When it comes to income taxes, cash businesses have always been a challenge for the IRS. Cash is hard to track. Businesses, whether large or small, often fail to keep records of cash transactions. In other cases, businesses keep the records lose the records by the time the IRS audits the business years later. And there are businesses that simply underreport cash, knowing that the IRS is unable or unlikely to notice or be able to do anything about it.

This is one aspect of tax where the widespread adoption of crypto currency could make the IRS audit much easier. In theory, it could eliminate the need for IRS audits. But absent something like that, the IRS will continue to audit cash heavy businesses and use estimation methods to identify what it seems to be unreported income. The amount of tax at issue is significant. This is not a minor issue for taxpayers or for the IRS.

We have addressed a few of these types of income-reconstruction cases on this site before. This time, we are going to consider the credit-card-to-cash method the IRS uses for cash-heavy businesses. The recent Clinco v. Commissioner, T.C. Memo. 2026-16, case provides an opportunity to consider this method. It involves a restaurant and the IRS audit that applied this method to estimate–and increase–the business’ income and tax.

Facts & Procedural History

The taxpayer ran a restaurant and bar near UCLA. The cafe was a family operation. The taxpayer owned 66.6%, a brother owned the remaining interest through 2014, and a third brother served as the manager and bookkeeper. In 2015, the taxpayer converted the entity that owned the cafe into a single-member LLC.

The cafe had about 60 employees and most of them only worked three to four hours per shift.

The taxpayer prepared his own 2015 tax returns. On his Schedule C for for the cafe, the taxpayer reported gross receipts of more than $1.6 million. After claiming $1.4 million in cost of goods sold and $600,000 in total expenses, he reported a net loss of about $400,000.

The IRS pulled the tax returns for audit in 2019. During a personal meeting, the IRS noted that the taxpayer had estimated that 10% of restaurant revenues came from cash.

The IRS agent believed there was a discrepancy between re…

The IRS agent believed there was a discrepancy between reported gross receipts and what the audited gross receipts should have been. This hunch was based on a credit-card-sales-to-cash ratio. This hunch prompted the IRS agent to summons the taxpayer’s bank records and conduct a full bank deposits analysis. She also pulled third-party information reporting returns data, including four Forms 1099: a Form 1099-MISC from UCLA and three Forms 1099-K from First Data Reporting, American Express, and Grubhub. The IRS agent purportedly reconciled the bank deposits analysis with this third-party data and the taxpayer’s statement about cash receipts. The result was reconstructed gross receipts of approximately $2.29 million—well above what the taxpayer had reported.

The IRS issued an IRS Notice of Deficiency for 2015 asser…

The IRS issued an IRS Notice of Deficiency for 2015 asserting underreported gross receipts. The taxpayer then died shortly after the notice was sent. His wife timely filed a petition with the U.S. Tax Court to challenge the IRS determination.

When Can the IRS Reconstruct a Taxpayer’s Income?

This case starts with the fundamental question as to whether the IRS can reconstruct a taxpayer’s income and, if so, then when can to do so? We have touched on these topics several times on this site.

Section 446(b) of the tax code gives the IRS authority to compute a taxpayer’s income. To do so, the IRS has to use a method that clearly reflects income. The IRS is generally only able to do this if the taxpayer’s own method does not clearly reflect income.

Courts have interpreted these concepts broadly. The rules can be summarized by the idea that when a taxpayer’s books and records are incomplete, unreliable, or do not match third-party information, the IRS can step in and calculate income using a reasonable method. The reconstruction does not have to be perfect. It has to be reasonable in light of all surrounding facts and circumstances.

The IRS has several recognized indirect methods. For example, the net worth method compares assets and liabilities at the beginning and end of a year. The markup method applies industry-standard percentages to cost of goods sold. These two methods are not all that common.

The IRS’s go-to method is the bank deposits method

The IRS’s go-to method is the bank deposits method. This method adds up all deposits, subtracts identifiable nontaxable items, and treats the remainder as income. Thus, an IRS audit where the bank deposits method is used requires the IRS to review every deposit and make judgment calls about what is income and what is not. In a cash-heavy business like a restaurant, these judgment calls can get complicated fast and they can lead to trade-offs that make the results incorrect and, in most cases, unreliable. This brings us to the credit-card-to-cash ratio.

About the Credit-Card-to-Cash Ratio

Theh credit-card-to-cash ratio is also not a method that the IRS uses all that often. It is usually used in cash heavy businesses given the limitations of a pure bank deposit method.

For this credit-card method, as in this case, the IRS agent will ask the taxpayer what percentage of sales comes from cash versus credit cards. That answer sets the stage for everything that follows. If the known credit card receipts represent 90% of gross income, and the examiner can verify them through Forms 1099-K, then simple math yields the estimated cash component.

The IRS Retail Industry Audit Technique Guide specifically instructs examiners to ask about this ratio during the initial interview and verify it against bank deposits.

This is what happened in this case. The IRS agent verified credit card receipts through Forms 1099-K totaling over $2 million from First Data Reporting, American Express, and Grubhub. She added the Form 1099-MISC from UCLA. She then applied the taxpayer’s own 10% cash estimate to arrive at $228,929 in estimated cash receipts. The total reconstructed gross receipts came to approximately $2.29 million–which was in excess of the $1.6 million the taxpayer reported.

The IRS agent could have also used industry data to provi…

The IRS agent could have also used industry data to provide the percentage. The IRS will use industry data if they are working with a tax savvy taxpayer who does not volunteer an estimate of cash payments or who offers an unreasonably low estimate. The case does not address it, but the IRS agent didn’t have to do that here as it accepted the taxpayer’s own estimate. It may be that the estimate provided was in line with industry standards and the IRS agent checked, or it may be that the IRS agent just accepted the estimate to move on with the audit.

Defending Against the Credit-Card-to-Cash Ratio

The credit-card-to-cash ratio is clearly just an estimate. This is why it is not used all that often. But with that said, the courts have sanctioned the use of this method in other cases.

For example, the Supreme Court allowed this method to be used in United States v. Fior D’Italia, Inc., 536 U.S. 238 (2002), in the context of FICA taxes on unreported tips. There, the IRS examined a restaurant’s credit card slips, calculated the average tip percentage, assumed cash-paying customers tipped at the same rate, and multiplied the resulting rate by total receipts to estimate aggregate unreported tips. The Court held that this aggregate estimation method was authorized by law, so long as the method was reasonable.

Back to the present case, in this case, the court noted that the taxpayer had the burden to disprove the IRS agent’s conclusions. The taxpayer raised several arguments against the IRS adjustment to income. Each one fell short. They were that the IRS failed to label the 1099 income correctly (even though it was reported by third parties to the IRS), that the IRS failed to account for non-taxable capital contributions to the business, and that the IRS had confused this cafe with a similar one in the area that was not owned by the taxpayer. The court noted that mere arguments as to these items were not enough to overcome the IRS’s determination.

The court opinion does not address this

The court opinion does not address this, but the way to overcome the taxpayer’s burden in these cases is to put a better reconstruction in front of the court. The taxpayer’s own records—even partial ones—can serve as a starting point. A forensic accountant or other expert can take those records and build an alternative analysis that accounts for variables the IRS overlooked, such as non-cash tips paid out to employees, comped meals, vending or catering revenue that does not follow the same cash-to-card split, or seasonal fluctuations that make a single annual ratio misleading.

Industry data from comparable restaurants can also be used to challenge the IRS’s assumed percentages. The goal is not necessarily to prove the IRS’s number is wrong down to the dollar. The goal is to get competing evidence into the record so the court has something to weigh against the IRS’s analysis. Without that, the court is left with only the IRS’s method and the taxpayer’s unsupported objections—and as this case shows, unsupported objections do not carry the day.

The Takeaway

The IRS’s has broad authority to reconstruct income. It frequently does this as part of its “income probe” when it starts an IRS audit. While the bank deposits method is most effective and common methods the IRS uses for identifying unreported income, it has other methods that it uses in cash-heavy businesses. This case provides an example of the credit-card-to-cash ratio where the IRS combines third-party data, bank records, and a taxpayer’s own statements to build a reconstruction. This case also shows that the courts will uphold the IRS’s method as reasonable absent evidence in the record showing that the method is not reasonable and/or that some other method is more reasonable.

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