A recent Tax Court decision highlighted all of the things that business owners shouldn’t do if they want to stay out of trouble with the IRS. Let me share some of the actions by business owners in this case so you can avoid the problems they incurred.
Two people owned two nail salons and agreed to split the profits 50-50. So far so good. Their business model was to pay workers a salary and let them keep all their tips. Again, sounds normal. But t he IRS suspected that they weren’t reporting all of their income. A single Schedule C income for 2007 showed $37,000; in 2008 one owner reported $38,000 and the other $44,000. The IRS wanted to take a closer look. Here’s where problems arose.
They didn’t keep books and records, or at least not good ones. They claimed all their income was from credit card receipts and checks; they said they were never paid in cash. (I don’t know about you, but I see many nail salon customers paying in cash.) The IRS used what’s called the “bank deposit method” to figure their real income. As a result, the IRS said their income was about six times as much for 2007 and about three times as much for 2008. During the audit, the owners refused to provide the agent with any records at all.
At trial, acting pro se (without representation) the owners didn’t help their case. For example, one owner testified that an amount in the bank account was a cash advance, which obviously isn’t income. But he didn’t show the credit card statement that would be evidence of this. And they made other arguments about the income that simply weren’t believable.
The result: A civil fraud penalty against one of the owners (the other was just following directions) in addition to back taxes, interest, and an accuracy-related penalty for both owners. They severely understated their income, failed to keep books and records, and failed to cooperate with the IRS. And they represented themselves.
The lesson for us all: Don’t do what these owners did. Instead, to state the obvious, do this:
- Report all of your income (even if paid in cash).
- Keep good books and records.
- Cooperate with the IRS during an audit.
- Bring in a tax professional to help.
Note: Despite the fact that audit rates are low and not expected to increase in the near future, Schedule C filers continue to face higher audit rates than other taxpayers. Those operating businesses receiving payment in cash (bail bonds, convenience stores, laundromats, car washes, and other cash-intensive businesses) should review the IRS audit guide for its agents on cash businesses to see what piques the government’s interest.