More often than not, states are using their data warehouses to identify audit candidates. Techniques like comparing gross receipts levels for both income tax and sales tax reporting or comparing your taxable sales percentage to other filers for your NAICS code are becoming standard.
What can you do to minimize your audit risk or be better prepared in the event you are selected?
In most situations, sales tax returns are prepared by the company themselves, while the income tax returns or financial statements are prepared by an outside accountant. Therefore, it is important to adjust your sales tax receipts by any monthly adjusting entries made by your accountant. If annual amounts are not equal, you will need to be able to reconcile any differences.
Examples can include:
- Tax included in bar prices but added to food sales in a restaurant/tavern business
- Differences between gift certificates sold vs. redeemed
- Miscellaneous income (for example, recovery of a bounced check, scrap sales, or fixed asset sales)
- Employee meals treated as an offset to expense on the financial statements but treated as gross receipts on the sales tax return
- Customer’s discretionary tips as compared to mandatory tips for large parties
- Gambling devices—gross receipts vs. net receipts
What happens in an audit?
So what happens when you are audited and your receipts do not tie between sales tax reporting and income tax reporting? The auditor prepares workpapers of the unreconciled difference and asks the business to explain the difference. The auditor may also compare bank deposit amounts to receipts reported. You should spend the time to review your records to explain any reporting differences at this point.
If you cannot reconcile the amounts, the auditor will assume there are unreported receipts. The auditor will then perform various income reconstruction methods such as:
- Cash receipts and expenditures method. Compares all sources of cash, both business and personal, to all use of cash, both business and personal.
- Markup method. Lists the quantity of items purchased and multiplies by the selling price.
- Bank deposits and cash disbursements method. Is an analysis of all deposits, less transfers, and nontaxable sources of funds plus all cash disbursements.
- Net worth method. Re-computes the taxpayer’s balance sheet.
Once the auditor decides to perform an income reconstruction, you are on the defensive because the auditor’s determination is presumed correct and the burden to show that the reconstruction is in error is on you, the taxpayer.
So what can you do to prevent the need for an income reconstruction?
- Always keep original source documentation from your cash register system to show daily sales by categories. More sophisticated businesses may use point-of-sale systems that provide better individual product information.
- If you have gaming machines, make sure you either do not clear the history or secure a backup of the data when the machine is reset.
- Document cash into the business (personal and bank loans) and cash out of the business (salary or member draws).
- Maintain written procedures of your daily closing process.
- Keep a log of significant product price changes (daily specials or permanent price increases).
Most governmental agencies have procedures that must be followed for auditors to initiate an income reconstruction. Therefore, it should be your focus to provide timely answers for any requests for data, procedures, or reconciliations. Carefully consider any answers you provide to the auditor concerning markups, selling price, waste, giveaways, etc. for accuracy. The answers you provide could have an impact on any potential income reconstruction procedures. Any underreported receipts for sales tax are usually deemed underreported receipts for income tax purposes. If you reach the point that an income reconstruction has been performed, it is best to involve a CPA or an attorney specializing in tax audits as soon as possible.
Just because you operate a cash-based business should not mean that your receipts are underreported. However, in practice, auditors assume so in cases when the recordkeeping appears inadequate. If you invest the time and effort to thoroughly maintain your records and document your internal controls, it is less likely that an income reconstruction will be necessary.