[1]The IRS has previously issued an Audit Techniques Guide [2] (ATG) for examinations of cash intensive businesses. The IRS noted in the ATG that many cash intensive businesses have weak internal controls, lack an audit trail, and have inadequate books and records. As such, the IRS emphasized that an examiner’s focus should be on probing for unreported income.
Cash Businesses
In the IRS’s view, a cash intensive business is one that receives a significant amount of receipts in cash. Examples include restaurants, convenience stores, hair styling salons, bail bonds, car washes, scrap metal dealers, and taxicabs, basically, businesses which handle a high volume of cash transactions. Industry practice may also support a cash intensive business, the IRS observed; noting independent contractors in the construction trades and trucking are often paid in cash.
Misappropriated Cash
The most likely evasion method for a cash intensive business that does not report its full income is to skim cash prior to its entry in the accounting system, the IRS noted. This can be done by failing to deposit all of the funds, failing to use a cash register to record sales or failing to report an income stream. The result is that the books will reconcile to the return and the bank deposits, but income will be missing. The IRS also noted that cash may also be misappropriated by a taxpayer stealing it after it has been recorded. Another method to misappropriate cash is to create a fraudulent disbursement.
The IRS also identified some red flags for misappropriation of cash from a business, such as taxpayers living lifestyles that cannot be supported by the income they report. Other red flags include a business that continues to operate despite losses year after year, with no apparent solution to correct the situation; and unusually low annual sales for the type of business.
Observations
The IRS instructed agents to observe how cash payments are made and how they are handled by the taxpayer. This includes spending time watching the procedures at the taxpayer’s cash register, comparing the cash register tapes from the day the register was observed to the tapes for the audit period and matching the taxpayer’s statements, cash register records or reports, against the findings.