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Small Business Tax Lessons from the IRS Letters

taxesIn its latest effort to boost compliance, the IRS has sent letters to approximately 20,000 small business owners requesting additional information regarding potentially underreported income. Essentially, the IRS is checking to make sure that you have reported and paid tax on all cash transactions. The IRS letters are ominously titled “Notification of Possible Income Underreporting.”

While there have been some comments that these letters imply assessments of additional tax or penalties, the IRS states that these letters do not constitute an audit, rather they are simply requesting more information in order to help close the “tax gap” – the difference between what taxpayers owe and what they pay. In the most recent data available, underreported small business income is said to total $141 billion. 

The IRS has access to detailed data about credit and debit card transactions, which it analyzes in order to pinpoint companies that may have a higher than average level of card transactions in relation to the income that is reported. A business’s credit card and cash receipts are compared with industry averages - if your company has what is considered an unusually high proportion of credit card sales, the IRS will be looking for an explanation.

There are a number of good reasons that your business may have reported high card receipts in comparison to cash. Card receipts can include any cash the customer takes back. Card receipts would also include gift card sales, which can result in a mismatch because they do not count as a sale for accounting purposes. Finally, sales tax can be the cause of the discrepancy since it is a liability and is not reported as revenue, yet would show up as a card receipt.

Work with your accountant to determine the reasons behind your higher than average credit card sales and to draft your IRS response. Your accountant should be able to walk you through the documents required and also contact the IRS to clarify any questions you may have.

Keeping the IRS at Arm’s Length
Whether you’ve received one of these letters or not, it’s a good time to look at a few steps you can take to ensure you stay out of the tax spotlight or are prepared for an audit or other information request:

  • Report All Income. This is a no-brainer, but it is one of the most common reasons for an IRS audit. Even omitting a small amount could cause problems. And don’t round things off – a lot of round numbers can be a red flag to the IRS that you are estimating rather than drawing from actual records.

  • Keep Thorough Records. I cannot emphasize this point enough - proper record-keeping is essential in case you are ever audited and need to provide back-up. Additionally, if your bookkeeping is in good order, it is an important sign to the IRS of your diligence in all relevant financial areas of your business.

  • Maintain Consistent Accounting. If you have sales under $5 million, you can choose whether you would prefer to implement cash or accrual accounting. In order to switch methods, you need to get IRS approval. If you switch on your own – or if you switch in the middle of the year – your tax return will be scrutinized.


Again, I would encourage you not to panic in light of these letters. Allow them to be a clarion call to improve and further organize your company’s accounting practices so that you can have confidence and peace-of-mind.

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