year, with no apparent solution to correct the situation;
• Bank balances, debit card balances and liquid investments increase annually despite reporting of low net profits or losses;
• A significant difference between the taxpayer's gross profit margin and that of their industry; and
• Unusually low annual sales for the type of business.

Example. A cash intensive business, which is the only reported income for this family of four, consistently reports ordinary income of $20,000 to $30,000 in the past six years. During the same period, the taxpayer has accumulated two rental properties whose fair market value is in excess of $180,000. Both properties report unusually small rents and substantial expenses, resulting in losses. This scenario, according to the IRS, could indicate misappropriation of cash and tax evasion.

Misappropriated cash

The IRS identified three principal methods to misappropriate cash from a business.

• Cash can be skimmed from receipts;
• Cash can be stolen after it has been recorded; and
• A fraudulent disbursement can be created.

In-person examinations

The IRS emphasized the importance of conducting in-person examinations. In a cash intensive business, the IRS noted that there may be very few tangible records. This makes the interview with the taxpayer crucial as the oral testimony of the taxpayer may be the only evidence provided. The IRS instructed its agents to ask the taxpayer to explain every step from the time that cash and other income is received until it is deposited to a bank or spent. An interview for a cash intensive business may take two or more hours, the IRS noted.

The IRS also instructed its agents to observe how cash payments are made and how they are handled by the taxpayer. This includes spending time watching the procedures at the taxpayer's cash register, comparing the cash register tapes from the day the register was observed to the tapes for the audit period, and matching the taxpayer's statements, cash register records or reports against the findings.

IRS Cash Audit Techniques Guide (Revised April 2010)