If you run a business that takes cash, an audit letter means one thing above all: the IRS wants to know whether every dollar you took in made it onto the return. Expenses come second. The examiner's tools for answering that question are described in the IRS's own manual, and the most common one starts with your bank statements.
Here is what to expect, step by step, and where the defenses are.
Step one: the minimum income probes
IRM 4.10.4, Examination of Income (revised August 29, 2025), sets minimum steps for examining income on every business return. For an individual business return, they include a financial status analysis, an initial interview, a tour of the business site, an evaluation of internal controls, a reconciliation of the books to the return, testing of gross receipts, bank account analysis and business ratio analysis.
The bank account analysis is not optional and it is not limited to the business account. IRM 4.10.4.2.3.7 tells examiners to analyze the taxpayer's business and personal bank and financial accounts, including investment accounts, and says the IRS is not prohibited from asking for those records, and wire transfers, on the initial document request or at any time during the examination. The stated purposes include identifying deposits that may be taxable income, determining whether expenses were paid from other sources such as cash on hand, estimating the risk of commingled accounts and determining whether cash is deposited.
The interview question that decides cases
In the first meeting, the examiner will ask how much cash you had on hand at the beginning and end of the year, including money in a safe, a safe deposit box or at home. The IRS's Retail Industry Audit Technique Guide (revised March 5, 2021) calls covering cash on hand during the interview "imperative."
IRM 4.10.4.5.8.3 explains why. Cash on hand and accumulated funds can explain a gap between income and spending, but the IRS wants the amount established early, and the IRM says the after-the-fact "cash in the mattress" defense cannot be used if actual cash on hand has already been established. Whatever number you give in that interview is the number you will live with. Know it before you walk in, and be able to support it.
When the IRS can reconstruct your income
Formal indirect methods are not automatic. IRC 7602(e) says the IRS shall not use financial status or economic reality examination techniques to determine the existence of unreported income unless it has a reasonable indication that there is a likelihood of unreported income. IRM 4.10.4.5.1.1 identifies formal indirect methods as the techniques that trigger that limit.
IRM 4.10.4.5.2.1 lists circumstances that can support using a formal method, including a financial status analysis that cannot be balanced, irregular books and weak internal controls, gross profit percentages that swing significantly or are unusual for the industry, unexplained deposits, and a taxpayer who does not regularly deposit income but uses cash instead.
The legal authority for reconstructing income traces to IRC 446(b): if a taxpayer has no method of accounting, or the method does not clearly reflect income, taxable income is computed under a method that does.
How the bank deposits method works
The bank deposits and cash expenditures method is described in IRM 4.10.4.5.4. In concept:
- Total all deposits to every account the taxpayer maintains or controls, business and personal, including savings, brokerage and credit union accounts. IRM 4.10.4.5.4.3 defines total deposits that broadly.
- Add cash spent that was never deposited, and cash accumulated without being deposited.
- Subtract nontaxable items. IRM 4.10.4.5.4.4 lists examples that are not gross receipts: gifts, inheritances, loan proceeds, transfers between accounts, checks to cash that were redeposited, tax-exempt interest, insurance proceeds and federal tax refunds.
- Compare the resulting gross receipts to what was reported.
The IRM tells examiners what makes a deposit stand out: unusual size, cash deposits in a business that normally receives checks, round-dollar deposits that break a pattern of odd-cent deposits, and deviations from the taxpayer's usual pattern or frequency. A pattern of deposits just under $10,000 raises a separate and more serious issue; see our guide to structuring.
A limit the IRM itself recognizes
IRM 4.10.4.5.4.2 says the bank deposits method should not be the automatic choice, and that cash intensive businesses, where significant receipts are not deposited and there are numerous cash outlays, do not lend themselves to it. It also says that if the method is used, the entire analysis must be completed, and shortened versions that do not account for business and personal cash expenditures are insufficient. A computation that totals deposits but ignores cash paid out is incomplete under the IRS's own manual.
For businesses where inventory drives income, such as restaurants and bars, the markup method may be used instead; see our guide to restaurant audits.
Your defenses
IRM 4.10.4.5.8 groups the defenses to any formal indirect method into three categories, and the IRM's own discussion of each tells you how to build them.
The computation is wrong
The IRM notes that most challenges to the bank deposits method focus on the nature of individual deposits. Common errors: transfers between your own accounts counted twice, redeposited returned checks counted twice, loan proceeds treated as sales, and deposits into accounts that are not yours.
The money came from a nontaxable source
Loans, gifts, inheritances, insurance proceeds and sales of assets on which you had basis. Each needs paper: loan agreements and the lender's records, gift letters and the giver's bank records, estate documents, settlement statements.
The money came from cash you already had
Cash on hand from earlier years can explain current deposits, but only if you can show it existed. Prior bank withdrawals, prior returns showing enough after-tax income to build savings, and consistent statements from the first interview forward.
The recordkeeping baseline
All of this starts with IRC 6001, which requires every person liable for tax to keep the records the IRS prescribes. In a cash business, the records that matter most are the ones created at the moment of sale: register tapes or POS reports, daily cash counts and deposit slips that tie to them. When those exist and agree, an indirect method has little to work with.
Third-party contacts
In a cash business audit, the examiner may want to talk to your customers, suppliers or bank. IRC 7602(c) says IRS employees may not contact third parties about your tax liability unless the contact occurs during a period, not longer than one year, specified in a notice given to you generally at least 45 days before that period begins. The IRS must also give you, periodically and on request, a record of the persons contacted. You will know it is coming.
Before the examiner arrives
- Reconcile every bank account, business and personal, to reported income for each year under audit.
- Identify every nontaxable deposit and gather the proof.
- Establish your cash on hand with documents.
- Deposit cash intact going forward and pay expenses from the bank, so next year's records explain themselves.
Card and platform income will already be on the IRS's computers; see our guide to 1099-K mismatches. If the examination has already begun, read how the firm approaches IRS audits before the first interview.
The IRS will count your deposits. Count them first, explain every one, and walk into the interview with the answer to the cash on hand question already written down.