What Cash Businesses Can Do to Avoid IRS Audits

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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.

It's called the Tax Gap, the amount of money spent in the U.S. economy that isn't reported to the IRS. For the last years this tax gap was studied (2008-2010), the average annual estimated gross tax gap was $458 billion. This gap is caused by the underground economy, all the taxable transactions that take place without documentation or reporting. Some of this activity is illegal (drug transactions, for example) but much of it is people doing business in cash and not reporting it.

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 possible audit.

What the IRS Looks For

The IRS is interested in businesses who receive most of their income in cash. The IRS audit guidelines discuss cash businesses that typically underreport income, 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.

The IRS looks at a business owner's entire financial life, not just the business finances because cash can easily be transferred from the business to personal accounts.

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?

During a tax audit, the IRS might interview you to get information about your business and personal finances and how you document transactions. The auditor might ask:

  • How incoming cash is handled in your business, from the time it's received until it is recorded (if it is).
  • How cash payments are made, including where the cash comes from to make these payments
  • Where cash on hand is kept and who has access to it
  • How the business accounting records are kept and what kind of accounting system is used.

Being prepared for these questions can help you get through a tax audit more easily.

Does Your Business Handle Large Cash Transactions?

All cash transactions of $10,000 or more must be reported to the IRS on Form 8300 and you must give a written statement to anyone named on this form. Failure to comply can result in both civil and criminal penalties.

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 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 home in a high-value area, not in proportion to reported income?
  • Could the business have indirect sources of additional income?
  • Is the income enough to support a family?
  • Does the business have foreign accounts?
  • Do total deductions indicate expenditures in excess of net income reflected? You should be able to show income and deductions throughout the year.

What an IRS Auditor Looks for in a Cash Business

The IRS guide for tax auditors includes 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. 

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    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.