Philadelphia area newspapers have been following a high-profile tax evasion prosecution of the owners of South Jersey’s most successful pizza shops. The owners of Manco and Manco pizza are accused of failing to report almost a million dollars of cash receipts over a period of years. I have no intent to comment on the details of the case itself or the problems facing this family that are prominent members of our community. This post is not an endorsement, excuse or condemnation. The sole purpose of my post here is to use this case as an example of two important tax compliance points that affect many small business owners. This is a rare “teachable moment” in small business tax compliance.
Lesson #1: A 5% margin of error in cash reporting is unacceptable at this volume
When we read that almost a million dollars was unreported income, that sounds like a lot. Yet it is important to consider that number represents less than 5% of the gross income of the businesses for the five-year period under investigation. It other words, the tax accountant for Manco and Manco got it 95% right and had an error of less than 5% in overall reporting of receipts. Consider that with many thousands of cash transactions, scores of employees handling cash and most likely several layers of cash management practices in effect we presume that the end result was that the owner was successful in properly collecting and reporting more than 95% of these transactions. In many other areas of business and mathematics we would consider an error rate of less than 5% to be acceptable and in some cases even admirable. Even under the audit procedures of small businesses with multiple locations that deal in cash, some rate of accounting error is expected.
Consider that most small business owners draw cash from the business for personal expenses and plan on doing the tax accounting later. Whether the intent was to intentionally evade taxes or some lesser flaw, the fact is that this practice happens everywhere. Any small business accountant finds examples where owners fail to report all income for a wide range of reasons. All reasons are equally illegal but the vast majority are not based on pure criminal intent. In my own practice, I would say that the busy pace of business and life is the #1 reason that some business receipts are not properly recorded. It is simply too easy to grab cash from the register on your way out the door to an expensive personal engagement and then fail to properly record the transactions.
This raises a series of questions from a tax accountant’s perspective:
So what is an acceptable level of accuracy in cash receipts reporting? It is an interesting question that every business owner should consider. We know that 100% accuracy is simply not attainable in a business of this nature. We know that 95% is unacceptable. So logically we know that the acceptable goal is between these two: somewhere between 95% and 100%. If we hire five different accountants to calculate the gross cash receipts, there will be five different amounts of gross income. It is naive to think that there is a single number that is the only acceptable result for income tax reporting. Increasing the level of accounting accuracy is certainly possible but it costs significant time and money. Given this perspective, we need to consider what level of reporting accuracy that our small business cash accounting systems be designed to achieve.
What could the accountant have done to detect to under-reporting problem earlier and avoid the audit investigation? The fact that all the unreported cash reportedly came from one store location is a red flag on numerous levels. My guess is that is could have been pretty easy for the accountant to avoid this mess long before it made headlines. In my own experience, business owners typically do not wish to pay the accountant for these additional tax accounting procedures that would have detected and corrected the problem – not because they are trying to hide illegal activity but simply because they don’t want a higher accounting bill.
What can be done to tame owners’ use of cash? The fact is that use of cash is “out of control” in many businesses. Getting owners (and often their spouses and adult children) to change their habits is very difficult. I know business owners that want to improve their cash handling procedures and have no intent to under report income but they simply can’t seem to get away from old habits. When faced with this type of dilemma, I often conclude that a degree in psychology would be more useful than a degree in accounting.
Lesson #2: Do not make statements to IRS investigators if you are at fault
Newspapers report that the business owners made multiple statements to IRS investigators. This is simply wrong! Business owners need to know that they should never give a statement to a tax auditor. If any value is gained from this case, it should be that business owners should let professionals handle audits and investigations. A CPA will handle non-criminal investigations and a tax attorney must be retained when a criminal investigation is indicated.
Presuming that successful business owners are smart enough to know that they should not give statements to tax investigators, why do they do it? I see three main problems: 1) ego (i.e. “I an handle this”), 2) a momentary mental/emotional lapse that may be a stress reaction, or 3) desire to avoid paying a professional. In any case, the answer is simple: hire a professional immediately before any contact with IRS and then let the professional handle it.
In this Manco and Manco case, it seems likely that we would never have known about the tax investigation because the professional representative would have settled it long ago.