TAXLITIGATOR – Tax Controversy (Civil & Criminal) Report

IRS Audit or investigative techniques for a cash intensive business might include an examiner determining that a large understatement of income could exist based on return information and other sources of information. A cash intensive business is one that receives a significant amount of receipts in cash. This can be a business such as a restaurant, grocery or convenience store that handles a high volume of small dollar transactions. It can also be an industry that practices cash payments for services, such as construction or trucking, where independent contract workers are generally paid in cash.

The IRS has long been interested in business operations that receive most of their income in cash. Since certain businesses do not always deposit all of their cash receipts, the Cash Intensive Business ATG provides various methods by which an examiner may be able to reconstruct total gross receipts and expenditures. Cash transactions are believed to be anonymous, leaving no trail to connect the purchaser to the seller, which may lead some individuals to believe that cash receipts can be unreported and escape detection. Cash can be misappropriated cash from a business by being skimmed from receipts and pocketed before it is recorded. If this happens it will not be discovered by auditing the books. It can be stolen after it has been recorded by being removed from the cash register or goods stolen from the shelf for future resale. A fraudulent disbursement can be created such as a payment to a vendor that is actually cashed by the owner.

Pattern of Losses. A significant indicator that income has been underreported is a consistent pattern of losses or low profit percentages that seem insufficient to sustain the business or its owners. Other indicators of unreported income include 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 apparent solution to correct the situation; a Cash T shows a deficit of funds; bank balances, debit card balances and liquid investments increase annually despite reporting of low net profits or losses; accumulated assets increase even though the reported net profits are low or a loss; debt balances decrease, remain relatively low or don’t increase, but low profits or losses are reported; a significant difference between the taxpayer’s gross profit margin and that of their industry; and unusually low annual sales for the type of business.

If the examiner believes the business may not be reporting all of its income, the examiner may issue a summons to suppliers and other third-parties for records of sales or deliveries to the business, including original purchase invoices, during the period under examination. The examiner may then mark-up the purchases by a reasonable amount based upon ATG industry standards to determine what are known as the audited sales for the business. Absent a reasonable explanation for a discrepancy between audited sales and reported sales, the IRS will determine income tax adjustments (and maybe penalties) based upon the discrepancy.

Interviews. The examiner will formulate interview questions based on the preliminary Cash-T information, and, at the initial interview, the taxpayer may respond that no loans or gifts were received nor was a cash hoard maintained. When questioned the some taxpayers respond that unexplained deposits or cash represents loans and gifts from relatives who may live outside the United States although there are no records to support the claim that the amounts are loans or gifts, except a copy of a letter from a relative stating that the relative gave the amounts at issue.

If the examiner believes the unexplained amounts represent unreported income, the ATG advises the examiner to ask the taxpayer for the specific dates and amounts of the currency received from friends or family – a vague and self serving letter from a friend or relative is not likely a sufficient response. The examiner will inquire about exactly how much currency was received on each specific date. Was it U.S. currency or foreign currency? Can the loan be verified by any other source? Can the lender show it was withdrawn from their bank on that date? Were FinCEN forms filed if currency was brought into the country? What day did the taxpayer get the money?  How much did the taxpayer receive on that day? What did the taxpayer do with the money that day?

The examiner will ask for the name, address, telephone number of each person providing cash loans and inform the taxpayer that the examiner will be contacting these individuals for proof, including requesting copies of their tax returns or other documents. How the foreign currency was converted to U.S. currency? Where did the lender convert the currency? The examiner will ask for a copy of the exchange receipt issued by the bank or whomever exchanged the foreign currency for U.S. currency. If the lender converted the currency and brought it into the U.S., the examiner will request a copy of their passport showing entry to the U.S. on that day. If the taxpayer converted the currency, the examiner will request a copy of the exchange receipt.

The examiner is advised to get specific information from the taxpayer and that the taxpayer must have records of this, because if currency was received, the taxpayer would know how much it was. If it is a loan, the taxpayer would typically know amounts borrowed so they can pay it back. They will need to know when it was borrowed to calculate interest. If the taxpayer cannot provide specific information the examiner is advised that they should question the credibility of the statements. This questioning is often intensive and highlights inconsistencies if the cash loans do not exist.

Specific dates and amounts are important, because a large cash expenditure in January can’t be explained by a trip to a foreign country to obtain cash in March of the same year. The examiner should consider issuing an IDR to obtain this information. If the taxpayer has sufficient detailed information, the examiner is to summons the lenders or cash donors for an interview and additional documents would be appropriate. Also, summonsing bank records for the specific deposits would be appropriate.

When foreign currency is given by gift or loan, exchange rates can be found for the transfer dates. If they were not favorable, it is unlikely a friend or relative would have exchanged the currency at that time unless it was absolutely necessary. And, if it was absolutely necessary, the money would go into the bank or into the business immediately. If the amounts in issue are asserted to be a loan, the examiner is advised to inquire about repayment and how interest is calculated. The loan will have occurred in the examination year, and by time of the later examination, the taxpayer should have paid some of it back. If the taxpayer is repaying by taking currency to the foreign country, the examiner will ask for the same type of specific information (exchange receipts and copies of their passport, etc.). Does the business show enough profit to be able to pay back loans on those dates If only one payment is made during the year, it would likely be a larger than normal loan payment. Can withdrawals be found in the amount claimed to be paid back? Examiners are advised to analyze the cash in and cash out for the week of the repayment.

Examiners are to interview the lenders and review their tax returns. They will inquire about the specific dates and amounts provided to the taxpayer? Was it foreign or U.S. currency? Who converted the currency to U.S.? When? Where? What records do you have to prove this? What records do you have to guarantee the money will be repaid? Have any repayments been made? When? Where? How much? If not, why not? They will ask to see copies of their passports to show they traveled into the country when they say they did and copies of their bank withdrawals if money was withdrawn to lend to the taxpayer. It is possible that, when face to face with the examiner, the lender will make statements inconsistent with the taxpayer’s statements or give some evidence that they did not really have the ability to make these suggested loans.

Typical Interview Questions Addressing Accumulated Funds. Taxpayers often assert that unexplained amounts represent accumulations of wealth over a period of time. Common interview questions include whether the taxpayer keeps more than $1,000 on your person, at your home, at your business, or in any other location? What do the accumulated funds consist of? (For example, paper money, coin, money orders, cashier checks, etc.). In what denominations were the funds accumulated? Where are the accumulated funds maintained? How long have the accumulated funds been kept in the foregoing location? What kind of container were the accumulated funds kept in?

Further questions could include how much accumulated funds did the taxpayer have on hand at the beginning and end of the year under audit? How much in accumulated funds does the taxpayer have on hand presently? Over what period of time were the funds accumulated? Do the accumulated funds solely belong to the taxpayer or does it belong to more than one person? Identify each person having ownership of these accumulated funds. Do any of the other owners have access to these accumulated funds? Identify the increase or decrease in accumulated funds for each access. Identify the type of records kept to identify the name(s), date(s) and effect on the accumulated funds each time there was an access.

Why were the funds accumulated and not deposited in a financial account? What is the original source of the money included in the accumulated funds? How often are the accumulated funds accessed? What is the effect of each access? Are there additions or withdrawals from the accumulated funds? Was the taxpayer accompanied by another individual when the accumulated funds were accessed? If yes, provide the name and address of the persons involved. Does the taxpayer count the accumulated funds every time they are accessed? If not, provide the dates and purpose for when the funds were counted. Does anyone else know about the accumulated funds? If yes, provide the name, relationship, address, and phone number for the person. Also determine whether these persons have access to the accumulated funds and if so, the manner and circumstances under which their access was made.

CORY STIGILE – For more information please contact Cory Stigile, Esq. (CPA) at CS@taxlitigator.com or 310.281.3200. Mr. Stigile is a tax principal at Hochman, Salkin, Rettig, Toscher & Perez, P.C. and represents clients throughout the United States and elsewhere involving federal and state, sensitive and complex civil tax examinations and administrative appeals, criminal tax investigations as well as in civil tax litigation. Additional information regarding Mr. Stigile and the firm practice of  Hochman, Salkin, Rettig, Toscher & Perez, P.C. is available at http://www.taxlitigator.com.