After reading the 80 page IRS audit technique guide made specifically for the scrap metal recycling industry (click here to request a copy) it was obvious the IRS will focus their audits primarily on cash purchases. More specifically, when a scrap yard makes a cash purchase, the IRS wants to corroborate that purchase with the third party seller, which means the IRS is looking for the recycling yard to have the following information on a cash slip/weight ticket that is given to the seller some sort of identifying information about the seller such as their full name, address, social security # or taxpayer identification #, drivers license #, phone #, license plate #, signature etc etc. To the IRS the more identifying information, the better. This identifying information can be difficult and sometimes borderline commercially unreasonable. As many in the industry know, a lot of the small sellers that come to the scrap yard are….well….shady. Some will end up going to sell their scrap elsewhere once you start asking these questions and the others will just give you fake names, addresses and phone numbers. And if they do give real names and phone numbers, what are the chances they corroborate a transaction to an IRS agent that went unreported on their personal income tax returns? Not likely.
So what happens if you don’t get this information, or if the information you do have is inaccurate or fragmented? Let us look at the two court cases that are cited in the in the IRS audit guide. (click here to request a copy).
In Bard V. Commissioner the taxpayer had only “informal and fragmented” information regarding his cash purchases. His documentation consisted of a log created by him with dates of purchase, dollar amount, and very few names of the sellers. When the IRS tried to contact the sellers they denied the transactions. The end result was the disallowance of $423,104 of cost of goods sold deductions in one year and $95,033 in the next. That result is a lot of back taxes and penalties to be paid! This is clearly not the way to go.
In Bobry V. Commissioner, the result was a little more advantageous to the taxpayer and is the foundation for my recommendation to all scrap metal recycling centers accounting for cash transactions. In Bobry, the scrap yard issued a 3 way carbon copy receipt to every seller with the unit cost, total cost, metal type and weight when the seller came to the yard with metal to sell. The seller would then bring the receipt to the cashier who would pay the seller and retain 2 of the copies for the scrap yard accounting records. At the end of the day all of the receipts were totaled and reconciled to the cash balance on hand and a check was written in that amount to replenish the cash spent on that day, therefore, the daily checks written to cash were the company’s way to account for cost of goods sold.
Because the taxpayer did not retain any names or ways of identifying the sellers, the IRS argued proper substantiation was not retained and disallowed all of the cost of goods sold deductions on cash purchases. The courts disagreed with the IRS and ultimately allowed 95% of the deductions. The 5% that was disallowed was due to the taxpayer using cash on hand to occasionally pay for items other than scrap, such as paying contractors (plumbers, roofers etc). The court did however sustain a 20% accuracy related penalty for negligence or disregard to rules and regulations for not maintaining seller’s names when specifically instructed by the IRS to do so.
So let’s put it all together. 5% was disallowed as an estimate of funds used to pay contractors for other than purchases of scrap. While this was a win for the taxpayer it still had a significant cost. Let’s put some numbers on it. Let’s say in years 1-3 you have five million dollars of sales, at a 10% margin. With tax rates at 30% you would pay $150,000 in taxes yearly. If the IRS determined only a 5% decrease in cost of goods sold, that would increase net income to $225,000 resulting in a 3 year tax bill of $202,500 with additional penalties amounting to $40,500.
However, if nothing other than scrap was purchased through the cash box accounting system then no deductions would have been disallowed and there would be no deficiency and the 20% accuracy related penalty would have calculated to $0. While we do always recommend keeping records of your purchasers, the Bobyr case proves strong controls over your cash purchases can be sufficient substantiation for cost of goods sold, even without names being maintained.
Just as many dealings with the government there is no perfect answer, but these two cases allow us to evaluate possible tax risk and find ways to reduce potential exposure. While you may not be able to fix the past, keeping the status quo will only increase your potential tax liability. On one side of the spectrum, to be completely free from risk you must keep detailed records and controls over your cash including detailed information of all of your purchasers. At a minimum, as we see in Bobyr strong controls over your cash purchases without seller identifying information can be sufficient substantiation, but, you will bear a higher risk of a tax adjustment and possible tax penalties.