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.