When Bad Bookkeeping Triggers an IRS Audit: Lessons from US Tax Court
A Red Flag That Started It All
Lakeview Hospice Care, Inc., a family-run hospice agency in Burbank, California, found itself in Tax Court after what began as a routine red flag: its corporate tax return showed no officer compensation.
For a C corporation with active owners, that’s a problem. The IRS expects a corporation to compensate its officers if they’re performing services. When a company has substantial revenue but reports zero officer wages, it signals that something may be off in the accounting.
That missing salary line on the return caught the attention of the IRS, prompting an audit. But when the revenue agent started digging, she uncovered much deeper issues in the company’s bookkeeping.
A Bookkeeping System That Didn’t Add Up
Lakeview’s books were maintained by a long-time outside bookkeeper who had set the company up on an accrual accounting system. Unfortunately, the system wasn’t being used properly.
Among the problems the IRS found:
- Accounts receivable were reversed to zero without explanation.
- The general ledger contained numerous vague “adjusting journal entries” labeled simply as “reverse of year-end accruals.”
- Invoices were handled manually — stamped “paid” and placed in folders — instead of being linked to the ledger or billing system.
- No monthly reconciliation was done between the bank accounts and the books.
The company’s records didn’t match its billing activity or its bank deposits. Although the books were labeled “accrual basis,” the data didn’t actually reflect income when it was earned or expenses when incurred.
That inconsistency gave the IRS authority under Section 446(b) of the tax code to disregard Lakeview’s accounting and reconstruct its income using another method.
The IRS Turns to the Bank Deposits Method
When books are incomplete, the IRS can use the bank deposits analysis to estimate income. The auditor adds up all deposits for the year, then adjusts for:
- Nontaxable items (like account transfers or shareholder contributions), and
- Changes in receivables and payables to approximate accrual-based income.
Using this method, the IRS initially claimed Lakeview underreported more than $200,000 in income across two years.
The Tax Court agreed that the auditor’s method was appropriate — Lakeview’s records simply didn’t “clearly reflect income.” But the Court also found that the IRS’s totals were too high, because the company’s explanation for certain deposits made sense.
Some of those deposits came from owners, refunds, or other non-taxable sources — not from hospice revenue. The judge accepted Lakeview’s adjustments and ruled that those amounts should be removed from income.
✅ In short: Lakeview lost on the method but won on the numbers.
Where Lakeview Lost Ground: The Deductions
The Court did not, however, side with Lakeview on its expenses. Some of the questioned deductions included
- $222,000+ in “miscellaneous accruals,”
- Advertising expenses paid to a related person
- “Other deductions”
- $171,000+ Net Operating Loss from a prior year
When pressed, Lakeview couldn’t provide invoices, receipts, or other proof. Some expenses were handwritten, others were tied to related parties, and others were simply labeled as “accruals” with no support.
The judge sided with the IRS - those expenses lacked substantiation and the deductions are disallowed. The net operating loss was also denied because the company couldn’t back it up with prior-year records.
In short, Lakeview’s bookkeeping errors erased many of its deductions.
A Mixed Result — and a Pending Bill
Judge Holmes called it a “mixed result.”
The IRS was right to question the books and reconstruct income, but Lakeview was right that not all deposits were taxable.
The company avoided penalties because it had relied — in good faith — on professional help. But the Court ordered that the final tax amount be computed later under Rule 155, a standard procedure to calculate the final bill after applying the Court’s adjustments.
So, while we don’t yet know how much Lakeview will owe, it’s likely to be a significant tax balance – probably tens of thousands - once the math is finalized.
My Opinion on this Case: When Business Owners Don’t Provide the Data
There’s an old saying in the accounting world: “Garbage in, garbage out.”
No matter how skilled a bookkeeper may be, they can only work with the information they’re given. If a business owner doesn’t provide timely bank statements, credit card records, invoices, and receipts, the financial reports — and the tax returns based on them — will never be accurate.
Many accounting and bookkeeping firms struggle with this same issue. It’s not always carelessness on the bookkeeper’s part; sometimes it’s simply that the client hasn’t provided the data needed to close the books correctly. In Lakeview’s case, that may have been a big part of the problem. The outside bookkeeper set up an accrual system, but without complete input from management, the records never reflected reality.
At the same time, this doesn’t absolve the outside bookkeeper of responsibility. The Tax Court seemed to recognize that balance — removing the penalties partly because Lakeview had relied on a professional, but still making it clear that the bookkeeping itself was unreliable. In my view, a competent bookkeeper should press harder for accurate information or even disengage if the client won’t provide it. Personally, I would have fired this client rather than continue producing records that I knew weren’t accurate. A professional’s duty isn’t just to record what’s handed to them, but to ensure that the books meet quality standards and will stand up in audit.
Takeaway Tips: How to Avoid Lakeview’s Mistakes
- Always report officer compensation.
Even for C corporations, listing zero wages when officers are active can draw attention from the IRS. - Use accrual accounting correctly.
Record income when earned, and expenses when incurred — not just when money moves. - Keep complete documentation.
Every deduction should be backed by invoices, receipts, or agreements. Ledger entries alone aren’t enough. - Reconcile your accounts monthly.
Your bank activity, billing system, and accounting software should always line up. - Give your bookkeeper what they need.
Timely access to bank statements, credit card accounts, and supporting paperwork is essential. Your financials can only be as accurate as the information you provide.
Author’s Note
Written by KAC Consulting, Inc. — a firm specializing in bookkeeping, tax advisory, and resolution services for small businesses. We help owners maintain clean, compliant records and audit-ready financials.
📅 Don’t wait until tax season to find out there’s a problem. Contact us before year-end for a professional books review and make sure your financials are accurate, complete, and audit-ready.
