By: A.J. Cook


The Mom and Pop store that sells for cash has it tough when the Internal Revenue Service audits it.

It isn't alone. Most small businesses that deal with lots of cash cannot prove they reported all their income and so are not able to disprove larger IRS income estimates. Even the IRS audit guide tells agents disproving by the taxpayer will be difficult. Difficult? No-it's almost impossible. In small cash businesses, the accounting controls needed to prove all cash is reported tend to be nonexistent or poor at best.

The agency audits these Mom and Pop shops because it thinks this is one group of taxpayers that doesn't report all their income. The IRS figures it has a lock on most other income: wages, which are reported by employers; dividends and interest income, which are reported by the payer; and large companies, which are audited by certified public accountants.

Often IRS auditors use one of three methods to estimate income: adding cash expenditures to bank deposits, adding family living expenses to their net worth increase, increasing purchases by the average markup to determine gross sales. To make these computations, the auditors ferret out information from banks, suppliers and customers for the data not available from company records. Once the agency makes this estimate, it expects you to prove its numbers are wrong or prove you have an adequate control system.

But who knows what an adequate control system looks like? The law, the regulations and the IRS don't say what one looks like. Recently the Tax Court described an inadequate system:

Taxpayers routinely used unrecorded cash receipts to meet payrolls, pay business expenses and satisfy personal needs; the husband alone controlled and prepared the books; and they did not retain records, such as cash register tapes and sales receipts, that would have substantiated the amount of income received.

Another court gives one solution to this predicament. The agency had computed the income of Helen and Robert Zimmerman's jewelry store in Defiance, Ohio. The judge said the agency improperly assumed the taxpayers' income was wrong simply because they hadn't reported the amount computed by the IRS. This is not sufficient, said the judge - the government must also show that the taxpayers' accounting controls are inadequate.

The couple had hired an accountant to set up and supervise their bookkeeping. The judge, realizing they did everything they could be expected to do, threw out the IRS computations.

Prepare for an IRS audit with an accounting control system that proves you reported all income. If you aren't sure your system does this, hire a CPA to review it.

Businesses call it a lot of trouble.

The new program gives auditors specialized training in a particular profession, industry or tax issue. Agents learn to look for unreported income and "over-ing" -- overstating cost of sales, over-contributing to pension plans, overpaying officer / shareholders, over accumulating profits rather than distributing them to shareholders.

Under the guidelines, auditors follow some or all of the following steps:

• Interview and Tour the Business
  

At the initial interview, agents ask questions such as the location of safe deposit boxes and if you bought major assets or made major improvements at the business or at home. They are checking if you are hoarding unreported cash or spending beyond the income reported on the return.

Auditors will then tour the business to confirm what was learned during the interview and to verify the information on the tax return. The tour includes matching actual inventory with reported and looking at storage supplies to see if these should be in inventory.

• Review Records
  

Agents might check appointment books, cash box receipts or contracts with employees. They will also look at journals and ledgers.

If records are inadequate, the IRS has authority to estimate income. To do this, agents might interview some of your suppliers, customers or employees. They also might use one of various methods to compute income.

Sometimes they add up bank deposits. Other times they assume you had income equal to business and personal expenditures. They also use your markup on individual inventory items to interpolate your gross income. The estimate, of course, will favor the IRS. It might surprise you that the courts accept this slant. One judge explained why. He said businesses that fail to keep adequate records risk being taxed on income which cannot be determined with certainty.

• Challenge Independent Contractor Status
  

Businesses may think they know their workers are independent contractors, but the IRS may beg to differ.

Under MSSP, agents look into whether workers reported as independent contractors should be reported as employees. For independent contractors the business doesn't withhold payroll taxes or pay any Social Security taxes -- a savings in time and money. So auditors are told to see if workers wear uniforms of the taxpayer or use major equipment provided by the business. If the answer is yes, agents check to see if the company reports them as employees. This is an inadequate test. The key issue is not what clothes workers wear or equipment they use. The key issue is who has the right to control the details of their work -- where, when and how it's done. If the company doesn't have control, the workers aren't employees.

• Review Tip Income Reporting
  

If your employees receive tip income, the auditor might estimate what they should have reported. Agents use average customer tips on charge tickets to estimate total tips. Once agents discover employees have not reported the estimated amount, the IRS will pressure the business to report future income of employees based on the estimated tip rate. And the IRS can exert heavy pressure.

Planning Tip: Consider having a tax professional review your accounting procedures to make certain everything is in order. Because of MSSP, today's IRS auditors know how to root around until they find what they call "productive" issues. Be wise -- be prepared.