Bookkeeping

by Michael Hale Daily Notes

In a recent IRS audit I was talking to the auditor about different industries, and methods used when they are selected for examination.  Two different types of businesses that we discussed were Chinese Restaurants and Massage Parlors.  The methods used to calculate income for these industries shows the unique thinking of the Internal Revenue Service.

On the Chinese restaurants, since so many records are kept in Chinese and they are such a family run operation, they contacted the company that provided the fortune cookies to the restaurant.  They figured that each customer that went to the restaurant received a fortune cookie after they were done eating and presented with a bill.  The IRS figured what the average price of the meal was per person, multiplied by the number of fortune cookies purchased, and calculated the years gross income to the restaurant.

On the massage parlor, the IRS verified the receipts from the laundry that serviced the linens for the parlor.  Once the IRS determined the numbers of towels and sheets cleaned by the service during the year, and determined the average price for a massage. the yearly income was calculated.  This accounted for any customers that may have paid in cash and the business forgot to report.

These methods of reconstructing income are what is called indirect methods of proof, and have help up in court to be a sound method to arrive at gross receipts when adequate books and records are not available. Keep in mind also that if the records used to prepare your tax returns are of such poor quality that the returns prepared from them are not accurate, the IRS can attach up to a 40% penalty of additional tax for the inadequate records penalty.

Know your business, maintain accurate books and records, stay in tax compliance, use planning to lower any possible tax liability, and respond to any IRS notices you may receive.

So you received a letter from the IRS, maybe even certified. Do NOT have a heart attack or loose sleep over this letter. Review the information, know where you stand, and respond with a sound plan to resolve the issue.  There are a series of letters that the IRS (Internal Revenue Service) will send to you before an actual person is assigned to meet with you.  One of these is a letter called the CP2000. (I will be discussing other letters in future posts).

What this letter means is that when you filed your original return you forgot to report some income and they have sent you this notice telling you what you forgot and what you now owe (called a summary of proposed changes not an actual assessment) when they added this income to your return.

For example: on a recent notice the IRS told my client he owed an additional $48,000 in tax because of this additional income (in this case income from stock sales that had been inherited). What the IRS failed to take into account was the basis for the stock that was sold, and eventually resulted in a loss for this client and a refund once the return was corrected.

Just because the IRS sends you a letter does not always mean you have an additional liability.  They are a large business, and are accurate most of the time, but it is your responsibility to be sure what they are stating is accurate.  Review their correspondence, know where you stand, and if in doubt consult a tax professional before agreeing to these additional tax increases. Know your rights and treat the IRS in a professional manner and they will be more than willing to explain items to you or your representative.