The purpose of this article is to explore the methods for analyzing cash-based businesses.  We will explore techniques for uncovering unreported income.  I will take you into the new digital world for hiding cash transactions through cellphone transfers, EFTs, PayPal, and WebMoney.  We’ll discover how barter and bit-coins are finding common alliances.  Reference is made to the IRS Auditors’ Study Manual known as the Audit Technique Guide.  So strap yourself in and prepare to learn something about cash-based businesses.

What is a cash-based or cash intensive business?

A cash intensive business is one that receives the majority of its revenue from a non-traceable source, such as, cash currency, money orders, barter, or some form of digital cash.  Non-traceable means there is no way of tracking it “into” or “out” of the business (unless it was  properly reported on the books).  Herein lies our dilemma.  How do we as tax professionals exercise “due diligence” in determining the proper reporting of income? 

Every business has procedures, books, and records and that is a good place to start.  You must determine what your taxpayer is reporting in order to run comparisons.  So you need to ask your taxpayer questions about their books, records, and procedures.  The only way to understand the taxpayer’s record keeping system is to have them explain it to you.  Once you have the taxpayer’s figures and an understanding of how they were determined, you are ready to apply some indirect methods for determining accuracy.

You might be asking “Why is this my job?”  I am not being paid to audit the taxpayer.  You are right!  You are not being paid to do that, but under Circular 230, §10.22, you are asked to verify the accuracy of the information appearing on the tax return that you prepare.  Are we now auditors?  No, but we are verifiers. This became one of those subtle changes that Circular 230 dropped on us about 4 years ago, when we went from being preparers to verifiers of the taxpayer’s information.  So where do we go from here?

Signs and Indications of Unreported Income

What are we looking for?

The most recognizable form of unreported income is seeing a consistent pattern of losses or low profits that clearly are not sufficient to sustain the livelihood of the business or its owners.  An example of these cases is listed below:

• A life style or cost of living that can’t be supported by the income reported.
• A business that continues to operate despite losses year after year, with no additional income or infusion of capital.
• A Cash-T Analysis that shows less income coming in than money spent during the year.
• Bank balances, debit card balances and liquid investments increasing annually in spite of low net profits or losses.
• Accumulated assets increase even though the reported net profits are low or a loss.
• Debt and credit card balances decrease, remain relatively low or don’t increase, while low profits or losses are reported.
• A significant difference between the taxpayer’s gross profit margin and that of their industry.
• Unusually low annual sales for the type of business the taxpayer is running.

Ways a Business Under-reports Income

Cash transactions are anonymous, leaving no trail to connect the purchaser to the seller, which may lead some individuals to believe that cash receipts can go unreported and escape detection.

There are three main ways to misappropriate cash from a business:

• It can be skimmed from receipts, for example, pocketed before it is recorded.  If this happens, auditing the books will not reveal it.
• It can be stolen after it has been recorded at the point-of-sale, for example, cash removed from the cash register or goods/inventory that are taken out of the business.
• A fraudulent disbursement can be created, for example, creating a payment for a supplier that is actually switched and cashed by the taxpayer or a relative.

Is There Anything Obvious to Us?

Remember the fact, that the taxpayer does not want to be discovered or caught in this unlawful act, but there are ways he/she does stand out in plain sight.  So let’s mention a few of these:

• Living in an affluent area that does not add-up to the income they report.
• Buying new vehicles or jewelry that they cannot afford on their income.
• Taking expensive vacations that should be outside of their price range.
• No recent influx of funding from inheritance, gifts, or trust funds.
• Living a life-style that most people in their income position could not afford.

How do we Uncover Unreported Income?

Comparative Analysis & Ratios

Comparative analysis can be as simple as dividing sales taxes paid by the sales tax rate.  For example, if the business paid $14,282 in sales tax for the year and the rate is 7%.  By dividing the 7% into the sales tax paid this should get you back to gross sales of $204,028.57.  If the taxpayer only reported $172,000 in gross sales, we have a discrepancy.  Some taxpayers do not think analytically and can be caught with “their hand in the cookie jar”.  Other analysis may require going to the Bureau of Labor Statistics for statistical information before calculating a gross profit percentage.  If this term sounds familiar, it is.  You use the same process for Installment Sales on Form 6252.  The Audit Technique Guide is full of comparative analysis ideas if you want to learn more.

Charts and Other Ideas

The most common chart is the “Cash-T Analysis” which IRS uses quite regularly in audits these days.  The large ”T” which shows cash received on the left-side as debits; and then cash expended on the right as credits.  If you work with accounting it’s like running a Trial Balance. If your expenses are larger than your cash received; you could be dealing with unreported income, unless the taxpayer received non-taxable gifts or inheritance (child support, VA compensation, loan proceeds, cash advances, or other non-taxable funds).  Other charts include Net Worth Analysis or just plain old Bank Deposit Summaries for the year.

Electronic Money and Digital Cash

The New Non-Bank Accounts

For those of us over age 50, banks have always been involved with monetary transactions including checking, savings, travelers & cashier’s checks, credit & debit cards, and even wire transfers.  In today’s world, things have changed.  We look at Electronic Funds Transfer (EFT), e-money, electronic cash, digital currency, direct deposit, PayPal, and E-gold funds.  So how does this affect us?  Electronic money and digital cash allow many transactions to go undetected by the banks.  So why should this matter?  Simply put, our tracking has always been done with banks.  This is no longer the case since funds are now transferred through cellphones, anonymous money orders and wire transfers, PayPal (into and out of 103 countries/regions), and even from stolen credit cards.  Users can hide their identity and transact cash transfers from a position of anonymity.  Even Western Union which is low tech can provide the anonymity from the IRS.

E-gold lets anyone fund an account with cash or a cashier’s check. The funds can be moved to other digital accounts or used for payment without revealing the payer’s identity.  It can have an untraceable check issued to a payee in any currency or be transferred to a debit card and then withdrawn anonymously at any ATM.  This takes a cash business to a whole new level.

Digital Currency

Since digital currency is not issued by a sovereign government or country is has never been elevated to the status of “legal tender;” however, on the internet it exists as a form of payment much like “barter.”  In fact to establish its value, you must use a barter technique to figure its worth.  What is the value of the “service” being-paid-for with this digital currency?  This is the same way you determine the value of barter.

Let’s look at an example.  The most common internet currency today is the “Bit-coin.”  If you were to trade 30 million Bit-coins for a $3,000 used vehicle, you would divide the 30 million by $3,000 to establish a value of 10,000 Bit-coins = $1.  If you were reporting this transaction for a business on their tax return, you would use the same valuation method.  You might be smiling while thinking, this is not any of my customers, but at least you know how it works.

Parting Remarks

I hope you will take the time to look into the entire ‘Audit Technique Guide’ for Cash Intensive Businesses.  It can be found on irs.gov along with a myriad of other audit topics.  Someone took the time to file a Freedom of Information Act request thus opening these guides for our inspection.  Don’t overlook this valuable resource the next time you are called on to represent a taxpayer in an audit.  You have the oppositions “playbook.”  Use it!

Appendices, Bibliography, & References

IRS Publications & the Audit Technique Guide for Cash Intensive Businesses

Reference material applies to pages 1-4.

© Ben A. Tallman EA

May 2015