Defending IRS Cash-Based Audits – Guilty Until Proven Innocent: Computing Income

As discussed in our previous article, The Case for Using a Forensic Accountant, confronting the prospects of a cash-based audit is fraught with potential traps and exposure to civil and criminal penalties, including incarceration. Understanding the government’s process and having the information to respond quickly will make the process smoother. The goal should be to demonstrate that all income has been reported and, if that is not possible, keep the review in the civil realm.

The IRS is aware that businesses with substantial amounts of cash are susceptible to good old-fashioned greed, resulting in underreported income. The IRS (or State) revenue agent will first attempt to validate whether the reported income is accurate; should that fail (it’s going to fail), they will attempt to arrive at their own conclusions.

Engaging a forensic accountant in advance of the audit to assess if all income has been reported and, if not, the level of unreported income can provide a path to address the auditor’s findings before they reach undesirable conclusions.

The review has implications far beyond federal and state income taxes and includes sales tax, gross receipts tax, and any other assessment where revenue is a determining factor.

Before discussing the various approaches the Agent will take, we need first to learn to recognize the environment that can lead to opportunities, motivation, and rationalization for the business owner to choose to minimize or eliminate cash revenues.

Prior to commencing this investigation, the investigator should be covered under a Kovel letter with counsel. This makes the forensic accountant part of the defense team. The accountant does not want to become a witness for the government.

The business environment is the first and most noticeable sign that conditions are ripe for diversion. The condition or lack of business records, diligence in recording and reconciling transactions, segregation of functions, internal controls around cash as well as the tone at the top all contribute to creating an environment where fraud can occur and will be evident to the revenue agent and the forensic accountant from the outset.

Cash has a destination. It is either hoarded, expended, invested, or laundered. Asking basic questions regarding where the money goes once collected can reveal answers that may not be favorable to the client’s case.

Those who choose to hide cash from view have a plethora of means to do so. Understanding the options available to the business owner and their activities in exploiting these opportunities will be telling. Some means include virtual currencies, collectibles, gift cards, register zappers, gambling, and barter. In addition, cash revenue may not be deposited in the bank but retained in a safe either on or off location.

The motivations to divert cash are as varied as there are businesses. The reasons go from troubled financial situations, gambling or other addictions, avoidance of sales or income taxes, evading of the pesky payroll and minimum wage rules, and attempts to obtain other government benefits. The list goes on. Understanding the business and the owner’s lifestyle can reveal the need for and use of cash.

Some other indicia of the diversion of cash revenue will be evident from a review of the income tax returns. The business return may have continual losses with no real explanation for how the losses are funded. The business owner’s return may not reflect enough income to support their lifestyle, and the social media pages of the owner’s significant other(s) and kids will be glaring exhibits of a seemingly unsupportable lifestyle, hence unreported income.

Disgruntled (former) spouses, employees, and whistleblowers are wonderful sources of information on unreported income. We have already mentioned social media. The purchases or sales of businesses for values that do not comport with the recorded financial information will identify income not supported by the official books and records. Discussions with customers, vendors, and employees can also identify cash transactions that do not appear in the business records.

The auditor will look at much more than just the numbers on the pages of the tax returns. The approach will be much more holistic, incorporating a review of the business and its owners. Some questions and observations will likely include:

No one indicator will flag the problem; however, the totality of the indicia will arouse the auditor’s suspicions and drive their decision to pursue unreported revenues.

The initial series of inquiries will be around testing the reported information. The auditor cannot move to use an indirect method of proving revenue without first demonstrating that there are missing revenues. This is the point in the audit where a team of professionals must focus on providing the agent with the information and documentation to support the reported amounts. Should the team be successful here, the audit will never move to the next phase, which is far more susceptible to estimates and assumptions and is more likely to take an unwanted turn.

In connection with the client and others, the forensic team needs to undertake a similar analysis to demonstrate, if possible, that all revenue is reported. The most important thing for the team to remember is that the examination is all about cash flow; getting diverted to other rabbit holes will deter attention from relevant analysis.

The starting point is a multiple-year comparative analysis of the tax returns of the subject entity and all related parties. While that is deeper than the agent is likely to go, it will go a long way in identifying the source and use of funds. The analysis should extend to industry data and any other comparative third-party information that can be obtained. We also recommend running public record searches (the IRS will already have done so) and reviewing insurance policies to identify business or owner assets that may not be recorded on the books and records of the entities and the owners.

Documenting the taxpayers’ processes for handling cash is also critically important. It is equally important to confirm that the processes are working as described. In addition, understanding the background of the financial staff could become relevant.

Validation of the reported revenues and comparing them to other available business records is the next step in the analysis. Inevitably, there will be other records that need to sync or be reconciled to the tax return, such as:

Another area of concern is if the taxpayer’s inventory is susceptible to personal use, such as in a restaurant. This will be an area of inquiry as it is a means to divert company assets to personal use. The controls in this area should be documented, and the possible diversion of goods should be reviewed. Other areas of inquiry likely to come up include:

There are several methods that the agent can use to determine the “actual” revenues if unreported revenue is suspected. The three most common methods include Percentage Markup, Bank Deposit, and Net Worth Methods. None of these methods is perfect. The agent will make assumptions. The client and forensic accountant’s job is to identify the weaknesses in the selected methodology so the agent’s findings can be effectively countered.

This method works best when inventory is a major driver of revenues. Businesses with a limited number of suppliers or companies where unit sales prices can be ascertained also make this method more effective.

Conceptionally, this method works as follows: industry data reflecting typical gross margins is identified and applied to the business purchases. This expected mark-up percentage is then compared with the reported amounts. The difference is deemed to be unreported revenues.

This method has weaknesses where the use of product samples is prevalent, where there is waste or natural shrinkage, and if there are discounts and other variability in pricing.

Although generally not recommended for cash-intensive businesses, it remains a tool that can be used. This method computes the total deposits plus cash expenses, less nontaxable revenues, to arrive at the expected revenue. The calculated amount is then compared to the reported income. The method requires an understanding of the personal expenditures of the owners, which is why it does not work well with cash businesses. At its core, it is looking for expenditures not supported by the recorded cash flow.

The method requires a combined review of the business and the owner’s bank accounts. The technique presents unique challenges for companies that maintain accrual method books and records, as they must be converted to cash. Other challenges include sales of property and equipment where the basis of the property sold needs to be considered. Finally, bank transfers need to be eliminated from the computation.

The net worth method takes a different approach. Here, the agent seeks to identify the change in the net worth of the combined business and its owners, which, once adjusted for nontaxable income (subtract) and non-deductible expenses (add), should align with the reported income.

The method will typically be used when there are no or incomplete records.

There are several pitfalls to the use of this method. The opening or baseline net worth needs to be established with a level of certainty. The use of cost versus market value for assets needs to be utilized. Finally, identifying the universe of non-deductible expenses, such as living expenses, is challenging at best.

Wrong facts make for inaccurate conclusions. Unfortunately, the business owner needs to deal with the cards they are dealt, and the facts and circumstances may not be ideal. The agent will produce a result which is often unfavorable to the owner. The forensic accountant will then use the knowledge from reviewing the taxpayer’s business to respond. Some of the issues that are typically dealt with include: 

Ultimately, the computation of taxable revenues utilizing any of these approaches is an estimate and will rely on assumptions, particularly where books and records are incomplete or nonexistent. The initial use of a forensic accountant to validate, investigate, and potentially assist in recreating the financial activity will give the taxpayer their best chance of minimizing the government’s findings.