The Underground Audit

4/8/2013

When it comes to audits, our friends at the IRS are interested in examining returns as accurately as possible. So the Small Business/Self-Employed department has compiled a series of Audit Technique Guides to help examiners with insight into issues and accounting methods unique to specific industries. As the IRS explains, "ATGs explain industry-specific examination techniques and include common, as well as unique, industry issues, business practices and terminology. Guidance is also provided on the examination of income, interview techniques and evaluation of evidence."  

Conveniently, these guides are all listed on the IRS website, so if you find yourself on the business end of an audit notice, reading your industry's AGT is like getting an advanced copy of your opponent's battle plan!

There are currently dozens of ATGs available. Some are straightforward and predictable, like attorneys, consultants, and child care providers. Others are more specialized or esoteric, like art galleries, cost segregation studies for real estate investors, and timber casualty losses. At one point, there were even two separate guides for Alaskan commercial fishing activities – one for the fishermen who catch the fish and another for the vendors who sell it.  

One of the more interesting AGTs is for “Cash Intensive Businesses.” This industry category includes legitimate businesses like taxi cabs and Laundromats, but it also includes the category “Underground Economy.” The IRS defines this category as “income earned under the table and off the books. It can include legal and illegal, or black market, goods, including drug sales, money laundering and warehouse banking schemes.”   

You might be surprised that the IRS is publishing an audit guide for businesses that are clearly illegal. But U.S. citizens are subject to tax on all worldwide income, from whatever source derived. The IRS really doesn't care how you make your income – they just want their fair share (remember who finally nailed Al Capone?).  

So what kind of deductions could you take to cut the tax on your spoils from your “underground” business? Hypothetically, you’re welcome to deduct home office expenses, as long as you use the home office “exclusively and regularly for administrative or management activities of your trade or business” and “you have no other fixed location where you conduct substantial administrative or management activities of your trade or business.” To substantiate this deduction, keep a log and take photos to record your business use. It also doesn't have to be an entire room – you can claim any “separately identifiable” space you use for work.  

Additionally, you could capitalize equipment like computers and printers that you use for your business, or choose first-year expensing for faster deductions. You can also deduct day-to-day expenses, like internet access, utilities, and vehicle costs for driving (mileage allowance or actual expenses).  

Even though the IRS has an AGT for illegal activities, they obviously do not encourage such practices, and if you were to be audited, you’d probably be in trouble with more than just one government agency. But if you do have a legitimate business, the AGT for your industry can be a useful tool to help you understand what the IRS will be looking for if they audit you!