What Cash Businesses Can Do to Avoid IRS Audits

illustration of a businessman under a magnifying glass
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Cash businesses (those that take in mostly cash, such as restaurants, flea market vendors, beauty salons, and many others) are more likely to be audited by the IRS and have a particular problem when audited because it is difficult to verify income received in cash. To find information about this subject, I interviewed CPA Gail Rosen about cash businesses and taxes.  I also found an interesting IRS publication telling auditors what to look for when trying to find hidden cash. 

How to Avoid Being Audited

The IRS is interested in businesses who receive most of their income in cash. The IRS guidelines give particular attention to the underground economy including used car sales, child care, house cleaning, pet sitting, handyman businesses and construction workers. The IRS also has specific audit techniques for bail bond agents, beauty salons, car washes, coin operated amusements, convenience stores, mini-marts, bodegas, and laundromats.

This article is not being written to help you hide cash and assets from the IRS, but rather to give you some suggestions to make your legitimate cash business less likely to be subject to IRS scrutiny and to be less likely to have the IRS question your business tax return if they do decide to audit. Gail Rosen has some suggestions for how you can minimize audit risk for a cash business:

Be Able to Show How You Support Your Lifestyle

Have a personal and business lifestyle that can be supported by the income you report. For example, if you drive a luxury car and have a second vacation home, but you report little business (or other personal) income, the IRS will get curious.

Document Business Transactions as Much as Possible

Document operating losses, asset purchase sources, and other business transactions. Where did you get the money for that new equipment, if you didn't have any sales?

Verify Financial Transactions with Ratio Analyses

Another good way to avoid an audit is to show that your business financial information is in line with other businesses of your type and to show a consistent pattern of income. Comparisons with industry benchmarks, otherwise known as ratio analyses are extremely important in evaluating reasonableness in a cash-intensive business. The ratios should include:

  • A vertical analysis which is a comparative analysis within a given tax year of certain expenses relative to gross receipts.
  • Industry analysis to show how your business compares to others and how your business compares with the industry as a whole. Bizstats.com is a free service that can be used to find comparative financial data for your industry.
  • A comparative analysis should show some consistency over the years.
  • Inventory analysis can be used to show reasonable turnover ratios.

The Protocols a Business Can Use to Help at a Tax Audit or Before an Audit

The examples below are questions the IRS may ask a cash business.

  • Is the taxpayer's address in a high-value area, disproportionate to reported income?
  • Is the occupation or business one that could have indirect sources of additional income?
  • Will reported income support the size of the family reflected?
  • Is the foreign accounts question answered?
  • Do total deductions indicate expenditures in excess of net income reflected? Evidence to support your position should be maintained throughout the year.

What an IRS Auditor Looks for in a Cash Business

I ran across an interesting article on the IRS website. It is a business audit techniques guide that gives auditors some information to look for in their audits. Here are some of the ways IRS auditors can find hidden cash: 

  • Asking disgruntled employees or spouses in a divorce proceeding
  • Finding hidden transactions to family and friends, like free or low rent or payment of other personal expenses, and loss of inventory that is given to individuals
  • Withdrawals from the business bank account or purchases greater than the net profit of the company
  • Comparing the profits of the business with industry average profitability
  • Purchases that reveal sales. For example, the purchase of auto insurance or registration points to the purchase of a car (with cash?)

    While you may not avoid having your cash business audited, you can survive an audit better if you know the audit triggers and what the IRS is looking for. 


    Disclaimer: The information on this post and on this site are for general information purposes only; it is not intended to be tax or legal advice. Each situation is specific; consult your CPA or attorney to discuss your specific business questions.