Small businesses targeted by IRS for underreporting cash payments

Many small business owners may feel that they are in the cross hairs of the Internal Revenue Service. Since last fall, the agency has sent out 20,000 letters to small businesses seeking more information related to "possible income under-reporting" of their business receipts.

A 2008 change in the law allowed the agency broader access to credit- and debit-card transactions. Mining the data has allowed the IRS to reach industry averages for card versus cash payments. If a small business reports that 90 percent of its receipts are card-related, but the industry average is 75 percent, it could raise a red flag.

Many businesses in different industries have received the letters. One example was a baking supply company that received a letter stating, "A larger amount of noncard revenue would be expected." Eighty percent of the previous year's annual revenue was through credit card transactions. In response, the business owner detailed how a change in the firm's business model to online sales had resulted in a larger proportion of credit card sales.

Another way the IRS is seeking to close the "tax gap"

For many years the IRS has sought to close the so-called "tax gap," which amounts to the difference between what Americans owe and pay. Enforcement efforts have targeted offshore account holders and now small businesses.

The IRS estimates that a substantial chunk of the $450 billion "tax gap" may come from underreported small-business income. The idea behind the letters is that businesses with "an unusually high portion" of credit card sales could be underreporting cash transactions as a way to avoid paying business taxes.

The premise behind the investigations fails to take into account the reality that most purchases are made with plastic. From credit card rewards programs to ease of use on the internet, most consumers utilize credit and debit cards more than cash for purchases.

Responding to an IRS request

A typical letter may have the headline "Notification of Possible Income Underreporting." The time to submit a response is generally 30 days. This means there is very little time to investigate the issue and respond. If revenue was underreported, a business could be subject to an assessment of additional tax, penalties and interest.

Many reasons exist to explain a higher percentage of card transactions or discrepancies between reported revenue and card payment data. One common reason might be sales tax, which is not included as revenue.

When you receive a letter from the IRS related to your small business tax return, contact a tax attorney to discuss your situation. Filing a response before the deadline outlined in the letter is important, but may not provide much time for review of your individual circumstances. Contacting a business tax attorney early in the process may be one way to avoid a more extensive audit or possible civil penalties.

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