Have you ever wondered how the IRS audits a business for unreported income, particularly when we’re talking about a small business with little internal controls, and a business model where customers can pay with cash?
Well, the IRS has published an audit guide explaining what they look for.
In the guide, they explain the 3 principal ways income goes unreported:
- It can be skimmed from receipts, for example, pocketed before it is recorded. If this happens it will not be discovered by auditing the books.
- It can be stolen after it has been recorded, for example, cash removed from the cash register or goods stolen from the shelf for future resale.
- A fraudulent disbursement can be created, for example, a payment to a vendor that is actually cashed by the owner’s son.
What may be more useful is understanding the audit techniques the IRS might use when your small business gets audited:
The most significant indicator that income has been under reported is a consistent pattern of losses or low profit percentages that seem insufficient to sustain the business or its owners. As an accountant/tax preparer, I like to call this the ‘smell test’, a technique I often use on all the tax returns I prepare. For instance, if someone is consistently showing income of only $5-10,000 per year, but at the same time consistently shows substantial (if any) home mortgage interest, real estate taxes, and charity, then this return would fail the smell test. Typically, I would ask the taxpayer a lot more questions, at least so I can be reasonably comfortable that the return is correct, since if I think the return is suspect, so will the IRS.
Other indicators of unreported income can include:
- A life style or cost of living that can’t be supported by the income reported. Can the business support the houses and vehicles that are recorded in the owner’s name?
- A business that continues to operate despite losses year after year, with no apparent solution to correct the situation. Oftentimes, people will worry about the ‘hobby’ rules, but the real threat is if the government can’t understand where the losses are even coming from.
- Bank balances and liquid investments increase annually despite reporting of low net profits or losses.
- Accumulated assets increase even though the reported net profits are low or a loss.
- A significant difference between the taxpayer’s gross profit margin and that of their industry.
- Unusually low annual sales for the type of business.
Having good books and records, including cash register receipts, is crucial in an audit. Having daily balancing of the cash register, and monthly balancing of the bank account to the books can be extremely useful in helping an auditor be comfortable that income has been reported.
One technique that you can expect on virtually any audit of a small business is a gross receipts test of all the bank accounts, both business and personal, where the government will try to agree your reported income or gross sales to the amounts actually deposited into your bank account(s).
If you’re not sure if your business would survive an audit (and we continue to see a noticeable increase in clients being audited), I would be happy to sit down with you and discuss in more detail how your books and records could be improved upon.