Best of TaxLetter: How to Audit a Sex Shop

Thomas and Margaret Campsie operated a bookstore, peep show, and massage parlor in San Diego. They didn't keep a very accurate set of books. But an IRS agent determined that over 90% of their business was from massages.

Of the money collected for a massage, a masseuse received 40% of the fee, paid to her in cash each evening. The other big expense was towels and sheets. When the agent requested all the books and records, he received only some envelopes which contained expense receipts, linen invoices, and a series of incomplete notes on income figures. So, he used the Towel Count method of reconstructing income for 1972, 1973, and 1974. During that period, they used 47,300 towels (and the agent determined that each towel resulted in $6.91 of gross income,) which meant $327,000 gross income. Subtract 40% paid to the masseuses and you have income. (The agent didn't bother reconstructing allowable expense deductions.) Compute income tax, add self-employment tax, interest, and for good measure, add a 25% fraud penalty.

At trial, the taxpayers insisted they had kept adequate books and records which were "destroyed by a fire not caused by them." All this might have been avoided if the taxpayers had not forgotten to sign their 1972 tax return. (No. 16)