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The tax gap's biggest contributor - underreported income

FTB's audit program has its eye on underreporting, as the largest segment of the tax gap. Underreporting includes unreported cash transactions, and several other types of transactions that business owners may not think of as income.

If asked what should be included in business income, most people would list cash, checks, or credit card payments that are received for goods sold, or services provided. While that answer would be correct, it would be incomplete. It overlooks other forms of income that are received in connection with business operations (except those specifically excluded by law). Although many people may not realize it, business income also includes the benefits received in these transactions:

  • Bartering
  • Canceled debt
  • Promissory notes
  • Kickbacks
  • Redirecting income

Bartering is a common business practice where property or services are exchanged for other property or services. Bartering is gaining popularity on various Internet Websites. In a bartering agreement, the fair market value of the property or services received should be included in business income.

Example: Jane is a veterinarian. Jane consults with Joyce, a florist, about flowers for her wedding. Joyce suggests to Jane that they should exchange $3,000 worth of flowers for $3,000 worth of veterinary services. Both Jane and Joyce should report $3,000 in their gross receipts for the exchange of business services regardless of the personal nature of the barter exchange.

Canceled debt is income if your debts are paid by another person, or canceled by a creditor. The amount paid or canceled should be reported as income.

Example: Joe, a doctor, is being sued by a patient. Joe hires Valerie, an attorney, to represent him. Several months later Joe owes Valerie $10,000 for her services. Joe cannot afford to pay Valerie. Since Joe is a long-time client of Valerie, she decides to relieve $8,000 of his debt. Joe must report $8,000 of income for the canceled debt.

Promissory notes received in exchange for property or services should be included in income.

Example: Gerri is a CPA. She buys furniture for her office from Dan's Furniture Store. Dan's Furniture Store provides a 90-day, same-as-cash program. Dan's Furniture Store obtains a promissory note from Gerri stating she will pay the balance of $5,000 within 90 days. Dan's Furniture Store must report the $5,000 promissory note in its gross receipts.

Kickbacks are payments or other types of compensation that are made to influence and gain profit from an individual or company. In spite of its unsavory or unethical character, kickback payments or compensation should be reported as income. All income is taxable, including income derived from illegal activities.

Example: Dan's Furniture Store owns a delivery truck, which was involved in an accident. Dan's Furniture Store takes the truck to Tim's Repair Shop. Tim's Repair Shop agrees to bill the insurance company for more than the actual cost, and agrees to split the difference. Tim's Repair Shop kicks back one-half of the excess proceeds to Dan's Furniture Store. Although the income was received through illegal activity, the kickback is taxable. Dan's Furniture Store, as well as Tim's repair shop, should report this income as gross receipts.

Redirecting income is another form of underreporting. Directing a customer to pay a third party does not exclude the amount from the seller's income.

Example: Jim and Mary have a rental business. They have a recurring customer whose rental agreement stipulates that the payments are to be made directly to Jim and Mary's son. Jim and Mary must include this amount as gross receipts. Moreover, accumulating cash, paying expenses out of cash, or other receipts that are not deposited, should also be included in gross receipts. For instance, Jim and Mary like to accumulate rental income that is paid to them in cash, for emergency repairs. Although this income is kept in their safe and not deposited, it must still be included in gross receipts.

Business owners must maintain accurate books and records to insure the proper amount of income is reported. Accurate information will help the business owner to monitor the business's progress, prepare financial statements, track deductible expenses, prepare tax returns, and substantiate items reported on the tax returns.

Although there is no specific method of maintaining books and records, your clients should ensure that their record-keeping systems accurately reflect business income. They need to keep documents that identify and support the amount and source of gross receipts. For example, cash register tapes, bank deposit slips, receipt books, invoices, credit card charge slips, 1099 forms, and other similar documentation will meet this need.

Underreported income is the largest portion of the tax gap. Although cash transactions are largely responsible for underreporting, we have seen that there are other ways income is underreported. We will continue to scrutinize underreporting in all its forms, and take actions to reduce it through taxpayer education, encouraging self-compliance, and conducting audits.