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IRS looking at income under-reporting by small businesses

The concerns of small business owners are a frequent focus of this blog. That focus is with good reason. Businesses with fewer than 50 employees face a host of tax issues that affect their operation, from payroll and sales tax compliance to their employees' health insurance options.

In the last week, however, the tax compliance plot for small businesses thickened considerably. The IRS has sent letters to thousands of business owners regarding the possible under-reporting of income.

Quite naturally, small business owners in Southern California and across the country are very concerned about this. It could be an indicator of a larger federal initiative to crack down on businesses that do not report all of the income from their cash sales.

The letters that went do not have the formal status of a tax audit. But small business owners are still worried.

So far, only about 20,000 letters have gone out. But many more could follow as a cash-strapped U.S. government looks to bring in additional revenue to close the chronic budget deficit.

But why does the IRS think that many small businesses have underpaid taxes after under-reporting their income?

It isn't merely that mom-and-pops and many other small businesses are known to rely more heavily on cash than larger businesses. The IRS is relying, rather, on powers it gained under a 2008 law change. That change gave the agency more visibility into the credit card and debit-card transactions of merchants.

Once it has that data from third-party card companies, the IRS can compare it to what it receives from small businesses themselves. If the percentage of card transactions seems overly high, the IRS could become concerned about tax evasion. In many cases, however, there may be perfectly legitimate reasons for having a high percentage of card transactions.

Source: Wall Street Journal, "Small Businesses in IRS Sights," John d. McKinnon and Siobhan Hughes, August 9, 2013