When a tax examiner audits a cash intensive business, she is primarily looking to see if the taxpayer is reporting all of his income since there is no paper trail, such as a check, at the point of sale.  An IRS Audit Technique Guide lists several indicators which the tax examiner can explore to see if all income is being reported.

These are: (1) a lifestyle that cannot be supported by the income reported; (2) a business that continues to operate despite year-after-year losses; (3) bank balance, investment and/or asset increases when there is a very low net profit or a net loss; (4) significant differences in the taxpayer’s gross profit margin and that of similar businesses; (5) unusually low sales for the type of business that is being audited.

According to the Guide, the most critical aspects to a successful (i.e., increased tax liability) audit of a cash intensive business are the examiner’s ability to (1) gather information about the taxpayer’s methods of conducting business; (2) document cash inflows and outflows; and (3) conduct a detailed interview with the owner to nail down business and non-business cash receipts and expenditures.  It is highly recommended that one who finds himself in such as audit retain a competent professional to represent the taxpayer in the audit.