Cash intensive businesses
Operating a cash intensive business is often accompanied by poor record keeping as well as the lack of any meaningful internal controls. These two factors make it difficult, if not impossible, to determine the taxpayer’s operations, financial condition, and most important, whether the taxpayer’s tax returns are true and accurate. Where tangible evidence concerning the taxpayer’s business is absent, an IRS agent will have to rely on the oral testimony of the taxpayer as it relates the financial information contained in the taxpayers returns in order to determining whether the taxpayer’s testimony is credible.
A taxpayer, who is not represented by an attorney, is at a clear disadvantage when the IRS comes calling. A nervous response or responses to confusing questions may result in the examiner forming a negative opinion of the taxpayer and a decision to expand the scope of the examination or make a criminal referral. A taxpayer operating a cash intensive business should never submit to an IRS interview without the presence of an experienced tax attorney.
IRS examination of a cash intensive business entails:
- Conducting an initial interview of the taxpayer to determine how cash is handled from the time the income is received to the time the income is deposited into a bank account or spent. This is a painstaking process where the IRS agent tries to understand the taxpayer’s business cycle and the identity of the individuals involved in handling the cash. The taxpayer has to explain in detail the mechanics of cash handling. This involves each step in the process including collection of gross receipts from every source and the manner in which cash sales are recorded.
- Preparing a cash flow chart reflecting the time cash is received to the time it is placed in the hands of a third party. The flow chart will also contain the names of each individual who has contact with the cash at each point. Following its preparation, the agent will ask the taxpayer if the flow chart is correct. The above process will likewise be applied to cash disbursements. An agent will want to know who is authorized to pay cash and where the cash comes from. Where expenses are paid in currency, the agent will inquire as to how the expenses are recorded, whether a receipt was retained, whether the transaction was entered into books and an explanation as to how the disbursement is included in determining net income or a net loss.
- Determining whether the taxpayer has an accounting system in place, and if so, who is responsible for maintaining the records. This a critical part in the examination. The examiner will ask about cash-on-hand that the taxpayer has access to, including funds available from friends or relatives. The agent is required to explain to the taxpayer that cash-on-hand includes pocket money plus cash in a safe or other location, and cash held in trust by others. The taxpayer’s responses to the agent’s questions will be taken down in detail and often times are accompanied by actual quotes from the taxpayer.
- Developing data related to the taxpayer’s business and related businesses and determining whether any related party transactions exist. The IRs agent will ask about any recurring losses that are reflected on the taxpayer business or personal returns and attempt to determine what caused the losses and whether any remedial action has been taken by the taxpayer.
- Careful scrutiny as to whether the taxpayer is commingling funds from his business accounts with his/ her personal bank accounts or his/ her immediate family member’s bank accounts. In this regard, the agent will inquire about the existence of any bank or personal loans, accounts payable and other borrowed funds as well as personal loans made to or from family members.
With all the scrutiny and complexity embedded in cash intensive businesses by the IRS, operating a cash intensive business presents significant risks in terms of the tax and potential criminal consequences. If you operate a cash intensive business and have been notified of an IRS examination, it is important that you immediately seek the advice of an experienced and knowledgeable tax attorney prior to ever speaking with anyone. In some cases, IRS agents will show up at the taxpayer’s place of business or home, in an attempt to catch the taxpayer off guard. Should this happen to you, you should always refrain from answering any questions and ask to have an attorney present.