Income reconstruction audits of cash businesses are a focus

March 19, 2018|Brad Sweet

Implementing sound recordkeeping practices and having a good grasp of potential audit methods can ensure you’re reporting properly and could help you avoid exposure.

Over the past few years the Wisconsin Department of Revenue has increased its focus on ensuring businesses dealing with cash are properly reporting income. In fact, the revenues generated from these audits has led to the department designating an entire unit of auditors for compliance in this area.

Take a look at your recordkeeping practices, especially if you’re subject to an audit involving methods of income reconstruction. If at the initiation of an audit it is determined that your recordkeeping system is not sufficient, or gross receipts appear to be underreported, an auditor may choose to reconstruct your business’s gross receipts to verify what was reported or to help determine unreported income. Various methods of income reconstruction may be used to corroborate their findings.

Recordkeeping

In general, the statute of limitations for a return-filing taxpayer is four years from the non-extended due date of your income or franchise tax return or the date the return was filed, whichever is later. Records must be accurate so that income and deductions can be verified. These records may include sales invoices, cash register reports/tapes, bank statements, vendor purchase invoices, check registers, contracts and more.

State law requires that your alcohol beverage and/or cigarette license be kept on the licensed premises and purchase invoices for beer, liquor, alcoholic beverages, cigarettes and other tobacco products are to be kept on-site for two years. Failure to do so can result in inventory confiscation and/or prosecution.

Income reconstruction audit methods

The mark-up method uses purchase records and profit percentage markups to calculate what sales should be if all inventory items purchased during a period were sold at their retail value.

For example:

A restaurant purchases a twelve-pack of beer, twelve burgers, a pack of hamburger buns and a bottle of ketchup. The analysis may show the following results:

Purchase item Cost Items for sale Sales price/item Sales
 Beer $9.99 12 $2.75 $33.00
Burgers $12.75 12 $4.25 $51.00
Buns $5.25 0 $0 $0
Ketchup $2.99 0 $0 $0
Totals $30.98     $84.00

In this example the markup ratio would be 271% (84/30.98). Total food and beverage costs for the audit period would be summarized and the markup ratio would be applied to determine the amount of sales that should have been reported. Any unreconciled differences would be considered unreported income.

  Calendar year-end (CYE) 12/31/2016 CYE 12/31/2017
Total food costs $55,250 $63,175
Total beverage costs $84,760 $89,970
Total costs subject to markup $140,010 $153,145
Markup ratio 271% 271%
Sales based on markup $379,427 $415,023
Less reported sales $325,150 $385,885
Unreported sales $54,277 $29,138

The bank deposits and cash expenditures method compares bank deposit analysis over the audit periods to the total reported income for those same years. The analysis would remove items from bank deposits that are not taxable or represent duplicity, like transfers from one bank account to another. On the other hand, the analysis would add items like cash payments for cash that may have never made it to the bank. Any unreconciled differences would be considered unreported income.

For example:

  CYE 12/31/2016 CYE 12/31/2017
Deposits to bank account ending 8895 $225,000 $350,000
Deposits to bank account ending 3566 $168,000 $178,250
Less transfers from 3566 to 8895 $73,250 $19,785
Less loan from ABC Bank $2,500 $125,500
Add cash payments to Supply Inc. $67,500 $32,175
Subtotal $384,750 $415,140
Less reported sales $325,150 $385,885
Unreported sales $59,600 $29,255

The receipts – expenditures method summarizes and compares all sources of receipts against all expenses. If the expense totals are greater than the receipts, the question arises, “Where did the money come from to pay for the excess expenses?” The auditor will assume that the expenses were paid for with unreported income.

For example:

CYE 12/31/2017 receipts CYE 12/31/2017 expenses
Register 1 $180,135 Rent & utilities $65,000
Register 2 $105,360 Inventory purchases $153,145
Banquet $47,775 Supplies $77,365
Catering $7,490 Legal/professional $13,630
Video gaming machines $45,125 Insurance $24,250
Total receipts $385,885  Other $84,125
     Total expenses $417,515
    Less total receipts $385,885
     Unreported sales $31,630

All three income reconstruction method examples conclude that in the calendar year-end December 31, 2017, there is an approximate underreporting of $30,000. This underreported income amount found in audit would be subject to Wisconsin’s applicable sales/use, income and/or corporate franchise tax rates, interest and penalty. Any state adjustment of this nature would also be of interest to the IRS for federal reporting and amended returns would be recommended.

As a business operator in the hospitality and retail industry, it is critical that you implement good recordkeeping practices and understand potential audit methods to ensure proper reporting and to help avoid exposure. For more information about recordkeeping, audits and possible exposure, contact Brad Sweet or another member of Schenck’s Hospitality & Retail team at 800-236-2246.


Brad Sweet, supervisor, has nearly 10 years of experience providing tax services to a variety of clients. He is skilled in multi-state tax research and compliance, sales and use tax audit representation, and Wisconsin manufacturer’s utility exemption analysis. Prior to joining Schenck, Brad was a revenue field auditor for the Wisconsin Department of Revenue, specializing in sales and use tax, along with individual and corporate franchise tax.