IRS Methods for Reconstructing Cash Income in a Tax Audit
After the Service has targeted a cash business for audit, laid a foundation, examined applicable records, and interviewed the taxpayer, the nitty gritty begins. The auditor will indirectly reconstruct business income if the records are inadequate, inconsistent with the interview answers, or otherwise suspect.
In general, IRS audit methods can include indirect income reconstruction if there is a reasonable indication of potential unreported income. That’s a pretty low standard, so auditors frequently employ this tactic. Cash businesses are especially at risk. The IRS essentially presumes that marijuana dispensaries and other such businesses underreport their income.
Direct Income Reconstruction
Purchase history often reveals accurate sales data. For example, if a car dealer purchased 100 smog certificates from the state or federal government, the dealer most likely sold 100 cars. Or, if a video game store purchased fifty Call Of Duty WWII games and has none remaining in its inventory, the shop most likely sold all fifty copies. Normally, auditors give owners a chance to explain any discrepancies before they do the math themselves.
There are a few other reconstruction techniques that are also effective IRS audit methods. Some of them are:
- Examining Sales and Loans: Potential buyers often get very accurate records when they inquire about businesses for sale, lest they conclude that where there’s smoke (shoddy records) there’s also fire (something worse). Additionally, the records that owners give to potential lenders are often more accurate than the data they provide to the IRS. If necessary, the auditor can obtain such records through an administrative subpoena.
- Talking to Witnesses: Ex-spouses who aren’t too happy about a property division are often more than willing to give details about the amount of money flowing into a household. Likewise, disgruntled employees may blow the whistle on cash handling methods, procedure circumvention, or cash payments to workers.
- Uncovering Hidden Benefits: Many times, the employees or co-owners include extended family members or other people of the same ethnicity. If that’s the case, auditors often assume that these individuals receive free samples, get their bills paid out of the business treasury, or receive other benefits.
Auditors only pursue this angle if it’s the path of least resistance and the answers are easy to obtain. Otherwise, they quickly move on to other IRS audit methods.
Indirect Income Reconstruction
If direct reconstruction doesn’t work, auditors often use the percentage markup method to indirectly reconstruct income. Using sources like the Bureau of Labor Statistics, PPC (Practitioners Publishing Company) manuals, and various supplier or industry websites, auditors estimate the markup on individual items then multiply that number based on known sales figures. There are two specific IRS audit methods in this area:
- The percentage computation method often works well for businesses that have relatively uniform profit percentages. Auditors are supposed to account for variables like the size of the operation and the quality of merchandise.
- If the business is in the service industry, once auditors know the volume and price per unit, they can calculate gross income using the unit and volume method.
These techniques obviously have some significant problems, mostly due to the diverse nature of retail businesses. Auditors normally only use this method in civil court, since the burden of proof is lower.
In criminal audits, agents often use the net worth method. They establish XYZ’s net worth on January 1 and on December 31. Then, they assume that any increase, aside from taxable receipts, came from unreported income. There are issues here as well; for example, the increase could be due to a cash hoard or an inheritance. But under Taglianetti v. United States, the IRS only has to establish reasonable certainty.
Regardless of the method the agents use, it’s very, very important to have an experienced attorney on your side. Otherwise, it’s almost impossible to fight an IRS audit.
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