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Reconstruction of Income for Small Businesses

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I know what you are going to say about this even before I say it. As a small business owner you need to claim all of the income that you receive for goods and services. I know that sounds basic, but you would be shocked at what I hear during tax time. Most people believe that if they are paid in cash, there is no way to trace the income, and therefore the IRS would NEVER find out if you didn’t report it. That sounds logical, right? Maybe you are keeping your cash under your mattress and you think that the IRS will never be able to trace this amount if it comes to an audit. This article is designed to debunk that myth. Cash is a lot more traceable than you may think, and I am going to prove it to you in the following paragraphs.

I spend a lot of money on research tools. The reason for this is that if I have to research something I want to be able to not only pull the Internal Revenue Code, but I want United States Tax Court Cases, Appellate Court Cases, United States Supreme Court Cases, and other information to support my tax planning. Each morning around 4:30 am, my research software sends me changes to the tax code, Tax Court Cases that have been decided, and other things. I spend about an hour to two hours sorting through the decisions that have been made about different tax laws. I admit it…I am a tax nerd.

This morning I came upon Blessing U. Anyanwu v. Commissioner, TC Memo 2014-123. Mrs. Anyanwu was the owner of a home healthcare business, and she owned several rental properties. On her rental properties she was paid cash by the tenants some of the time, and she was paid by check the other times. She had six different properties for which she collected rent. In 2007, she filed her 2006 return listing only the checks that she received for rent as income. Because the amount of income she received was so out of whack with her expenses for the rental properties, the IRS selected her return for examination. They determined through a cash flow analysis (I will explain this later) that she had over $45,000 in income that she never claimed. Mrs. Anyanwu appealed this decision by the IRS and ended up in Tax Court, where the court sided with the Internal Revenue Service.

Reading this case this morning reminded me of the first time I represented a client before the Internal Revenue Service for an audit. My client owned a bar, and only claimed his credit card sales as sales on his income tax return. If you know anything about the bar business you know that about 30 percent of the business transactions are cash. My client told me that he only claimed the credit card sales because they could be traced and that cash couldn’t. The reason why the return was examined in the first place was that my client claimed that he made $259,000 in income and had $450,000 in expenses. This gave him a huge loss on his tax return which he offset against a large amount of other income. This resulted in my client owing less money to the IRS then he was supposed to pay.

Before we get into the particulars of this case, let’s talk about how tax returns are selected for audits. Less than 5% of all tax returns that are filed will be audited. Of those returns that are audited less than 1% are randomly selected for audit. It is a fact that the IRS just randomly selects about 100,000 tax returns each year for examination. The reason these returns are just randomly selected is so the IRS can update their DiF Scoring System. A DiF score is given to every tax return that is filed in the United States. The higher the DiF score the greater the chances of the tax return being audited. One of the factors that go into a DiF score would be economic reality. A good example of economic reality would be if you are claiming income of $25,000 and you then have itemized deductions of $30,000, how could you have possibly paid $30,000 in expenses when you had less income than your deductions? Sometimes there is a logical explanation. For instance, if you incurred $20,000 in credit card debt, then you lived on credit. Maybe you inherited some money from the death of a relative. However, more often than not, there is no explanation other than all of the income was not reported.

My client’s tax return was selected for audit due to economic reality. The IRS’s position was that he did not claim all of his income so that he could have a large deduction to offset a one-time taxable payment. During the audit the IRS did something called a cash flow analysis. A cash flow analysis takes into consideration all of your expenses. In my client’s case it was his business expenses, but it could be done with personal expenses as well. The IRS added up all of the necessary business expenses that it took the business to run. After that was done, they compared the expenses to the income that was reported. If there is a difference, they ask for documentation such as loan agreements, credit card statements, proof of inheritance, or any proof of non-taxable income. If you don’t have that then they increase your income by the amount that you should have claimed, and assess tax on that amount. In my client’s case he couldn’t document $85,000 worth of cash, so they classified it as income and assessed tax on it. He didn’t deposit this money, but the IRS found it. Some people actually deposit the excess cash into a bank account and claim another number as income. This can be easily discovered by just adding up the deposits to the bank.

I didn’t prepare my client’s tax return, I just represented him before the IRS. I would have never filed a tax return showing that much of a loss without asking a lot of questions.

As I stated in my intro, I know what you were thinking: “Of course he is going to say claim all of your income, even cash.” I did say that, but not because I have to, but because cash is more easily traced than you may think.

Craig W. Smalley, E.A., C.E.P.®, C.T.R.S.® has been Admitted to Practice Before the Internal Revenue Service, is a Certified Estate Planner™, and a Certified Tax Resolution Specialist™. He is the managing partner in the nationally recognized firm CWSEAPA®, LLP that is headquartered in Wilmington, Delaware with offices in Delaware, Florida, and Nevada.