What Cash Businesses Can Do To Avoid an IRS Tax Audit

Customer paying business owner with cash
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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 Internal Revenue Service (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. The average annual estimated gross tax gap was $441 billion for the years 2011 to 2013 (the last years studied). This is lost revenue to the U.S. government.

This article looks at how the IRS goes about auditing cash businesses.

Key Takeaways

  • The IRS closely looks at cash businesses because they have the potential to be hiding income.
  • Cash businesses often don't have many records, so the IRS must closely interview owners on their accounting, cash management, and banking processes.
  • The best way to avoid an audit of your cash business is to begin implementing an accounting system that includes putting as much as possible in writing.

What Are Potential Audit Triggers?

The IRS is interested in cash businesses that receive most of their income in cash because they have the potential for underreporting that income. 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.

An IRS auditor's job is to test the accuracy of a taxpayer's tax return and especially their income sources. 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.

Tips for Cash Business Audits

Document Cash Transactions

Carefully consider how you would answer questions like these at an audit:

  • How is incoming cash is handled in your business, from the time it's received until it is recorded (if it is)?
  • Where did you get the money for that new equipment if you didn't have any sales?
  • How are cash payments are made? Where does the cash come from to make these payments?
  • Where is cash on hand kept and who has access to it?
  • Does your business use petty cash receipts for small purchases?
  • Is your home in a high-value area, not in proportion to reported income?
  • Is the income enough to support a family?

The IRS is also on the lookout for digital cash (e-money, electronic cash, cryptocurrency, and services like PayPal and Electronic Funds Transfer). These types of online transactions could be used for money laundering and other illegal activities.

Keep Business and Personal Funds Separate

One big problem auditors often catch is combining business and personal accounts. Some business owners start out using their personal checking account because they don't want to pay bank fees for a business account. This is a bad habit to get into.

If you haven't done it already, get a separate business bank account. Then record business checking and personal transactions in the correct accounts.

Here's an example: If your business is a sole proprietorship, you use Schedule C to report your taxable business income, which you would then include on your personal tax return. When you have your tax return done, have your tax preparer separate out the cost for work preparing Schedule C from the cost to prepare the rest of the return. Then pay the business part with a business check and the personal part with a personal check.

Here are other ways to separate your cash business from your personal financial transactions:

  • Get a business credit card.
  • Apply with vendors and suppliers for trade credit terms.
  • Get an Employer ID Number (a business tax identifier) and use it for banking, loans, and other business transactions.
  • Use a business accounting software system to make it more difficult to record personal transactions (the categories are different.

Compare Your Business to Industry Standards

One 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 IRS uses several different types of analysis, including:

  • Comparative analysis within a given tax year of certain expenses relative to gross receipts of the business (It should show some consistency over the years.)
  • Bank account analysis, looking for patterns, nontaxable deposits, and cash transactions
  • An 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.)

Other Ways the IRS Finds Hidden Cash

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 with 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
  • Purchases that reveal sales. For example, the purchase of auto insurance or registration points to the purchase of a car (with cash?)

Preparing for a Tax Audit

While you may not be able to completely avoid having the IRS audit your business, there are some things you can do to prepare.

  • Gather as many records as possible to document income and expenses, including bank and credit card statements, payroll records, and records of purchases.
  • Use for customers to show payments.
  • Get receipts from vendors, suppliers, and others for tax-deductible expenses like insurance, rent or mortgage payments, utilities, etc.
  • If you don't have a business accounting software program, consider getting one and using it to record everything.
  • Any contracts or agreements should be in writing. For example, if you contract with an independent contractor to work on your website, make sure you create a contract.
  • Collect any travel logs or diaries for business travel to reconstruct at least some of these expenses.

The IRS has a list of the types of records tax auditors might ask for. If you haven't been audited yet, now's the time to think about how to get these records.

Frequently Asked Questions (FAQs)

Must large cash transactions be reported to the IRS?

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.

What if my cash business doesn't have records?

This won't stop the IRS from investigating your business. The agency will initially determine what records you do have, and then conduct a detailed interview to find out how you handle your receipts and purchases. The IRS may also interview others who have knowledge of your business, like accountants, brokers, banks, suppliers, and vendors.

In this situation, it's important to be as cooperative as possible with the auditor, giving them anything you have to prove your tax return information.

Does the IRS have law enforcement power in audits?

The IRS has the authority to obtain and examine any information necessary to determining and collect internal revenue taxes. This authority includes issuing an administrative summons to the taxpayer or other persons, including suppliers, vendors, professional advisors, banks, stockbrokers, and attorneys. If the person being summoned doesn't appear or disobeys the summons, the examiner can take the person to federal district court.