Do Not Try These 5 ‘Loopholes’ to Cheat Your Taxes — Or You Will Get Caught

5 min readApr 5, 2024

If you’re thinking about cheating Uncle Sam, think again

(This column originally appeared in Entrepreneur)

I’m not going to name names, but over the past 25 years of practicing accounting, I’ve run across a fair number of business owners who are tax cheats. These are the people that are playing what I call “audit roulette.” They are knowingly underpaying the taxes they owe and hoping they don’t get selected for an audit. Considering that the IRS only audits less than 3% of corporate tax returns (it’s .1% for S-Corporations) — and most of them are larger companies with bigger pocketbooks — it’s not a bad gamble.

Are you cheating on your business taxes — or thinking about it? I don’t recommend it. Here are the five most popular ways I’ve seen people do this and — most importantly — how they get caught.

1. Under-reporting their revenues

This is generally done by cash-based businesses (generally a corporation or partnership if its average annual gross receipts for the three prior tax years were $26 million or less ) like restaurants. These establishments don’t accept credit cards and only accept cash. The methodology is simple: For every $100 received, they pocket a percentage and keep the rest on their books.

How does an auditor figure this out? In the restaurant example, one easy way is to spend a few Saturday nights on the premises, figuring out an average check, counting the customers and making some estimates. Or comparing the restaurant’s revenues, expenses and margins with industry norms. Another way is to look at the owner’s personal bank statements for any unusual deposits. And then, of course, there’s a simple series of interviews with the owner’s staff because who knows who’s unhappy and willing to spill the beans. Similar procedures can be done for businesses in other industries. Never underestimate the power of observation.

2. Running their personal expenses through the business

Many small businesses — lacking resources and accounting knowledge — combine their expenses with their business expense, and this always creates headaches for their accountants. Others blatantly run personal expenses — vacations, gifts, dinners — through their business. Some have the foresight to come up with a rationale for the expenses. Others I know don’t seem to care. They should.

A competent auditor will perform a review of a company’s general ledger to reveal expenses that aren’t business-related. The same goes for a review of credit card statements, which can provide a very detailed picture of spending in a number of different ways. If a blatantly wrong deduction is found, that opens the floodgates to questions of other transactions, and the ending to that story is never happy for the taxpayer.

3. Undervaluing their inventory

Business owners with inventory know that manipulating their taxes is a great way to do so. Why? Because inventory valuations can often be subjective. Inventories are always unique to an industry and require a deeper understanding of cost accounting in order to properly value them. The less inventory on hand, the more of these costs you’re running through your income statement and the higher your deductions. So, it’s tempting to value your inventory as low as possible and keep as few records as possible.

For some of the reasons given above, many tax auditors can find it challenging to properly value inventory. But it’s not impossible. Consulting with similar companies in an industry will review trends. Comparing gross margins on sales from year to year and product to product can also be telling. Looking at inventory balances over time compared to sales will indicate any abnormal fluctuations. Uncovering inconsistencies in how inventory is reported (one year overhead is added, the next year it’s not) will also raise red flags. And just a simple walk around the warehouse and the examination of invoices supporting the physical items on the shelves will reveal anomalies.

4. Changing the timing

Owners of cash-based businesses always do their best to defer cash receipts to the next year and speed up payments into the current year. It’s a timing strategy, and for the most part, it’s kosher. However, for those businesses that use the accrual method of accounting, things can get dicey. Sometimes, a bad actor may sit on an invoice until the next year, even though products have already been shipped. Or they record expenses for services or items that weren’t yet performed. Or — worse yet — they manufacture paperwork in order to record it.

A good auditor can see through this through what’s known as a “cut-off test.” They examine shipments made after a year and match them to the invoice to ensure they were recorded within the proper period. They examine invoices received during the last week of the year and investigate when the services were performed. These are all standard procedures. Were sales unusually large during the first week of January? Were expenses unusually significant in the last week of December? A simple analytics review can raise all sorts of questions.

5. Undervaluing their fixed assets

Even though the amount of “bonus depreciation” (additional first-year depreciation deduction allowed by the IRS) is being phased down, most small businesses can deduct as much as 60% of their first year’s expenses for capital items put into service in 2024. However, the remaining 40% would need to be capitalized and depreciated over the life of the asset, which would reduce the deduction amount that can be realized. A way to avoid this is to just charge it all through the income statement and take the full deduction. Who’s going to know?

A good auditor will. That’s because they know that expenses like these generally get charged to “repairs and maintenance” or similar facility-related accounts. Reviewing the details and asking for supporting documentation will reveal if the item has been properly expensed or should have been put back on the balance sheet.

There are plenty of other ways to cheat on one’s taxes, but these are five of the most common I’ve seen. Some of my clients don’t realize the true consequences of doing this. Mistakes can be made, and penalties will be paid. But if the IRS believes that willful fraud has occurred, it’s a whole new ballgame. A criminal ballgame with potential jail time. Too many bad actors spend too much time figuring out how to cheat the government. Wouldn’t their time be better spent figuring out who to grow their profits instead?

Originally published at https://www.entrepreneur.com on April 5, 2024.