By Alan Pinck, EA & Ann E. Kummer, EA, CPA/ Published Nov/Dec 2014 / EA Journal
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If your practice includes audit representation, you may encounter a situation in which you are representing a client with a cash-intensive business. If you prepare returns for business clients, you should know this process as well. You will find these are quite unlike typical audits; the auditors are generally much more prepared and organized than in other audits. You will detect the inherent assumption by the auditor (and, by extension, IRS) that the taxpayer did not report all income. Consequently, the auditor approaches the examination with that belief. The auditor’s goal, therefore, is to substantiate it.
This is an area the IRS believed its auditors needed guidance in, so they developed the Audit Technique Guide (ATG) for it. In the event you are engaged in a case involving such a business, be sure to read this guide, as it will help you understand why the auditor is asking for information not typically requested in other types of examinations.
The key to effectively representing your clients is to know as much about them and their business as you can. Anticipate problem areas with some legwork ahead of the exam appointment.
- Prepare a cash T-analysis (described in the ATG). Be sure that the auditor will already have prepared the analysis using national industry standards. By having the actual numbers, you can determine whether you have an issue and how large it may be. Having previously discussed those issues with your client will help you refute or explain discrepancies during your interactions with the auditor.
- Observe and absorb the business operations. Spend time in the business, watching the day-to-day transactions and interactions, as well as understanding all that is involved. You should be able to con- cisely explain what services are provided or products manufactured and be able to knowledgeably describe all business func- tions, especially the financial areas.
- Consider having the taxpayer present at the interview. As a rule, I do not have the client present during the interview process, but, in this type of audit, it may be beneficial. Having the client present may help expedite the interview process as he or she will be able to best explain the inter- nal controls of the operation. As much as we interview our clients to prepare for the audit, we cannot always think of every question the auditor may ask. If you decide to do this, schedule the business walk- through at the same time as the interview to limit the client’s exposure to the auditor. Be sure to prepare your client well so that he or she understands the process and the extensive questioning that will occur. People have a habit of providing too much information and not keeping their answers on point, so beware. Not every client is a good candidate for this option, so contem- plate this choice carefully.
- Do your homework. As previously mentioned, the auditor will have done his. Know all the client’s assets, both business and personal. Learn about the client’s prior business history, both in the current industry and in other dissimilar businesses. Th ese can be indicators that the client may be hiding something. For example, if the client was successful in a manufacturing business and is losing money or breaking even in a liquor store business, there will be an assumption that not all income is reported. A good business person will tend to be successful in other ventures. All industries have average costs, and the auditor will be familiar with those for the business in question. If your client is not in line with industry averages, be prepared to explain why.
The auditor will be scrutinizing everything for signs that your client has underreported 25 November
December 2014 income. One such mark is a lack of proper internal controls. The more levels involved, then presumably, the more control there is, thus decreasing the opportunity to underreport income and circumvent the system. The auditor will examine how many people (and who) have access to the cash register, who counts the cash at the end of the day, who makes the deposits, who books the receipts to the ledger, how overages and shortages are accounted for, and the list goes on.
Another method of evaluation the auditor will employ is to compare purchases with sales. Do not be surprised to learn the auditor has summonsed a supplier for all invoices to perform a comparison between supplier records and taxpayer ledgers. The auditor will use a percentage markup approach to be sure the income is reported correctly. For example, if the audit involves a laundromat, the auditor will compare the number of gallons of water used per wash to the number of gallons of water used in a water billing cycle. For a bar or tavern, the auditor will evaluate the number of bottles purchased, the number of shots per bottle, and the average cost of drinks.
The auditor will prepare a bank deposit analysis (BDA), and any overages and shortages will need a detailed explanation. Shortages in a cash business will trigger more questions, since they may indicate that not all income was deposited. If so, it will fortify the auditor’s suspicion that not all income was accurately reported. If there is a reasonable explanation for the shortages, be sure to have as much supporting documentation to illustrate it was reported.
Conversely, you will need explanations and support to explain any overages in the BDA. If your client obtained loans, all the documentation should be available for the auditor. If the loans were from private parties or family members, they will be subject to higher scrutiny. If you are not in the habit of preparing your own BDA for this type of audit, you should incorporate this practice into future cash-intensive business examination engagements in order to have answers to these questions, because they will be asked. The ATG mentioned earlier goes into great detail with regard to loans sourced from off shore family members. Auditors are interested in the original currency, the conversion rate used, and, of course, observing that the proper FinCEN declarations were made.
While your client’s business history is meaningful, so is her concurrent business activities. The auditor will also investigate whether your client currently operates any other businesses. There is a theory that taxpayers in cash businesses tend to favor other cash businesses. The client may not believe he or she has another business as it is “casual.” For example, the client with the convenience store may also buy and resell used cars, or perhaps she likes to purchase items at garage sales and then resell them at the local flea market. As these are oft en handled solely in cash, the client may perceive these transactions as unreportable and not as the additional business ventures they truly are. How about that hobby that generates a little income? In a typical audit of your average tax client, you would not think to look into this as deeply, but the ATG reminds the auditor to explore these areas. You should, too.
When we think of a cash-intensive business, we do not always take into consideration the underground economy. I am not necessarily referring to illegal activities but to the “temporary laborer” or local handyman. You may observe this in your practice, perhaps with a client who may not appear to make much money in his job but has managed to accumulate assets. Possibly you will see this when representing a client with what appears to be only moderate W-2 income, yet she owns three rental properties. These observations should trigger a conversation between you and your client; rest assured the auditor will likely stumble upon this and open up a whole other issue. As practitioners, we need to work with our eyes wide open so that we can foresee what may be coming next.
Things to Consider
In the event that the audit does not go well and you intend to go further to Appeals, be sure to do an FOIA request. The FOIA request will yield you both the work papers and the auditor’s notes, among other documents and support. The information provided in response to the FOIA request could be invaluable at deciding whether to proceed to Appeals and while in Appeals, as you will know on what basis the auditor made his decisions.
Although in most cash-intensive businesses there would not be many sales that would warrant the filing of Form 8300 (Report of Cash Payments Over $10,000 Received in a Trade or Business) for cash transactions of $10,000 or more, we need to be mindful of the requirement. This will be something the auditor will be looking for if your client is in a business that deals in high-dollar cash transactions.
When taking on this type of engagement, you must be prepared to be patient and to let it take its course. These are not simple cases, and they take a considerable amount of time and organization. Be upfront with the client and make him or her aware that the auditor is going to start with the assumption of unreported income which he’ll be searching to identify. No stone will be left unturned. Be sure to stay on top of every request and provide it in a timely manner; any delay will be thought of as a lack of records.
Most importantly, understand your client’s business so that you can prevent the necessity of a meeting between the auditor and the taxpayer. These are challenging cases to work on, but they can also be very gratifying and enlightening when you successfully represent a client with a cash-intensive business under IRS scrutiny.
About the Authors:
Alan Pinck, EA, has more than 25 years of tax preparation experience in the San Francisco Bay Area. He has built a practice specializing in individual, small business tax preparation, and audit representation.
Ann E. Kummer, EA, CPA, is the tax manager at Kirshon & Company, P.C. in Poughkeepsie, New York. She has nearly two decades of experience in tax preparation and representation.
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The following are sources for you to use when researching industry standards: www.bizstats.com, Dunn & Bradstreet, Robert Morris & Associates periodicals, and Bureau of Labor Statistics (www.bls.gov).