- 4.10.4.6 Formal Indirect Methods of Determining Income
- Exhibit 4.10.4-1 Interview Questions Addressing Accumulated Funds
- Exhibit 4.10.4-2 Internal Sources of Information
- Exhibit 4.10.4-3 External Sources of Information
- Exhibit 4.10.4-4 Example of Financial Status Analysis for Individual Business Return
- Exhibit 4.10.4-5 Bypassing Powers of Attorney
- Exhibit 4.10.4-6 Auditing Net Operating Loss Deductions (NOLD)
- Exhibit 4.10.4-7 Interview Questions Addressing E-Commerce Activities
- Exhibit 4.10.4-8 Tax Treatment of Diverted Income
- Exhibit 4.10.4-9 The Bank Deposits and Cash Expenditures Method: Example of Computation of Gross Receipts.
- Exhibit 4.10.4-10 Source and Application of Funds Method: Example of Computation for Cash and Accrual Based Taxpayers
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Formal indirect methods and the techniques used to support their development are collectively known as "Financial Status Audit Techniques" and trigger IRC section 7602(e), which states that "the Secretary shall not use financial status or economic reality examination techniques to determine the existence of unreported income of any taxpayer unless the Secretary has a reasonable indication that there is a likelihood of such unreported income."
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"Financial Status Audit Technique" was defined as the use of formal indirect methods in the Government Accounting Offices's report, "More Criteria Needed on IRS' Use of Financial Status Audit Techniques," GAO/GGD-98-38.
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"Examination techniques" include examining and testing the taxpayer's books and records, analytical tests, observing, and interviewing the taxpayer. None of these techniques are unique to the use of a formal indirect method and do not trigger the limitation of IRC section 7602(e). The refinement of the personal living expenses (PLE) for actual costs (rather than using Bureau of Labor statistics), however, is an examination technique that should only be used after the decision to use a formal indirect method to determine the actual tax liability has been made.
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Form 4822, Statement of Annual Estimated Personal and Family Expenses, may be used as a guide by the examiner for determining the taxpayer's personal living expenses. The form lists the typical expenses incurred by most individuals.
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It is inappropriate to ask the taxpayer to complete the form independently. The examiner must make sure the taxpayer understands what is required to accurately complete each expense item. The discussion required to complete the form can often provide the examiner with information about the taxpayer, which may help clarify potential issues and adjustments.
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Care should be taken to avoid duplicating amounts when modifying estimates for actual costs.
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In certain cases, as described below, income may be reconstructed using Bureau of Labor Statistics (BLS) data or comparable statistics from a reliable source. The analysis is completed using the tables for annual expenses, not income, because determining the expenses represents a better reflection of the actual costs to maintain a household.
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The BLS data can be accessed at www.bls.gov, select "Inflation and Consumer Spending." Tables specific to year, region within the United States, and individual expenses are available.
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Statistical data cannot be used as a substitute for reconciling the taxpayer's books and records. If the taxpayer provides information, or information becomes available, which shows that income in a specific amount was earned, statistical data cannot be used to increase income to the national average.
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In court proceedings involving individuals, IRC section 7491(b) may shift the burden of proof. Section 7491(b) provides that the Service will have the burden of proof for any item of income where income is reconstructed using only BLS data or other comparable statistical information on unrelated taxpayers.
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Statistical data can be used in conjunction with other available information (tax return information, IRP documents, etc.) at any time. Statistical data should be used as the sole source of information needed to calculate taxable income only when all three of the following conditions are met.
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The taxpayer is in a business or income producing activity other than as an employee. Evidence of employment and wages earned, such as a filed Form W-2, constitutes evidence precluding the use of statistical data unless the taxpayer can be placed in an unrelated income producing activity that could have generated unreported income. See Senter v. Commissioner, T.C. Memo 1995-311.
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The taxpayer must be a nonfiler. If the taxpayer filed a tax return and reported income, then the examiner must use other recognized methods (specific item, indirect methods) to confirm or reconstruct additional income. Statistical data is not a substitute for obtaining and considering relevant evidence in reaching a determination. See IRM 4.10.4.3.5.
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The taxpayer must be uncooperative with the examiner during the audit. Examples of noncooperation include a taxpayer who is not willing to meet with the examiner or provide any information or records regarding income producing activities, whether or not the examiner has been able to actually identify that activity. Examiners must use judgment to determine whether the taxpayer is cooperative. Examiners must use all available administrative tools, including the summons enforcement, to gather necessary information before statistical data is used.
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In Miller v. Commissioner, T.C. Memo 1993-121, the taxpayer filed tax returns for 1982-1985, but they contained virtually no information other than his name, address, occupation, filing status, and the number of exemptions claimed. The various line items on the returns either stated "none" or were footed to statements containing specific objections based upon amendments to the United States constitution. The taxpayer signed the returns, but added a disclaimer. The taxpayer was totally uncooperative during the audit and did not provide books or records. Bank records were used to reconstruct the taxpayer's business receipts and expenses. Because the bank records reflected virtually no personal expenditures, BLS cost-of-living data was used to determine income attributable to some other untraced source from which personal expenses were paid in addition to the reconstructed gross business receipts. The Court sustained the use of BLS data under these circumstances, except where the BLS figures appeared to be duplications of expenses paid from the bank accounts.
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In Portillo v. Commissioner, 932 F.2d 1128 (5th Cir. 1991), the examiner relied upon a filed Form 1099 to determine that a taxpayer had additional unreported income. The taxpayer agreed he had additional income, but not the amount reported on the Form 1099. Ultimately, the filer of the Form 1099 was only able to document the portion of additional income with which the taxpayer agreed. The statutory notice of deficiency reflected the entire amount shown on the Form 1099. The Court found that the notice of deficiency was arbitrary because it merely matched the taxpayer's return with the Form 1099, assuming the taxpayer's return was false and the Form 1099 was correct. In such circumstances, the Service is obligated to investigate.
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In Senter v. Commissioner,T.C. Memo 1995-311, the taxpayer failed to provide requested information or appear for scheduled meetings. The taxpayer's correspondence with the examiner raised "protestor" type arguments. The taxpayer did not comply with, and objected to, administrative summonses, but the examiner did not seek enforcement. The notice of deficiency reflected unreported income determined using prior year reported earnings adjusted by the Consumer Price Index (CPI). The Court held this determination of unreported income to be arbitrary and erroneous. Some predicate (preexisting) evidence establishing income was necessary to support a determination of unreported income.
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Examiners are cautioned that the use of a formal indirect method will be determined on a case by case basis. The use of a formal indirect method to make the actual determination of tax liability is not a substitute for reconciling whatever books are maintained by the taxpayer to the tax return. The use of a [formal] indirect method, however, is not precluded by the presentation of books and records. See Lipsitz v. Commissioner, 21 T.C. 917 (1954).
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The use of a formal indirect method to make the actual determination of tax liability should be considered when the factual development of the case leads the examiner to the conclusion that the taxpayer's tax return and supporting books and records do not accurately reflect the total taxable income received and the examiner has established a reasonable likelihood of unreported income.
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The minimum income probes must be completed before considering the use of a formal indirect method.
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The following list, which is not intended to be all inclusive, identifies circumstances that, individually or in combination, would support the use of a formal indirect method.
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A Financial Status Analysis that cannot be balanced; i.e., the taxpayer's known business and personal expenses exceed the reported income per the return and nontaxable sources of funds have not been identified to explain the difference;
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Irregularities in the taxpayer's books and weak internal controls;
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Gross profit percentages change significantly from one year to another, or are unusually high or low for that market segment or industry;
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The taxpayer's bank accounts have unexplained items of deposit;
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The taxpayer does not make regular deposits of income, but uses cash instead;
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A review of the taxpayer's prior and subsequent year returns show a significant increase in net worth not supported by reported income;
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There are no books and records. Examiners should determine whether books and/or records ever existed, and whether books and records exist for the prior or subsequent years. If books and records have been destroyed, determine who destroyed them, why, and when.
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No method of accounting has been regularly used by the taxpayer or the method used does not clearly reflect income. (IRC section 446(b).)
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The selection of a formal indirect method is critical to effectively and efficiently determine the tax liability. For example, although the Bank Deposits and Cash Expenditures Method and the Source and Application of Funds Method are frequently used, they are not the most effective methods if cash is not deposited and/or the cash outlays cannot be determined unless voluntarily disclosed by the taxpayer. Realistically, it may be difficult to identify significant personal acquisitions or expenditure that the taxpayer has deliberately camouflaged. These weaknesses can be overcome by using a formal indirect method based on the taxpayer's business activities to make the actual determination of tax liability; i.e., the Markup Method or Unit and Volume Method.
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The following factors should be considered when selecting a formal indirect method:
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The industry or market segment in which the taxpayer operates;
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Inventories are a principle income producing activity;
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Suppliers can be identified and/or merchandise is purchased from a limited number of suppliers,
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Merchandise and/or service pricing is reasonably consistent,
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The volume of production and variety of products,
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Availability and completeness of the taxpayer's books and records,
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The taxpayer's banking practices,
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The taxpayer's use of cash to pay expenses,
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Expenditures exceed income,
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Stability of assets and liabilities, and
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Stability of net worth over multiple years under audit.
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The reasons why the examination of income was expanded to include the use of a formal indirect method to make the actual determination of tax liability should be documented in the workpapers, as well as why a specific method was selected. Notations on the leadsheet is not sufficient. The documentation should include a narrative explaining how the evidence in the file establishes the likelihood of unreported income, and justifying the use of a formal indirect method. The documentation should include:
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a summary of the facts relevant to the decision,
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procedures and audit techniques used up to that point,
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manager's comments (if appropriate),
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any other information relevant to the decision, and
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conclusions.
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Document likely sources of taxable income. It is not essential to pinpoint the specific source, but only to indicate the possibility of, or the opportunity for, likely sources of taxable income. To the extent that the possible source(s) can be identified, the more credible the results of a formal indirect method will be. Possible sources can be demonstrated by:
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specific omissions,
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demonstrating that the taxpayer's business had the capacity to generate more gross receipts, or
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comparisons over time.
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The documentation should be prepared concurrent to the decision; i.e., before using a formal indirect method to make the actual determination of tax liability.
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The Source and Application of Funds Method is an analysis of a taxpayer’s cash flows and comparison of all known expenditures with all known receipts for the period. Net increases and decreases in assets and liabilities are taken into account along with nondeductible expenditures and nontaxable receipts. The excess of expenditures over the sum of reported and nontaxable income is the adjustment to income.
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The Source and Application of Funds Method and the Financial Status Analysis are both based on an evaluation of the taxpayer's cash flows. The only difference is the use of statistics to estimate unknown personal living expenses. Therefore, when the Financial Status Analysis indicates a reasonable likelihood of unreported income and establishes a reasonable likelihood of unreported income, the Source and Application of Funds Method is an efficient method for determining the actual amount of the understatement of income.
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The use of the Source and Application of Funds Method of proof in establishing unreported income received the Supreme Court’s approval in United States v. Johnson, 319 U.S. 503 (1943) . In addition to proving the taxpayer owned gambling establishments whose winnings were unreported, it was proven that in three of the years involved, the taxpayer’s personal expenditures exceeded his current income plus his declared accumulated funds.
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This method is based on the theory that any excess expense items (applications) over income items (sources) represent an understatement of taxable income.
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The Source and Application of Funds Method is recommended in the following situations:
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The review of a taxpayer’s return indicates that the taxpayer’s deductions and other expenditures appear out of proportion to the income reported.
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The taxpayer’s cash does not all flow from a bank account which can be analyzed to determine its source and subsequent disposition.
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The taxpayer makes it a common business practice to use cash receipts to pay business expenses.
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Sources of funds are the various ways the taxpayer acquires money during the year. Decreases in assets and increases in liabilities generate funds. Funds also come from taxable and nontaxable sources of income. Unreported sources of income even though known, are not listed in this computation since the purpose is to determine the amount of any unreported income. Specific items of income are denoted separately. Examples of sources of funds include:
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Decrease in cash on hand, in bank account balances (including personal and business checking and savings accounts), and decreases in Accounts Receivable,
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Increases in Accounts Payable,
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Increases in loan principals and credit card balances,
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Taxable and nontaxable income, and
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Deductions which do not require funds such as depreciation, carryovers and carrybacks, and adjusted basis of assets sold.
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Application of funds are ways the taxpayer used (or expended) money during the year. Examples of applications of funds include:
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Increases in cash on hand, increase in bank account balances (including personal and business checking and savings accounts), business equipment purchased, real estate purchased, and personal assets acquired,
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Purchases, business expenses,
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Decreases in loan principals and credit card balances, and
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Personal living expenses.
Determining the beginning amount of Cash on Hand and Accumulated Fund for the year is important. See IRM 4.10.4.6.8.3 below for possible defenses the taxpayer might raise regarding the availability of nontaxable funds.
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See Exhibit 4.10.4-10. for an example.
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Since the results of this method are on a cash basis, adjustments must be made for an accrual basis taxpayer. Accounts Receivable at the beginning of the period examined are shown on the debit side, as they are presumed to be collected during the period. Ending Accounts Receivables are a credit adjustment, required to effect a noncash increase in income.
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Accounts Payable are shown as adjustments in the reverse order of Accounts Receivables. Beginning Accounts Payable are a credit adjustment having the result of increasing income and transferring a current period cash expenditure to the prior period in which it was incurred and deductible under the accrual method. Conversely, ending Accounts Payable balances are a debit adjustment having the effect of reducing income to result in a noncash reduction of income.
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See Exhibit 4.10.4-10..
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An important feature of any examination is the inspection or analysis of the taxpayer’s bank records. This is particularly so in the examination of inadequate, nonexistent or possibly falsified books and records. The depth of the bank account analysis (see IRM 4.10.4.3.3.6 and IRM 4.10.4.3.4.7(2)) will depend upon the facts and circumstances of the individual case. When the bank account analysis indicates a reasonable likelihood of unreported income, the examination of income may be expanded to include the use of the formal Bank Deposits and Cash Expenditures Method to determine the actual understatement of taxable income.
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In summary, income is proven through a detailed, in-depth analysis of all bank deposits, cancelled checks, currency transactions, and electronic debits, transfers, and credits to the bank accounts AND identification of the taxpayer's cash expenditures. The Bank Deposits and Cash Expenditures Method is distinguished from the Bank Account Analysis by:
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the depth and analysis of all the individual bank account transactions, and
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the accounting for cash expenditures, and
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determination of actual personal living expenses.
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The Bank Deposits and Cash Expenditures Method computes income by showing what happened to a taxpayer’s funds. It is based on the theory that if a taxpayer receives money, only two things can happen: it can either be deposited or it can be spent.
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This method is based on the assumptions that:
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Proof of deposits into bank accounts, after certain adjustments have been made for nontaxable receipts, constitutes evidence of taxable receipts.
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Outlays, as disclosed on the return, were actually made. These outlays could only have been paid for by credit card, check, or cash. If outlays were paid by cash, then the source of that cash must be from a taxable source unless otherwise accounted for. It is the burden of the taxpayer to demonstrate a nontaxable source for this cash.
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The Bank Deposits and Cash Expenditures Method can be used in the examination of both business and nonbusiness returns.
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The Bank Deposits and Cash Expenditures Method may supply leads to additional unreported income, not only from the amounts and frequency of deposits, but also by identifying the sources of such deposits. Determining how deposited funds are dispersed or accumulated (to whom and for what purpose) might also provide leads to other sources of income.
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If the Bank Deposits and Cash Expenditures Method indicates an understatement of taxable income, it may be due to either underreporting of gross receipts or overstating expenses, or a combination of both.
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The classic bank deposits case is Gleckman v. United States, 80 F.2d 394 (8th Cir. 1935). The court held that standing alone bank deposits and large items of receipts do not prove additional tax due. On the other hand, if it is shown that these amounts can be associated with a business or income-producing activity, then the income is taxable. Since the Gleckman case, the Bank Deposits Method has received consistent judicial approval.
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The Gleckman case, and the cases that followed, taught that in order to use the Bank Deposits and Cash Expenditures Method in determining income, it must be shown that:
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The taxpayer was engaged in a business or income-producing activity,
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The taxpayer made periodic deposits of funds into a bank account or accounts,
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An adequate investigation of deposits was made by the examiner in order to negate or eliminate the likelihood that the deposits arose from nontaxable sources of income, and
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Unidentified bank deposits have the inherent appearance of income; i.e., the size of the deposits, odd or even amounts, source of checks deposited, dates of deposits, etc.
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The Bank Deposits and Cash Expenditures Method should not be the automatic choice when selecting a formal indirect method. For example, cash intensive businesses, where significant amounts of gross receipts are not deposited and numerous cash outlays occur, do not lend themselves to this method.
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If the Bank Deposits and Cash Expenditures Method is the method of choice, the entire analysis must be completed; shortened versions that do not account for business and personal cash expenditures are insufficient.
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The Bank Deposits and Cash Expenditures Method is recommended when:
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The taxpayer’s books and records are unreliable, unavailable, withheld, or incomplete.
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The taxpayer makes periodic deposits of funds into bank account(s) which appear to be generated from an income-producing activity.
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The taxpayer pays most business expenses by check.
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The taxpayer previously used bank account deposits to determine and report taxable income.
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The advantages of the Bank Deposits and Cash Expenditures Method include:
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Provides a complete picture of the taxpayer's activities; it clearly reflects the size and scope of the taxpayer's financial activities.
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Avoids necessity of documenting business expenses, with the exception of technical adjustments such as depreciation.
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When the taxpayer overstates business expenses, the overstatement is automatically accounted for in the mechanics of the computation. It is not necessary to audit expenses claimed on the tax return.
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Total deposits include amounts deposited from both taxable and nontaxable sources to all bank accounts (both business and personal) maintained or controlled by the taxpayer, as well as deposits made to accounts in savings and loan companies, investment trusts, brokerage houses, credit unions, and other financial institutions.
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Gross Receipts represents the total or gross taxable receipts of the taxpayer during the year from all sources, not reduced by returned sales and allowances, cost of goods sold, basis, or expenses. Gross Receipts, or Gross Business Receipts, can be determined by computing the sum of the three items listed below and deducting nontaxable and/or nonbusiness receipts, duplicated deposits, etc.
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Funds received by a taxpayer during the year, which were deposited in financial institutions, such as banks, savings and loan associations, investment accounts, etc.
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Funds expended that were not deposited.
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Funds accumulated and not deposited.
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Gross Receipts includes, but is not limited to the following:
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Gross sales of a trade or business
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Gross fees and commissions
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Gross wages, salaries, tips, and gratuities
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Gross dividends, interest, rents, royalties, pensions, and annuities
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Gross income from estates, trusts, and partnerships
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Gross proceeds from the sale of assets
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Gross farm income
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Gross Receipts does not include nontaxable income, such as, but not limited to, gifts, inheritances, loan proceeds, transfers between accounts, checks to cash redeposited, tax exempt interest, insurance proceeds, and Federal tax refunds.
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Are there any unusual or extraneous deposits which appear unlikely to have resulted from reported sources of income?
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Size of Deposit—Due to the need for expediency, the examiner may limit the examination to large deposits or deposits over a certain amount. However, the identification of smaller regular deposits may be indicative of dividend income, interest, rent, or other income, leading to a source of investment income.
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Kind of Deposit—An item of deposit may be unusual due to the kind of deposit, check or cash, in its relationship to the taxpayer’s business or source of income. An explanation may be required if a large cash deposit is made by a taxpayer whose deposits normally consist of checks. Also, a bank statement noting only one or two large even dollar deposits, in lieu of the normal odd dollar and cents deposits, would be unusual and require an explanation.
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Pattern and Frequency of Deposits—Many taxpayers, due to the nature of their business or the convenience of the depository used, will follow a set pattern in making deposits. Deviation from this pattern may bear questioning.
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Frequency of Deposits- Bank statements or deposit slips which indicate repeat deposits of the same amount on a monthly basis, quarterly or semi-annual basis may indicate rental, dividend, interest or other income accruing to the taxpayer.
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Location of Bank On Which the Check Was Drawn—The examination of deposit slips may indicate items of deposit which appear questionable due to the location of the bank on which the deposited check was drawn. It is common practice when preparing a deposit slip to list either the name of the bank, city of the bank or identification number of the bank upon which the deposited check was drawn. If an identification number is used, the name and location of the bank can be determined by reference to the banker’s guide. In all cases, if the location of the bank on which the check for deposit was drawn bears little relation to the taxpayer’s business location or source of income, it may indicate the need for further investigation.
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Are there any loan proceeds, collection of loans, or extraneous items reflected in deposits? In the analysis of bank deposits, the examiner should identify all items of this nature. This is a necessary step before comparing receipts to deposits.
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If loan proceeds are identified, request the loan application documents to verify the source and amount of the nontaxable funds. Review the loan application information for consistency with other information; i.e., cash flows, assets, anticipated gross receipts, etc. Discrepancies should be resolved with the taxpayer's assistance.
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If repayments of loans are identified, request the debt instruments to establish that a loan was made, the terms of the debt, and the repayment schedule. Ask the taxpayer to document the flow of funds to the borrower (e.g., a cancelled check) and to explain where the money came from (e.g., Accumulated Funds). Ask how much money has been collected to date and whether the taxpayer reported interest earned. Contact the party receiving the loan and ask for a notarized statement outlining the terms of the loan, when it was received, and the amount of money repaid.
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Are there transfers between bank accounts or redeposits?
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Before an examiner can reach any conclusion about the relationship between deposits and reported receipts, transfers and redeposits must be eliminated.
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For example, if a taxpayer draws a check to cash for the purpose of cashing payroll checks and then redeposits these payroll checks, the examiner would be incorrect if total deposits were compared to receipts reported without adjusting for this amount. The taxpayer has done nothing more than redeposit the same funds in the form of someone else’s checks.
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Are there personal or nonbusiness bank accounts?
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Unreported income may be found in personal accounts. If the analysis is limited to an inspection of the business bank accounts only, omitted taxable income in personal accounts may not be discovered.
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The examiner should ascertain whether the deposits, as reflected in these accounts, can be accounted for by withdrawals or transfers from business accounts or from other known sources of funds.
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The examiner should not overlook the possibility of more than one personal or business bank account.
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Are the deposits in personal and business accounts, as adjusted, during short periods of time, accounted for by the records?
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It is not unusual to find that total deposits will reconcile on a yearly basis with the total receipts for the year reported on the tax return.
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A closer examination of deposits on a weekly or monthly basis may indicate that these deposits do not reconcile with the receipts reported during the same periods.
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Reported receipts may not be deposited in the closing months of the year to balance out the excess of deposits and the understatement of receipts in the earlier months.
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The Bank Deposits and Cash Expenditures Method is used to determine Gross Receipts from all sources; i.e., it is not limited to consideration of business receipts and it is not necessary to audit or verify expenses deducted on the return. The basic formula for computing the understatement of taxable income is outlined here. An example is shown in Exhibit 4.10.4-9, The Bank Deposits and Cash Expenditures Method: Example of Computation of Gross Receipts.
1. Total bank deposits Less: 2. Nontaxable receipts deposited 3. Net deposits resulting from taxable receipts Add: 4. Business expenses paid by cash 5. Capital items paid by cash (personal and business) 6. Personal expenses paid by cash 7. Cash accumulated during the year from receipts Subtract: 8. Nontaxable cash used for lines 4-7. For accrual basis taxpayers: 9. For Accounts Receivable, subtract the beginning balance from the ending balance. A net increase represents additional taxable gross receipts and is added here. A net decrease represents payments included in prior year gross receipts and is subtracted here. 10. For Accounts Payable, subtract the beginning balance from the ending balance. A net increase represents purchases on account during the year and is subtracted here. A net decrease represents payments on accounts and is added here. 11. Gross Receipts as corrected
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The following is an explanation of the specific items used in above computation. The items are identified by the line number. See Exhibit 4.10.4-9. for an example.
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Line 1: Total bank deposits means total deposits in all of the taxpayer’s bank accounts. This includes the taxpayer’s business and personal accounts, the spouse’s accounts, and dependent children’s accounts. (Note: This could vary if the spouse files a separate return.) The deposits should be reconciled, if possible, so that only the receipts during the current year are included. This is accomplished by totaling deposits as shown on the bank statements, adding to this amount any current year’s receipts (which were deposited in the subsequent year), and deducting any prior year’s receipts, which were deposited in the current year. See Exhibit 4.10.4-9. for an example.
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Analyze the deposits to identify those that appear unlikely to have resulted from the taxpayer's known business activity. Determining the source of the funds may result in the identification of additional sources of income.
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Look for amounts that are unusually large (or small) or in even amounts, received on a regular basis, or currency when deposits normally consist of checks. These irregular deposits may indicate that not all gross receipts are deposited.
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Line 2: Eliminate nontaxable deposits representing duplicated and nontaxable items. See Exhibit 4.10.4-9. for an example.
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Duplicated items include checks to cash where the proceeds are redeposited. An example is when the taxpayer writes a check payable to cash and obtains currency and/or coins from the bank in exchange for the check. This currency is then used to cash customers' checks, which are deposited into the taxpayer’s bank account; in effect, redepositing the funds withdrawn. This deposit must be eliminated in determining deposits from taxable receipts.
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Transfers between accounts are another example of nontaxable receipts. Transfers can occur between different checking accounts, different savings accounts, and between savings accounts and checking accounts. Such transfers do not represent additional receipts since they are merely a shifting of funds from one account to another. Deposits from transfers must be eliminated in determining deposits from taxable receipts.
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Loan proceeds should be documented with loan applications and records of disbursement. The documents should be reviewed to confirm the amount and terms of the loan and determine if the information supplied by the taxpayer on the loan application is consistent with information on the return. Differences should be reconciled and may result in the identification of additional sources of income.
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Other common types of nontaxable receipts that are often deposited and must be eliminated in determining deposits from taxable receipts include gifts, inheritances, nontaxable Social Security benefits, nontaxable Veterans Administration benefits, tax refunds, etc.
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Line 3: This line represents the total amount of net receipts deposited in bank accounts. At this point, the examiner has completed a detailed reconciliation of the bank deposits.
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The next step in the Bank Deposits and Cash Expenditures Method is determining the amount of gross receipts never deposited in the bank accounts. The Bank Deposits and Cash Expenditures Method is incomplete and ineffective unless the cash expenditures are accounted for.
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Line 4: Business expenses paid by cash are computed by determining the business expenses paid by check and subtracting this amount from the total business expenses reported on the tax return. Examiners should be satisfied that all checks have been presented. Should the taxpayer remove any portion of the nondeductible checks, the analysis would result in an understatement of unreported income. See Exhibit 4.10.4-9. for an example.
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First determine total disbursements by adding the total deposits to the opening account balance, and then subtracting the ending balance. The resulting figure must then be adjusted for checks written during the year, which have not cleared the bank and checks written in the prior year, which cleared during the current year. This is merely a reconciliation of the checks so that only the current year’s checks are taken into account.
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Then identify all the checks for personal expenses and purchases of assets (business and personal) that would not be deductible as a business expense on the tax return, and subtract from the total disbursements. The result will be the business expenses paid by check. Note: Generally, the number of nonbusiness checks written is less than the number of business checks. Nonbusiness checks include checks for personal living expenses, capital purchases (personal and business), checks to cash redeposited, check transfers between accounts, and payments on liabilities. Checks for these items would be included even if the taxpayer deducted them on the return.
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Analyze the business expenses claimed on the tax return to eliminate expenses which are not cash outlays; i.e., depreciation, depletion, bad debts, etc.,
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Subtract the business expenses paid by check from the expenses requiring cash outlays claimed on the tax return. The result is the amount of business expenses paid by cash rather than check. Note: This step is based on the assumption that outlays as disclosed on the return were actually made and could only have been paid for by either check or cash. The result could represent unsubstantiated business expenses. Effectively, the taxpayer is either underreporting Gross Receipts or overstating expenses. Either way, the adjustment amount is the same.
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Line 5: Capital items paid by cash include cash purchases of capital assets, cash deposited in savings accounts, and cash used to make payments on liabilities or debt. For each item, determine how much the taxpayer paid during the year and subtract any payments made by check to arrive at the amount paid with cash.
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Review information in the file included with the case building data.
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Personal assets may be identified by reviewing state registrations and licenses, property records and building permits.
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Review the depreciation schedules to identify business assets for which the taxpayer is making payments; i.e., the taxpayer does not have clear title.
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Line 6: Personal expenses paid by cash include living expenses, income taxes, etc. Personal items paid for by cash can be determined in the same manner as the business expenses paid by cash. Add up all the actual personal living expense identified as part of the Financial Status Analysis and by completing Form 4822 with the taxpayer's assistance, and then subtract the personal living expenses paid by check. The remainder will be the personal living expenses paid with cash. Personal living expenses purchased with credit cards must also be considered.
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Line 7: Cash accumulated during the year is the cash (undeposited currency and coins) received by the taxpayer during the year which is on hand at the end of the year (it was neither expended nor deposited). There are two considerations:
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Increases in cash-on-hand at the end of the year that is associated with normal business practices and the need to complete cash transactions with customers.
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Increases in accumulations of funds that are not generally associated with normal business practices. Taxpayers may accumulate significant amounts of funds for personal use.
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Examiners should establish the amount and verify the taxpayer's statements of cash on hand and cash accumulations early in the examination, before the likelihood of unreported income is established. This information is needed to complete the Financial Status Analysis. Asking taxpayer's about cash on hand and cash accumulations does not violate IRC section 7602(e), which requires the IRS to establish a likelihood of unreported income before using a financial status audit technique (formal indirect method) to make the actual determination of tax liability. For additional information see:
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IRM 4.10.4.2.5 and IRM 4.10.4.2.6
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IRM 4.10.4.3.3.2(3) and (4)
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IRM 4.10.4.3.4.4(3)
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Exhibit 4.10.4-1
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Line 8: Nontaxable cash used for (4) through (7) is nontaxable cash used to pay expenses, purchase capital assets, deposit into savings accounts, make payments on liabilities, and to accumulate. Nontaxable cash includes: loans not deposited, withdrawals from savings accounts not redeposited, gifts, inheritances, collection of loans receivable, nontaxable income, etc. It is important to get complete information about nontaxable income as efforts may be wasted if the taxpayer later provides information regarding the availability of nontaxable sources of funds to explain an understatement. See IRM 4.10.4.6.8.3 for possible defenses the taxpayer might raise regarding nontaxable sources of funds.
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Line 9: To account for changes in Accounts Receivable for accrual basis taxpayers, subtract the beginning balance from the ending balance to determine the change. A net increase represents additional taxable Gross Receipts, a net decrease represents payments already included in prior year Gross Receipts. See IRM 4.10.4.6.4.6.2 for complete discussion of adjustments for accrual basis taxpayers.
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Line 10: To account for changes in Accounts Payable for accrual basis taxpayer, subtract the beginning balance from the ending balance to determine the change. A net increase results from purchases on account during the year and is subtracted from Gross Receipts. A net decrease results from payments on account during the year in excess of purchases on account and is added to Gross Receipts. See IRM 4.10.4.6.3.6.2 for complete discussion of adjustments for accrual basis taxpayers.
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Line 11: Gross Receipts as corrected should be compared to the Gross Receipts reported on the tax return to compute the adjustment to income.
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If the taxpayer is on the accrual basis, the differences between the beginning and ending balances of Accounts Receivable and Accounts Payable should be added to or subtracted from the corrected Gross Receipts to convert the computation to the accrual basis accounting method. In some cases, it will not be practical to determine the amount of Accounts Receivable and Accounts Payable due to the inadequacy of the records. In such cases, these adjustments may be ignored unless the amount appears to be material. Changes in the balances of Accounts Receivable and Accounts Payable should be handled as follows:
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An increase in Accounts Receivable is added to Gross Receipts. An increase in receivables results from sales on accounts during the year being in excess of collections on account during the year. Therefore, the taxpayer has income from sales that is not reflected in deposits or cash expended because the cash has not yet been received. This increase is added to Gross Receipts, as determined, so that the taxpayer’s current income is properly reflected.
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A decrease in Accounts Receivable is subtracted from Gross Receipts. A decrease in receivables results from collections on account during the year. Therefore, the taxpayer has received cash during the year which is attributable to sales made in a previous year. This decrease is subtracted from Gross Receipts so that the taxpayer’s current income is properly reflected.
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An increase in Accounts Payable is subtracted from Gross Receipts. An increase in Accounts Payable results from purchases on account during the year. This affects the bank deposit computation in the following manner:
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The total outlays per return includes all purchases and expenses deducted on the return regardless of whether or not they were all paid (except depreciation, amortization, etc.). Thus, the amount of Accounts Payable at the end of the year is included in total outlays per return.
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The taxpayer presumably paid for all purchases and expenses incurred during the year, except for the Accounts Payable balance at the end of the year, and also paid off the Accounts Payable amount owing at the beginning of the year. Business expenses paid by check include all such payments, i.e., payments on Accounts Payable and payments of current expenses.
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The amount of business expenses paid by cash, which is added to deposits and other cash expenditures in arriving at Gross Receipts, is determined by subtracting business checks from total outlays per return.
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If the balance of Accounts Payable at the end of the year is greater than the balance at the beginning of the year, the total outlays per return will be greater than the actual amount paid by check and cash. Therefore, if an increase in Accounts Payable is NOT subtracted from Gross Receipts, the amount of business expenses paid by cash will be overstated in the amount of the increase in Accounts Payable, and the Gross Receipts as determined will be overstated in the same amount.
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A decrease in Accounts Payable is added to Gross Receipts. A decrease in Accounts Payable results from payments on account during the year being in excess of purchases on account during the year. This has the direct opposite effect on the bank deposit computation as an increase in Accounts Payable discussed in IRM 4.10.4.6.3(4) above. In other words, the total outlays per return will be less than the actual amount paid by check and cash. This will result in an understatement of business expenses paid by cash in the amount of the decrease in Accounts Payable, and an understatement of the Gross Receipts as determined in the same amount.
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Bank service charges are charged to a depositor’s account for various reasons. They appear on bank statements in the same manner as checks except that they are identified by code letters which are keyed to explanations. If all of these charges are allowable business expenses, no adjustment is necessary in the computation. The charges will automatically be reflected in the total checks written (beginning bank balance plus deposits less ending bank balance) and business expenses paid by check (total checks written less nonbusiness checks). Any charges which are not allowable business expenses should be included with the nonbusiness checks.
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Checks deposited by the taxpayer but returned by the bank are charged to the taxpayer’s account. This situation arises when the taxpayer deposits a check which is not paid by the bank on which it is drawn for some reason. For example, the maker of the check did not have sufficient funds in the account to pay the check, the maker did not have an account, etc. Since these items are reflected in the closing bank balances, no adjustments in the bank deposit computations are required. However, the transaction should be categorized as a nontaxable deposit.
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A bank account is overdrawn when the amount of the depositor’s outstanding checks is greater than the balance on deposit in the account. Normally, this situation will have no effect on the bank deposit computation. It will merely entail the use of negative bank balances in the computation of total checks written.
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An example of such a computation follows:
Bank balance @ beginning of year per bank statement $11,500 Less: Prior year outstanding checks (13,000) Balance @ beginning of year as reconciled (1,500) Add: Deposits made during the year 125,000 Total available $123,500 Bank balance @ end of the year per bank statement $5,000 Less: Current year outstanding checks ($7,200) Balance @ end of the year (2,200) Total checks written during the year $125,700 -
After the corrected Gross Receipts is determined, a comparison must be made with the amount reported on the return to arrive at the adjustment to income.
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The understatement of Gross Receipts and/or overstatement of expenses is added to the taxable income reported on the return.
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The Bank Deposits and Cash Expenditures Method does not account for noncash expenses claimed on the tax return that do not represent a current outlay of funds. Examples include depreciation, depletion, bad debts and inventory. Therefore, these expenses should be separately considered and specific item adjustments made if necessary. For example, if the bank deposit computation revealed an adjustment of $5,000 and depreciation claimed was found to be overstated in the amount of $1,000, there would be two adjustments:
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Unreported income in the amount of $5,000
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Adjustment to depreciation in the amount of $1,000
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The Markup Method produces a reconstruction of income based on the use of percentages or ratios considered typical for the business under examination in order to make the actual determination of tax liability. It consists of an analysis of sales and/or cost of sales and the application of an appropriate percentage of markup to arrive at the taxpayer’s Gross Receipts. By reference to similar businesses, percentage computations determine sales, cost of sales, gross profit or even net profit. By using some known base and the typical applicable percentage, individual items of income or expenses may be determined. These percentages can be obtained from analysis of Bureau of Labor Statistics data or industry publications. Use of the taxpayer’s actual markups is required if known.
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The Markup Method is a formal indirect method that can overcome the weaknesses of the Bank Deposits and Cash Expenditures Method, Source and Application of Funds Method, and Net Worth Method, which do not effectively reconstruct income when cash is not deposited and the total cash outlays cannot be determined unless volunteered by the taxpayer. If personal enrichment occurs that cannot be identified, the effectiveness of these methods is diminished. For example, the possibility exists that significant personal acquisitions or expenditures are paid with cash and are not evident. The Markup Method is similar to how state sales tax agencies conduct audits. The cost of goods sold is verified and the resulting Gross Receipts are determined based on actual markup.
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This method is most effective when applied to businesses whose inventory is regulated or purchases can be readily broken down in groups with the same percentage of markup.
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An effective initial interview with the taxpayer is the key to determining the pertinent facts specific to the business being examined.
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In United States v. Fior D'Italia, Inc., 536 U.S. 238 (2002), the majority held that IRC section 446(b) does not limit authority to use aggregate estimation of income taxes (unreported tip income).
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In Barragan v. Commissioner, TC Memo 1993-92, the Service properly determined gross receipts from a gas station based on the supplier's delivery records and the retail prices per an independent market survey. Similarly, in Stafford v. Commissioner, TC Memo 1992-637, the Service properly determined gross receipts from gas stations based on Bureau of Labor Statistics data.
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In Nichols v. Commissioner, TC Memo 1983-242, the Service was upheld in applying an established tip rate to the taxpayer's gross receipts to determine unreported tip income.
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In Webb v. Commissioner, 394 F.2d 366, 371-372 (5th Cir. 1968), aff'g T.C. Memo. 1966-81, the Government determined Webb's income from liquor sales using the Markup Method.
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It was held in the Estate of Bernstein v. Commissioner, TC Memo 1956-260, that the inability to use other [formal] indirect methods is not prerequisite for using a percentage method.
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In the case of Yorkville Live Poultry Co. v. Commissioner, 18 BTA 47 (1929), the Board of Tax Appeals approved a net income computation based upon 4 percent of the net sales where no books were available.
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The Markup Method is recommended in the following situations:
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When inventories are a principal income producing factor and the taxpayer has nonexistent or unreliable records.
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Where a taxpayer’s cost of goods sold or merchandise purchased is from a limited number of sources, these sources can be ascertained with reasonable certainty, and there is a reasonable degree of consistency as to sales prices.
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This method is effective for industries such as liquor stores, taverns, gasoline retailers, restaurants, and jewelry stores.
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Examiners should address the following issues when applying the Markup Method:
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Use the taxpayer's own records and oral testimony to establish the markup percentages based on known costs and sales prices. This should be the best source of information. Plausible explanations for why the taxpayer's markup percentages differ from national averages should be accepted.
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If it appears that the cost of goods sold and/or purchases are also understated, issue a summons to the taxpayer's suppliers for sales records.
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Judgment should be exercised by examiners when using industry standards or surveys to make sure the comparisons are valid and are for similar situations. Consider the availability of valid sources of information containing the necessary percentages and ratios. Adjust percentages and ratios to reflect those during the time of the return under audit. IRC section 7491(b) places the burden of proof on the Service with respect to any item of income that was reconstructed solely through the use of statistical information on unrelated taxpayers.
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The gross profit to sales ratio indicates the average markup on products. The calculation divides the gross profit margin (sales less cost of goods sold) by total sales:
Sales - Cost of Sales Sales -
Example: A taxpayer sells two products, A and B, and reports $140,000 in gross sales. The costs for product A are $50,000 and the costs for product B are $80,000. The costs are verified with the third party supplier and adjusted for opening and closing inventory.
Sales per return: $140,000 Cost of Goods Sold (Product A): $50,000 Cost of Goods Sold (Product B): $80,000 The examiner determines the gross profit margins for products A and B by interviewing the taxpayer, analyzing the taxpayer's records, and reviewing industry standards. Product A: 10% Product B: 20% Step 1: Determine the COGS% Product A Product B Gross Receipts: 100% 100% Less: Gross Profit % 10% 20% COGS% 90% 80% Step 2: Determine the correct Gross Receipts: (COGS/COGS% = Gross Receipts) Product A Product B $50,000/.90 $55,555 $80,000/.80 $100,000 Step 3: Determine the Adjustment to Gross Receipts Sales of Product A: $ 55,555 Sales of Product B: + $100,000 Sales as Recomputed: $155,000 Sales per Tax Return: - $140,000 Adjustment to Gross Receipts: $15,555
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Using the Cost of Sales to Gross Receipts ratio is a variation of the Gross Profit Margin to Sales ratio. It also is a comparison of costs to sales.
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Example: a taxpayer sells two products, A and B, and reports $70,000 in gross receipts. The costs for product A are $20,000 and the costs for product B are $30,000. The costs are verified with the third party supplier and adjusted for opening and closing inventory.
Sales per return: $ 70,000 Cost of Sales (Product A) $ 20,000 Cost of Sales (Product B) $ 30,000 The examiner determines that cost of sales is 75% of sales for product A and 50% of B by interviewing the taxpayer, analyzing the taxpayer's records, and reviewing industry standards. Step 1: Determine the COGS% Product A Product B Cost of Sales % 75% 50% Step 2: Determine the correct Gross Receipts: (COS/COS% = Gross Receipts) Product A Product B $20,000/.75 $26,666 $30,000/.50 $60,000 Step 3: Determine the Adjustment to Gross Receipts Sales of Product A: $ 26,666 Sales of Product B: + $ 60,000 Sales as Recomputed: $ 86,666 Sales per Tax Return: - $ 70,000 Income Adjustment: $16,666
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In many instances Gross Receipts may be determined or verified by applying the sales price to the volume of business done by the taxpayer. The number of units or volume of business done by the taxpayer might be determined from the taxpayer’s books as the records under examination may be adequate as to cost of goods sold or expenses. In other cases, the determination of units or volume handled may come from third party sources.
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This method for determining the actual tax liability has been effectively applied in carryout pizza businesses, coin operated laundry mats, and mortuaries.
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In Salami v. Commissioner, TC Memo 1997-347, the court held that a cab driver's gross income could be determined using claimed gas expenses, price per gallon, miles per gallon, occupancy rates, etc. Same for the cab driver in Irby v. Commissioner, TC Memo 1981-399.
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In Maltese v. Commissioner, TC Memo 1988-322, the Service was upheld in determining gross income by determining the number of pizza crusts per 100 pounds of flour times the average price per pizza.
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In Stanoch v. Commissioner, TC Memo 1959-132, the Service established Gross Receipts for a tavern by allowing a specific measurement of liquor per drink and a percentage for spillage.
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The Unit and Volume Method is recommended for making the actual determination of tax liability when:
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The examiner can determine the number of units handled by the taxpayer and also know the price charged per unit.
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The business has only a few types of products which are sold or there is little variation in the types of services performed, and the charges made by the taxpayer (sales price) for merchandise or services are relatively the same throughout the tax period.
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Examiners should be aware of the following when considering the Unit and Volume Method:
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Is there a common denominator for the business that drives gross receipts?
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Can the number of units handled or consumed by the taxpayer be ascertained?
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Is the price per unit or profit per unit obtainable?
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Is there a third party from whom the taxpayer's consumption, units of production, or sales are available?
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This example is for a coin operated laundry, where the known unit is the amount of water needed for each unit of sale (load of laundry). Per the utility bills, the taxpayer consumed 3,000,000 gallons of water.
Gallons of water consumed: 3,000,000 Non washing machine consumption (spillage): - 50,000 Net water available for paid loads (gallons): 2,950,000 Gallons of water per load of wash, determined from manufacturer or credible oral testimony, is 27 gallons. The reconstructed number of loads of wash is 2,950,000/27 = 109,259. The price per washing machine load is $2.50. The gross receipts from washing machines is 109,259 loads x $2.50 / load = $273,148. -
The price per dryer load is $1.50. Based on observations on different days of the week, the examiner determines that customers' use of dryers is 75% of their wash loads. The price per dryer load is $1.50. Therefore, the gross receipts for dryer use is .75(109,259) x $1.50 = $122,916.
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Summarize the Gross Receipts for all the services and compare to the Gross Receipts reported on the tax return.
Gross Receipts from washers: $ 273,148 Gross Receipts from dryers: + $122,916 Other Receipts (vending, arcade): $ 25,000 Sales as Recomputed: $ 421,064 Sales per Tax Return: - $ 376,745 Income Adjustment: $44,319
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The Net Worth Method for determining the actual tax liability is based upon the theory that increases in a taxpayer’s net worth during a taxable year, adjusted for nondeductible expenditures and nontaxable income, must result from taxable income. This method requires a complete reconstruction of the taxpayer’s financial history, since the Government must account for all assets, liabilities, nondeductible expenditures, and nontaxable sources of funds during the relevant period.
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The theory of the Net Worth Method is based upon the fact that for any given year, a taxpayer’s income is applied or expended on items which are either deductible or nondeductible, including increases to the taxpayer’s net worth through the purchase of assets and/or reduction of liabilities.
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The taxpayer’s net worth (total assets less total liabilities) is determined at the beginning and at the end of the taxable year. The difference between these two amounts will be the increase or decrease in net worth. The taxable portion of the income can be reconstructed by calculating the increase in net worth during the year, adding back the nondeductible items, and subtracting that portion of the income which is partially or wholly nontaxable.
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The purpose of the Net Worth Method is to determine, through a change in net worth, whether the taxpayer is purchasing assets, reducing liabilities, or making expenditures with funds not reported as taxable income.
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The Net Worth Method is a very old method of determining income. See United States v. Frost, 25 F.Cas. 1221 (N.D. Ill. 1869). The first criminal case involving the Net Worth Method was United States v. Beard, 222 F.2d 84 (4th Cir. 1955), which involved delinquent returns.
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The use of the Net Worth Method of proof has been approved by the Supreme Court in: Holland v. United States, 348 U.S. 121 (1954). Holland set forth the following requirements that the Government must meet when using the Net Worth Method:
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Establish an opening net worth, also known as the base year, with reasonable certainty.
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Negate reasonable explanations by the taxpayer inconsistent with guilt; i.e., reasons for the increased net worth other than the receipt of taxable funds. Failure to address the taxpayer's explanations might result in serious injustice.
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Establish that the net worth increases are attributable to currently taxable income.
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Where there are no books and records, willfulness may be inferred from that fact coupled with proof of an understatement of taxable income. But where the books and records appear correct on their face, an inference of willfulness from net worth increases alone might not be justified.
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The Government must prove every element beyond a reasonable doubt, though not to a mathematical certainty.
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The Net Worth Method is generally recommended in the following situations:
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Two or more years are under examination.
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Numerous changes to assets and liabilities are made during the period.
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No books and records are maintained.
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The books and records are inadequate or not available.
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The books and records are withheld by the taxpayer.
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The Net Worth Method should be used only if
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The group manager concurs that the Net Worth Method is the more appropriate method and should be used, or
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Criminal Investigation has requested that the Net Worth Method be used.
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The fact that the taxpayer’s books and records accurately reflect the figures on a return does not prevent the use of the Net Worth Method of proof. The Government can still look beyond the "self-serving declarations" in a taxpayer’s books and records and use any evidence available to determine whether the books accurately reflect the taxpayer's financial history.
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While the Net Worth Method was originally used against taxpayers whose principal source of income was from an illegal activity, it is now regularly recommended in fraud cases, especially where significant changes in net worth have occurred and other methods of proof are insufficient.
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In addition to being used as a primary means of proving taxable income so that an actual determination of tax liability can be made, the Net Worth Method is relied upon to corroborate other methods of proof and test the accuracy of reported taxable income.
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The formula for computing income using the Net Worth Method is as follows:
Total Assets $XXX Less: Total Liabilities (XXX) Net Worth, end of year $XXX Less: Net Worth, beginning of year (XXX) Increase or decrease in net worth $XXX Add: Nondeductible expenditures XXX Sub-Total XXX Less: Nontaxable income (XXX) Adjusted gross income (this figure would be net or taxable income in the case of partnerships and corporations) $XXX -
A complete discussion of the computation for the Net Worth Method and associated audit techniques is included in IRM 9.5.9.5.4 through IRM 9.5.9.5.9.
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If the use of a formal indirect method results in the identification of an understatement of taxable income, the examiner must ensure that the formal indirect method was applied correctly to eliminate any potential defense the taxpayer may use to discredit the results.
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The defenses can be grouped into three categories:
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Showing that the computation is inaccurate or flawed,
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Showing that the unexplained difference is due to a nontaxable source, or
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Showing that the unexplained difference is from expenditures of available cash accumulated in prior years.
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Bank Deposits and Cash Expenditures Method—Most challenges to the accuracy of this method focus on the nature of the individual deposits in the account(s). The taxpayer may claim that the deposits consist of taxable and nontaxable items that were not correctly classified by the examiner. Deposits of loan proceeds, gifts and inheritances, as well as transfers from other accounts are some of the most common claims. Redeposits of items, such as insufficient funds checks, may also cause inaccuracy if counted twice. The examiner should carefully review the analysis and attempt to identify the source and character of each deposit before presenting results as an understatement of taxable income.
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Source and Application of Funds Method— Challenges are made to the adjustments for the accrual method of accounting and the handling of loan transactions; i.e., loan payments are an application of funds. Also, the taxpayer may claim that purchases labor costs, materials and supplies, and other current period costs associated with inventory are an application of funds rather than the cost of goods sold.
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Markup Method—The main challenges to this method are to show that the computation relies upon improper percentages, improper cost of sales, or that the examiner’s computation fails to give adequate consideration to significant items such as spillage, breakage or theft losses. These issues should be addressed and quantified during the initial interview. Since the method relies on a comparison of a situation similar to that under examination, defenses could be formulated based on dissimilarities in several areas such as type of merchandise handled, size of the operation, locality, time period covered, or general merchandising policy.
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The taxpayer may attempt to refute the findings of the examiner’s formal indirect method by claiming the unexplained difference is actually caused by the receipt of nontaxable sources of funds.
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If it can be shown that all nontaxable sources of income have been considered, then it can be concluded that the only likely source remaining is a taxable one. Examiners need to show that increases in taxable income arose from a likely taxable source. This can be demonstrated by specific omissions, showing the taxpayer’s business had the capacity to generate more sales, or comparisons over time. To the extent that the possible source can be identified, the more acceptable the computation will be.
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The taxpayer may attempt to refute the findings of the examiner’s formal indirect method by claiming the unexplained difference is actually caused by the use of nontaxable funds accumulated in prior years.
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Since Cash on Hand and Accumulated Funds are important fundamental aspects of the examination of income and the formal indirect methods, examiners should establish the amount and verify the taxpayer’s statements of cash accumulations during the initial interview. This is necessary because:
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Cash on Hand and Accumulated Funds can explain Financial Status Analyses that appear to identify a potentially significant imbalance. The issue can be resolved quickly and with the least amount of burden to the taxpayer if it is addressed early in the examination.
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The information is needed to determine whether a formal indirect method should be used, and which method is most appropriate.
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An adjustment for unreported income can be challenged if the availability of Cash on Hand and Accumulated Funds is not addressed at the beginning of the audit. The after-the-fact "cash in the mattress" defense cannot be used if the actual Cash on Hand and Accumulated Funds have already been established.
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In order to avoid any misunderstanding by the taxpayer, it is important that the meaning of "cash on hand" and "accumulated funds" be explained prior to answering any inquiry. Taxpayers must understand the term, "cash on hand" means any undeposited currency and coins used for normal business transactions. Accumulated funds refers to cash accumulated by the taxpayer and is not associated with normal business practices and/or transactions with customers. The funds may have been taxed in prior years, originate from nontaxable sources, or may represent taxable income in the year under audit. Once the terms are understood, the examiner should inquire as to the existence of any cash on hand and accumulated funds. See Exhibit 4.10.4-1., Interview Questions Addressing Accumulated Funds.
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If a taxpayer attempts to avoid answering questions concerning cash, examiners should try to pinpoint amounts by starting with an estimate such as "over or under $10,000" and narrowing the range until the taxpayer agrees with a general amount.
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A commitment should be sought concerning whether an individual had any large accumulations of cash during the tax period under audit. Examiners should ask the taxpayer to make an affirmative statement regarding the existence or nonexistence of Cash on Hand and Accumulated Funds.
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If taxpayers allege that they have what appears to be an inordinate amount of cash, the examiner should further inquire to establish:
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The amount of cash on hand at the end of each year under examination to the present (at the time of the interview).
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How it was accumulated.
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Where it was kept and in what denominations.
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Who had knowledge of it.
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Who counted it.
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When and where any of it was spent.
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Why did the taxpayer accumulate the cash on hand
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Information regarding cash on hand and accumulated funds is necessary to establish the consistency and reliability of the taxpayer’s statement. Usually no direct corroborating evidence is available but statements made about the source and use of the funds can be verified. Look for inconsistencies. For example:
-
The taxpayer may not have had sufficient taxable or nontaxable income in prior years to accumulate cash.
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Taxpayer claims of substantial Cash on Hand or accumulated funds might be discredited by showing that the taxpayer borrowed money, made installment purchases, incurred large debts, was delinquent on accounts, had a poor credit rating or filed for bankruptcy. Demonstrating that the taxpayer lived sparingly may suggest that the taxpayer does not have accumulated funds, but showing that the taxpayer lived sparingly does not necessarily discredit a taxpayer's assertion that they had substantial accumulated funds. Cultural differences and individual philosophies regarding money management may explain the taxpayer's chosen lifestyle.
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Financial statements filed by the taxpayer at banks and other places could be reviewed to see if the taxpayer disclosed the Cash on Hand on these statements.
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A taxpayer’s explanation for Cash on Hand or Accumulated Funds may change during an examination. The examiner should document the information as it is received. The documentation should include when and where the information was received, who was present, what was said, and when the documentation was prepared; i.e., contemporaneously to the event.
The following template can be used as part of the initial interview with a taxpayer.
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Do you keep more than $1,000 on your person, at your home, at your business, or in any other location?
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What do the accumulated funds consist of? (For example, paper money, coin, money orders, cashier checks, etc.)
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In what denominations were the funds accumulated?
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Where do you keep the accumulated funds? (Provide exact location.)
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Were the accumulated funds always kept in the location identified in question 4? If not, provide the exact locations and dates that the accumulated funds were kept there.
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What kind of container were the accumulated funds kept in? (Shape and dimensions of the container.)
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How much accumulated funds did you have at the beginning of the year under audit? At the end of the year under audit?
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How much accumulated funds do you have right now (today's date)?
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Over what period of time were the funds accumulated?
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Are the accumulated funds yours alone, or does it belong to more than one person? Identify each person (name and relationship to taxpayer) having ownership of these accumulated funds.
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Do any of the other owners have access to these accumulated funds? If yes, provide the following information.
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Name of person with access.
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Date of each access.
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Identify the increase or decrease in accumulated funds for each access.
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Determine whether each person obtaining access was accompanied by another person. If so, provide the name and relationship of such person(s).
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Identify the type of records kept to identify the name(s), date(s) and effect on the accumulated funds each time there was an access.
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-
Why are you accumulating funds? (Ask each person having ownership.)
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What is the original source of the money included in the accumulated funds? (Ask each person having ownership.)
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How often do you access the accumulated funds?
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What is the effect of each access? Do you add or withdraw from the accumulated funds?
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Are you accompanied by another individual when you access the accumulated funds? If yes, provide the name and address of the persons involved.
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Do you count the accumulated funds every time you access them? If not, provide the dates and purpose for when the funds were counted.
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Does anyone else know about the accumulated funds? If yes, provide the name, relationship, address and phone number for the person. Also determine whether these persons have access to the accumulated funds and if so, the manner and circumstances under which their access was made.
| Information Data Retrieval System (IDRS) Commands | |
| AMDIS | Provides a summary of all years open for examination |
| AMDISA | Provides the exam records for a specific year under audit |
| Business Master File On-Line (BMFOL) - IRM 2.3.59 | |
| BRTVUE | Provides business entity return information |
| BMFOLI | Provides a list of all tax periods on Master File. Indicates whether a return was filed for those tax periods. Returns covered include income tax, employment tax, and excise tax. |
| BMFOLR | Return information |
| BMFOLT | Provides a return transcript for a specific tax period on Master File. |
| BMFOLU | Provides total wages for a calendar year per the Form(s) 941, W-3, and the W-2's filed by the taxpayer. It also provides the number of W-2's listed on the W-3 and the number of W-2's actually filed. This information is available if an MFT 88 appears on BMFOLI for the calendar year. |
| BMFOLZ | Audit history screen |
| The Dependent Database On-Line - IRM 2.3.54 | |
| DDBOL (def 0,1,2) | Access to dependent database for specific years |
| The Duplicate Direct Deposit On-Line Research - IRM 2.3.74 | |
| DUPOL (def 0,1,2) | Displays both IMF and BMF taxpayer information to help aid in fraud detection (use of SSN) by monitoring duplicate direct deposits made to taxpayers' bank accounts. |
| Individual Master File On-Line (IMFOL) (Provides read-only access to IMF - See IRM 2.3.51) | |
| RTVUE | Provides tax return information, including all schedules filed with the return. |
| IMFOLR | Provides account postings and basic nonbusiness tax return information such as AGI, wages, interest income, and itemized deductions. |
| IMFOLT | Tax module screen |
| IMFOLI | Provides a list of all tax periods on Master File. Indicates whether a return was filed for those tax periods and if the return filed was a substitute for return (SFR) or the taxpayer's return (POSTED). Also indicates subsequent assessments after the return was filed. |
| IMFOLZ | Audit history record |
| National Account Profile (NAP) | |
| INOLE | Provides access to the National Account Profile, which contains selected entity information for all Master File (MF) accounts such as name, address and date EIN established (or date of birth) - IRM 2.3.47 |
| INOLET | TIN type known |
| INOLES | Specific account |
| Information Returns Master File Transcript Request (IRPTR) | |
| IRPTR | Allows IDRS users to request either on-line or hardcopy IRP transcripts from IRMF - IRM 2.3.35 |
| IRPTRL | Payee IRPOL request (summary) |
| IRPTRO | Itemized payee listing of Forms 1099 and W-2 for the taxpayer |
| IRPTRR | Payer hardcopy request |
| The Transcript Research System (TRS) | |
| MFTRA | Allows for hard copy transcripts or real-time displays for transcript data - IRM 2.3.32. Provides dates of assessment, date tax return was filed, date tax return was due, date of prior audit, dates liens filed. |
| Payer Master File (PMF) | |
| PMFOLS | Provides information from the Payer Master File. The summary screen shows all sources of income and amounts - IRM 2.3.53 |
| Delinquent Return Investigations | |
| TDINQ | Displays entity and module data pertinent to delinquent return investigations (if present), including the Revenue Officer assigned to the taxpayer account - IRM 2.3.26 |
| Currency and Banking Retrieval System (CBRS) | |
| Overview | The Bank Secrecy Act and money laundering statutes were passed by Congress to help facilitate the identification and prosecution of individuals involved in illegal activities for profit. |
| The CBRS database is accessible to authorized personnel within the Treasury Department. The system can be used to identify bank accounts, secreted cash, leads to assets and foreign bank accounts, nominees and other useful information for Compliance and other law enforcement personnel. | |
| Form 104 (FinCEN) | Currency Transaction Reports (CTR) - Domestic financial institutions, including banks, credit unions, check cashing establishments, and currency exchanges are required to file a CTR on each deposit, withdrawal, exchange of currency, or other payment or transfer involving a transaction in currency in an amount greater than $10,000. Either cash-in or cash-out can generate the reporting requirements. |
| Form 103-N (FinCEN) | Currency Transaction Report by Casino (CTRC) - Casinos are required to file a CTRC on each deposit, withdrawal, exchange of currency, gambling token or chips, or other payment or transfer which involves a transaction in currency of more than $10,000. Formerly Form 8362. |
| Form 103 (FinCEN) | Currency Transaction Report for Nevada Casino- Same requirements as Form 8362, except is filed only by Nevada casinos. |
| Form 105 (FinCen) | Report of International Transportation of Currency or Monetary Instruments (CMIR) - Each person who transports, or has transported, currency of the United States, any other country's traveler checks, money orders, or investment securities, or any other negotiable instruments, is required to file this form. Formerly Customs Form 4790. |
| Form 90-22.1 (Treasury) | Report of Foreign Bank and Financial Accounts (FBAR)- United States persons must both file the form and answer yes to the question on Schedule B, Form 1040, if they have a financial interest in, or signature authority for a bank, securities, or other financial account, in a foreign country which exceeds $10,000 in total value at any time during the calendar year. |
| Form 8300 | Report of Cash Payments Over $10,000 Received in a Trade or Business - Required to be filed by any person who, in the course of carrying on a trade or business, receives more than $10,000 in cash in one transaction or related transactions. |
| Criminal Referral Form (CRF)- These forms are filed by banks on unusual, suspicious, structured transactions and cancelled transactions. They may also file Suspicious Activity Reports on a voluntary basis for any suspicious transaction. | |
| Form 7501 (Customs) | Entry Summary (EXC) - Filed by importers or licensed customs brokers whenever commodities are imported into the United States. CBRS reflects only those commodities that are subject to excise tax. |
Contacts made with government officials to obtain information that is available to the public are not considered third party contacts under IRC section 7602(c). Such contacts are routinely made and there is no expectation of privacy with respect to the information that is provided to, or maintained by, government officials and which is available to the general public. Some examples are:
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Contact with Postal officials to obtain a taxpayer's current address,
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Contact with a county clerk to obtain lien information on a taxpayer's property,
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Contact with a clerk of the Court to obtain publicly available court records,
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Contacts with state officials to obtain corporate charters or other publicly available information regarding corporate taxpayers or exempt organizations.
Treas. Reg. section 301.7602-2(f)(5) states that IRC section 7602(c) does not apply to any contact with any office of any local, state, Federal or foreign governmental entity except for contacts concerning the taxpayer's business with the government office contacted, such as the taxpayer's contracts with, or employment by, the government office. The term "office" includes any agent or contractor of the governmental office acting in such capacity.
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Government Agencies
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Bureau of Labor Statistics
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Social Security Administration
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U.S. Post Office
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Department of Motor Vehicles
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Law Enforcement agencies
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Occupational Safety and Health Administration (OSHA)
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Department of Social Services
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Department of Agriculture
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Small Business Administration
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Department of Transportation
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Fictitious Name Register
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Better Business Bureau
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Court Records
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Divorce
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Liens
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Probate
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Property records
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Mortgages (amount/holder)
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Bankruptcy
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State Information
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Permits
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Licenses
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Sales Tax
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Employment/Unemployment data
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Trade Associations
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Corporations (Charters, etc.)
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City Directory
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Subscriber Information Sources (Dun & Bradstreet, Robert Morris & Associates, LEXIS)
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News Media (newspapers, internet, magazines, etc.)
The Financial Status Analysis is an analytical method for determining whether the taxpayer has sufficient funds to pay known
expenses. Starting with the information on the tax return and internal/external sources of information, the Financial Status
Analysis is updated throughout the examination as information becomes available. It is important to proceed step-by-step during
the examination. Ultimately, the analysis will:
• Indicate that the taxpayer has sufficient funds to pay known expenses; or
• Indicate that, as a result of completing the minimum income probes, the taxpayer now has sufficient funds to pay known expenses. For example, additional taxable income may result from the identification of specific items of income or circumstantial evidence from which an inference can be made (see IRM 4.10.4.2.8); or
• Indicate that there is a likeliness of unreported income justifying an in-depth income probe and/or the use of a Formal
Indirect Method (see IRM 4.10.4.2.9). The Financial Status Analysis is easily converted to the Source and Application Funds
Method (see IRM 4.10.4.6.4).
Case Study
A cash basis taxpayer files his Form 1040 tax return for 2005 showing the following information:
1. The taxpayer is married and claims two children as dependents.
2. On Schedule A, the taxpayer claimed medical expenses of $1,500, property taxes (home and cars) of $5,500, $6,000 for interest paid on a home mortgage, and charitable contributions of $1,200.
3. On Schedule C, the taxpayer reported Gross Receipts of $200,000 and $115,000 in operating expenses, including $25,000 for depreciation. The taxpayer also purchased $75,000 in inventory for resale. ($115,000 – $25,000 + $75,000 = $165,000)
4. The taxpayer’s wife reported $25,000 in wages. The Form W-2 attached to the tax return indicates that her employer is a third party and $3,000 was withheld.
5. Interest earned on bank accounts is $125
Using information disclosed on the tax return and Bureau of Labor statistics for a family of 4, the following Financial Status Analysis is prepared.
| Sources of Funds | Applications of Funds | ||
|---|---|---|---|
| Wages | $25,000 | Withholdings (W-2) | $3,000 |
| Interest Income | $125 | ||
| Medical Exp. | $1,500 | ||
| Property Taxes | $5,500 | ||
| Interest (home mortgage) | $6,000 | ||
| Charitable Contributions | $1,200 | ||
| Schedule C Receipts: | $200,000 | Schedule C (operating expenses & inventory purchases) | $165,000 |
| Estimated Personal Living Exp. (statistical data, excluding Sch. A expenses. | $55,000 | ||
| Total Sources of Funds | $225,125 | Total Expenditures: | $237,200 |
Computation of Estimated Understatement of Taxable Income
| Total Applications of Funds | $237,200 | |
| Total Sources of Funds | $225,125 | |
| Potential Understatement of Taxable Income | $12,075 | |
The examiner interviewed the taxpayer and determined the following:
1. The taxpayer received a business loan of $50,000 in March of 2005. The interest was claimed as an expense on Schedule C. The taxpayer made payments of $1,500 each month beginning in April of 2005. The taxpayer made payments of $13,500 (9 x $1,500) that included $1,800 of interest (per tax return). The taxpayer repaid $11,700 in principal.
2. The taxpayer kept $1,000 as cash-on-hand for business purposes; it was the same at the beginning and the end of the year.
3. The taxpayer keeps cash at home for emergencies. At the beginning of the year it was $1,500; at the end of the year it was $200 (used the funds to pay holiday expenses).
4. The taxpayer makes monthly mortgage payments of $1,200 dollars, for a total of $14,400. Subtracting out the interest claimed
on Schedule A, the taxpayer paid principal of $8,400. The estimated Personal Living Expenses (BLS) included an estimated mortgage
principal payment of $12,000, and therefore must be reduced because the actual costs are known. ($55,000 - $12,000 = $43,000)
The examiner updated the Financial Status Analysis as follows:
| Sources of Funds | Applications of Funds | ||
|---|---|---|---|
| Wages | $25,000 | Withholdings (W-2) | $3,000 |
| Interest Income | $125 | ||
| Business Loan | $50,000 | Repayment of Principal: business loan | $11,700 |
| Cash on Hand (Beginning) | $1,000 | Cash on Hand (Ending) | $1,000 |
| Acc. Funds (Beginning) | $1,500 | Acc. Funds (Ending) | $200 |
| Medical Exp. | $1,500 | ||
| Property Taxes | $5,500 | ||
| Interest (home mortgage) | $6,000 | ||
| Charitable Contributions | $1,200 | ||
| Schedule C Receipts: | $200,000 | Schedule C (operating expenses & inventory purchases) | $165,000 |
| Mortgage (principal) | $8,400 | ||
| Estimated Personal Living Exp. (statistical data, excluding Sch. A expenses.) | $43,000 | ||
| Total Sources of Funds | $277,625 | Total Expenditures: | $246,500 |
The taxpayer has funds in excess of applications: $277,625 - $246,500 = $31,125
The examiner toured the business site and observed the business in operation:
1. The taxpayer sold merchandise on the Internet,
2. There didn’t seem to be enough space to store the ending inventory reflected on the tax return.
3. There were more assets on site (and producing income) than disclosed on the depreciation schedules attached to the tax
return.
Because it appeared that the taxpayer had purchased more goods for resale than could be stored, the examiner analyzed the
inventory records in depth and determined that the taxpayer had (as suspected) overstated ending inventory and therefore understated
Cost of Goods Sold, as shown below:
| Per Return | Per Audit | Adjustment | |
| Beginning Inventory | $35,000 | $35,000 | |
| Purchases | +$75,000 | +$75,000 | |
| Ending Inventory | -$85,000 | -$45,000 | |
| Cost of Goods Sold | +$25,000 | $65,000 | $40,000 |
An additional tax deductible expense of $40,000 is allowable for the additional Cost of Goods Sold, but the adjustment does
not represent a cash flow and thus does not affect the Financial Status Analysis.
The taxpayer not only understated the Cost of Goods Sold, but failed to record the sale of the additional inventory in the
books or report the income from the sale as Gross Receipts. The taxpayer’s mark up on the $40,000 of inventory was 15%; therefore
Gross Receipts of $46,000 had not been reported (1.15 x $40,000).
| Sources of Funds | Applications of Funds | ||
|---|---|---|---|
| Wages | $25,000 | Withholdings (W-2) | $3,000 |
| Interest Income | $125 | ||
| Business Loan | $50,000 | Repayment of Principal: business loan | $11,700 |
| Cash on Hand (Beginning) | $1,000 | Cash on Hand (Ending) | $1,000 |
| Acc. Funds (Beginning) | $1,500 | Acc. Funds (Ending) | $200 |
| Medical Exp. | $1,500 | ||
| Property Taxes | $5,500 | ||
| Interest (home mortgage) | $6,000 | ||
| Charitable Contributions | $1,200 | ||
| Schedule C Receipts: | $200,000 | Schedule C (operating expenses & inventory purchases) | $165,000 |
| Sale of Inventory | $46,000 | ||
| Mortgage (principal) | $8,400 | ||
| Estimated Personal Living Exp. (statistical data, excluding Sch. A expenses.) | $43,000 | ||
| Total Sources of Funds | $323,625 | Total Expenditures: | $246,500 |
The taxpayer now appears to have funds in excess of applications: $323,625 - $246,500 = $77,125
The examiner evaluated internal controls, flowcharting transactions, noting separation of duties and other efforts to ensure
the business operated as intended. The taxpayer had three employees, including an office manager who reconciled sales each
day and prepared the deposit slip for cash receipts that were deposited in the bank every couple of days. The taxpayer would
make the deposit on his way home from the office. The taxpayer also engaged a bookkeeper to prepare the books and records
based on summaries provided by the taxpayer each month; the bookkeeper also managed the business bank account and prepared
the checks to pay the business expenses, which the taxpayer signed.
The examiner then reconciled the taxpayer’s bank accounts, with the following results:
1. The Gross Receipts deposited in the business account reconciled to the Gross Receipts reported on the tax return. The bookkeeper
had properly accounted for cash deposits, credit card sales, and Internet sales.
2. The taxpayer did not commingle business and personal accounts. The taxpayer transferred money to two personal accounts
via check or ATM transactions.
3. The personal accounts reflected typical personal expenses, including automatic withdrawals for mortgage and utility payments
and ATM withdrawals for cash. Overall, there were few personal checks. However, one check to a hardware store for $1,000 was
noted. The taxpayer said that he had purchased materials to remodel the home. After discussions with the taxpayer, the examiner
contacted the store and determined that the taxpayer made purchases totaling $70,000, including the $1,000 purchased by check.
He also paid a carpenter $30,000 in cash. In total, the taxpayer spent $100,000.
4. The examiner also noted that only a few payments to major credit card companies were made from the personal accounts, yet
the monthly statements for the credit cards indicated that the taxpayer made payments every month. The taxpayer admitted that
he had a third personal non-interest bearing account. The account was setup to receive PayPal payments when the taxpayer sold
damaged merchandise on an Internet auction site. The taxpayer received $15,000 as electronic payments. The damaged merchandise
had been written-off as Cost of Goods Sold. In addition, the taxpayer used the account to transfer funds to, and receive winnings
from an Internet gambling web site. The winnings, netted for the wager amounts, were $25,000.
5. The table below shows the beginning and ending balances of the taxpayer’s bank accounts.
| Account Number | Beginning Balance | Ending Balance |
|---|---|---|
| Business Account | $15,000 | $12,000 |
| Personal #1 | $2,000 | $2,000 |
| Personal #2 | $1,000 | $1,000 |
| Personal #3 | 0 | $40,000 |
| Totals | $18,000 | $55,000 |
The examiner used the following techniques to test the taxpayer’s books and records.
6. Tested a sample of deposits by comparing the office manager’s reconciliation of Gross Receipts and deposits to the deposits
as recorded on the bank statements. For about half the sampled deposits, the examiner found that the actual amount deposited
was significantly less than the amount recorded in the office manager’s reconciliation. The taxpayer diverted the deposits
by preparing a new deposit slip and keeping a portion of the cash receipts for personal use. The examiner concluded that the
bank records were not a reliable record for determining Gross Receipts. Using the office manager’s records, the examiner determined
that the taxpayer has diverted $35,000.
7. Analyzed personal credit card use.
| Beginning Balance | $22,000 |
|---|---|
| Charges | +$32,000 |
| Payments | -$50,000 |
| Ending Balance | $4,000 |
Based on the personal bank account information and credit card transactions, it was determined that the best estimate of personal
living expenses were the known expenses; i.e., the sum of the credit card charges (determined from the monthly statements),
plus the cash withdrawn and checks written from the personal bank accounts. After accounting for expenses previously identified
(e.g., Schedule A expenses), the personal living expenses were an additional $57,000.
| Sources of Funds | Applications of Funds | ||
|---|---|---|---|
| Wages | $25,000 | Withholdings (W-2) | $3,000 |
| Interest Income | $125 | ||
| Business Loan | $50,000 | Repayment of Principal: business loan | $11,700 |
| Cash on Hand (Beginning) | $1,000 | Cash on Hand (Ending) | $1,000 |
| Acc. Funds (Beginning) | $1,500 | Acc. Funds (Ending) | $200 |
| Gambling Winnings | $25,000 | ||
| Medical Exp. | $1,500 | ||
| Property Taxes | $5,500 | ||
| Interest (home mortgage) | $6,000 | ||
| Charitable Contributions | $1,200 | ||
| Schedule C Receipts: | $200,000 | Schedule C (operating expenses & inventory purchases) | $165,000 |
| Sale of Inventory | $46,000 | Home Remodeling | $100,000 |
| Diverted Deposits | $35,000 | ||
| Internet Auction Proceeds | $15,000 | ||
| Bank Accounts Beginning Bal | $18,000 | Bank Accounts Ending Bal | $55,000 |
| Mortgage (principal) | $8,400 | ||
| Credit Card Charges | $32,000 | Personal Living Exp. (Taxpayer's Records) | $57,000 |
| Credit Card Payments | $50,000 | ||
| Total Sources of Funds | $448,625 | Total Expenditures: | $465,500 |
The taxpayer’s applications of funds now exceed known sources: $465,500 - $448,625 = $16,875.
At this point, the examiner concludes that, although specific items of unreported income have been identified, the taxpayer
still does not have sufficient funds to pay known expenses.
| Total Applications of Funds | $448,625 | |
| Total Sources of Funds | $465,500 | |
| Potential understatement of taxable income | $16,875 | |
To estimate whether substantially all the unreported income from the known business activity had been identified, the examiner
used the industry standard Gross Profit Percentage for comparison. The examiner used the corrected Cost of Goods Sold and
the corrected Gross Receipts.
| Per Tax Return | $200,000 | |
| Sale of Inventory | $46,000 | |
| Diverted Deposits | $35,000 | |
| Internet Auction Sales | $15,000 | |
| Excess Applications | $16,875 | |
| Corrected Gross Receipts | $312,875 | |
| Corrected Cost of Goods Sold | $65,000 | |
| Gross Profit Margin | 79.22% | |
The taxpayer’s gross profit margin is now within 5% of the industry standard. The examiner is satisfied that substantially
all the unreported income from the Schedule C activity has been identified and proposes the following adjustments totaling
$72,875.
| 1. Sale of Inventory | +$46,000 | |
| 2. Expense for additional Cost of Goods Sold | -$40,000 | |
| 3. Diverted Deposits | +$35,000 | |
| 4. Internet Auction Sales | +$15,000 | |
| 5. Excess Applications | +$16,875 | |
| +$72,875 | ||
In addition, the examiner proposes an adjustment of $25,000 for the net gambling winnings.
Total Adjustments: +$97,875
Authority granted under IRC 7521(c) permits the bypassing of a power of attorney responsible for unreasonable delays or hindrance of an Internal Revenue Service examination. (See IRM 4.11.55.3, By-Pass of a Representative.) Circular 230, "Regulations Governing the Practice of Attorneys, Certified Public Accountants, Enrolled Agents, Enrolled Actuaries, and Appraisers before the Internal Revenue Service," provides the regulations governing the practice of tax professionals before the Internal Revenue Service. The key provisions are contained in Subpart B, titled "Duties and restrictions relating to Practice Before the Internal Revenue Service."
Section 10.20, Information to be furnished to the Internal Revenue Service
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To the Internal Revenue Service
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A practitioner must, on a proper and lawful request by a duly authorized officer or employee of the Internal Revenue Service, promptly submit records or information in any matter before the Internal Revenue Service unless the practitioner believes in good faith and on reasonable grounds that the records or information are privileged.
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Where the requested records or information are not in the possession of, or subject to the control of, the practitioner or the practitioner’s client, the practitioner must promptly notify the requesting Internal Revenue Service officer or employee and the practitioner must provide any information that the practitioner has regarding the identity of any person who the practitioner believes may have possession or control of the requested records or information. The practitioner must make reasonable inquiry of his or her client regarding the identity of any person who may have possession or control of the requested records or information, but the practitioner is not required to make inquiry of any other person or independently verify any information provided by the practitioner’s client regarding the identity of such persons.
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To the Director of Practice. When a proper and lawful request is made by the Director of Practice, a practitioner must provide the Director of Practice with any information the practitioner has concerning an inquiry by the Director of Practice into an alleged violation of the regulations in this part by any person, and to testify regarding this information in any proceeding instituted under this part, unless the practitioner believes in good faith and on reasonable grounds that the information is privileged.
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Interference with a proper and lawful request for records or information. A practitioner may not interfere, or attempt to interfere, with any proper and lawful effort by the Internal Revenue Service, its officers or employees, or the Director of Practice, or his or her employees, to obtain any record or information unless the practitioner believes in good faith and on reasonable grounds that the record or information is privileged.
Section 10.21, Knowledge of Client's Omission
A practitioner who, having been retained by a client with respect to a matter administered by the Internal Revenue Service, knows that the client has not complied with the revenue laws of the United States or has made an error in or omission from any return, document, affidavit, or other paper which the client submitted or executed under the revenue laws of the United States, must advise the client promptly of the fact of such noncompliance, error, or omission. The practitioner must advise the client of the consequences as provided under the Code and regulations of such noncompliance, error, or omission.
Section 10.22, Diligence as to Accuracy
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In general. A practitioner must exercise due diligence -
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In preparing or assisting in the preparation of, approving, and filing tax returns, documents, affidavits, and other papers relating to Internal Revenue Service matters;
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In determining the correctness of oral or written representations made by the practitioner to the Department of the Treasury; and
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In determining the correctness of oral or written representations made by the practitioner to clients with reference to any matter administered by the Internal Revenue Service.
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Reliance on others. Except as provided in sections 10.33 and 10.34, a practitioner will be presumed to have exercised due diligence for purposes of this section if the practitioner relies on the work product of another person and the practitioner used reasonable care in engaging, supervising, training, and evaluating the person, taking proper account of the nature of the relationship between the practitioner and the person.
Section 10.23, Prompt Disposition of Pending Matters
A practitioner may not unreasonably delay the prompt disposition of any matter before the Internal Revenue Service.
The Net Operating Loss Deduction (NOLD)
An NOLD is reported as a negative amount on the "Other Income"
line of Form 1040. Deductions are allowable under IRC section 172. Examiners may require taxpayers to produce the records
necessary to prove that are entitled to the NOLD.
Proof
The taxpayer is required to maintain such records as will allow an examiner to verify the accuracy of the deduction. Copies
of tax returns are not proof, nor are accountants’ workpapers. In Owens vs. Commissioner, T.C. Memo 2001-143, the Court concluded
that "although each of the returns for 1990, 1991, and 1992 shows a loss attributable to the petitioners’ Schedule C business,
petitioners failed to introduce any evidence established the loss claimed in each of those returns. The returns for 1990 though
1992 constitute nothing more that the position of petitioners that they had the respective losses claimed on those returns."
Records are Made Available
Faced with the examination of an NOLD, a taxpayer should make records from the source years available to the examiner. Examiners must audit the records to determine the accuracy of the NOLD.
Alternatively, when the source of the NOLD is the same business (or there are other similarities), it is probably that, if the records were examined, the result would be similar to the current year adjustments. If the taxpayer agrees, the examiner may propose a full or partial disallowance of the NOLD based on this premise in the interest of reducing burden for both the Service and the taxpayer. If the taxpayer does not agree, the examiner must audit the records provided by the taxpayer.
If the taxpayer declines to produce the records, or the records are unavailable, the examiner should disallow the entire NOLD
for lack of substantiation.
Statutes of Limitation
The statute of limitation for the year of the net operating loss is not an impediment when making an adjustment for the purpose
of determining how much of the net operating loss may be carried forward and deducted in a subsequent year. Under IRC 7602(a),
the Secretary is authorized to examine any books, papers, records, or other data when may be relevant or material to such
inquiry.
Example 1
The taxpayer’s 2005 return includes the following:
1. Schedule C loss of -$45,000
2. NOLD of -$90,000
3. Taxable Income of -$150,000 (including the NOLD)
The NOLD is a carryforward of accumulated losses form the Schedule C business in the prior three years.
Year 2002 NOL = -$15,000
Year 2003 NOL = -$35,000
Year 2004 NOL = -$40,000
The examiner determines that the taxpayer did not report $100,000 in gross receipts from the Schedule C business in 2005.
Without considering the NOLD, the adjustment of $100,000 to taxable income will have no impact on the taxpayer’s income tax
liability; i.e., taxable income will be -$50,000. However, given that the source of the unreported income in 2005 is the same
business that is generating the NOLD, it is likely that taxable income was similarly unreported in the prior years. The examiner
audits the NOLD issue and determines that the entire NOLD should be disallowed. The corrected taxable income for 2001 is +$40,000,
reflecting adjustments for both the $100,000 additional income and the disallowed $90,000 NOLD.
Example 2
The taxpayer’s 2005 return include the following:
1. Schedule C loss of -$46,000
2. NOLD of -$110,000
3. Taxable Income of -$30,000 (including the NOLD and other sources of income reported on the return)
The NOLD is a carryforward of accumulated losses form the Schedule C business in the prior three years.
Year 2002 NOL = -$25,000
Year 2003 NOL = -$45,000
Year 2004 NOL = -$40,000
The examiner determines that the taxpayer did not report $25,000 in gross receipts from the Schedule C business in 2005. Without
considering the NOLD, the adjustment of $25,000 to taxable income will have no impact on the taxpayer’s income tax liability;
i.e., taxable income will be -$5,000.
Examiners have the authority to make factual determinations to arrive at the substantially correct tax liability. In this
case, the amount of unreported income in the current year is less than the amount of the NOLD; i.e., the taxpayer underreported
$25,000 in the current year and the NOLD was in excess of $75,000 (3 x $25,000). Assuming that there is a consistent pattern
over the four year period, such as the same business practices, the examiner could reasonably conclude that the taxpayer underreported
income in the prior years.
With the taxpayer's agreement, the examiner could propose an adjustment to the NOLD based on an analysis of business ratios without actually auditing the taxpayer's records. For example, if the Cost of Goods Sold to Gross Receipts ratio for the year under audit is 75% after correcting for the $25,000 underreported income, the same percentage could be used to compute the NOLD adjustment for the prior years if the taxpayer agreed.
| Year | Per Return | Corrected | Unreported Income | |
|---|---|---|---|---|
| 2002 | COGS | $170,000 | $178,000 | $27,333* |
| Gross Receipts | $210,000 | $237,333 | ||
| COGS/ Gross Receipts Ratio | 85% | 75% | ||
| 2003 | COGS | $252,000 | $252,000 | $36,000 |
| Gross Receipts | $300,000 | $336,000 | ||
| COGS/ Gross Receipts Ratio | 84% | 75% | ||
| 2004 | COGS | $192,000 | $192,000 | $16,000 |
| Gross Receipts | $240,000 | $256,000 | ||
| COGS/ Gross Receipts Ratio | 80% | 75% | ||
| • Limited to NOLD of $25,000 based on the 2002 return | ||||
The adjustment to the NOLD carryforward originating in 2002 is limited to $25,000, even though the amount of unreported income is $27,333. The NOLD adjustment for the 2001 return is $25,000 + $36,000 + $16,000 = $77,000.
The corrected taxable income would be $72,000, reflecting adjustments for both the $25,000 in additional income and the $77,000 reduction of the NOLD. The remaining NOLD is $33,000 computed as $9,000 from 2003 and $24,000 from 2004.
If the taxpayer does not agree with the results, the examiner must audit the taxpayer's books and records to make an actual
determination of tax liability.
Conclusion
Examiners will need to apply professional judgment based on all the facts and circumstances when deciding on the proper course
of action. The above examples are not intended to direct a like determination on actual cases; only to demonstrate approaches
that may be taken in similar circumstances.
Capturing Adjustments to NOL Carryforwards
Form 5344, Examination Closing Record, captures adjustments to taxable income, which may not generate income tax or self-employment tax in the year(s) under audit, but which result in revenue protection. Lines 44 and 45 capture information about net operating losses (NOL). See IRM 4.4.12.4.57 and Exhibit 4.4.12-6, which includes examples.
An important step in determining income from Internet activities is to ask the taxpayer about Internet use and websites during
the interview process. Refer to IRM 4.10.3.2 for general discussion and audit techniques. Questions specific to Internet activities
and websites are listed here with explanations.
1. Do you transact business using the Internet?
Explanation: The Internet can be used for a variety of purposes. When asking the taxpayer about their activities, be aware that payments made over the internet need to be considered as part of the minimum income probes:
□ Identify the accounts from which the payments are drawn.
□ The payments are considered an application of fund that should be accounted for in the Financial Status Analysis.
2. What products, services or memberships may be purchased on your web site or through the use of e-mail?
Compare the taxpayer’s answer to the information you have from reviewing the taxpayer’s web site, as well as the sources of
income identified in the books and records.
3. When was the web site "opened"
for business? Did the business exist prior to creation of the web site? Is the business conducted over the Internet separate
or distinct from the taxpayer’s historic line of business? Is the Internet based business an extension of an existing business
or does it represent a completely new endeavor?
Establish the date that the web site became operational. The date the taxpayer obtained their domain name may coincide with
the date the web site opened for business. Invoices from paid consultants or purchases of software, and service dates on bills
from the taxpayer’s Internet Service Provider (ISP) are all indicators as to when a web site became operational or there was
a significant upgrade in the capabilities of the web site to offer interactive business services.
4. What domain names have been registered either by you or on your behalf? What domain names do you have control over? Identify
who registered the domain names and when.
The domain name is the web site address on the Internet. Each web site is a separate business location with a storefront and
its own unique cash register. Identifying the number of websites a taxpayer has is no different than trying to identify all
the possible business sites or cash generators on your tour of a physical business site.
5. Do you have any paid referral or advertising contracts with other Internet websites? If the answer is yes, obtain copies
of the contracts.
The fee charged by the Internet Service Provider (ISP) might be either connection or volume based.
□ A connection-based fee is based on the simple fact that the taxpayer is paying for basic Point of Presence (POP) on the Internet.
□ A volume-based fee is based upon what is known as bandwidth and storage volume. You can have either or both together. Bandwidth
refers to the ability of a site to handle access volume. As access to a site grows, the host must expand its ability to service
multiple users. This is accomplished by expanding bandwidth. Therefore, a large bandwidth implies a high volume web site.
Storage volume is associated with the sophistication of the web site. The larger websites with heavy graphics require more
storage space when someone accesses the site.
In addition to bandwidth and storage, volume-based billing may also include charges for other ancillary services. The billing
for these extras is not necessarily volume based, but is generally associated with high volume sites.
In summary, the higher cost of a relatively more sophisticated web site implies a higher volume of business.
For more questions and explanations, see: http://e-commerce.web.irs.gov/ebg.htm (Income Probes > Sample Question and Answer).
Once the amount of corporate income diverted has been determined, the tax effect for the shareholder must be computed. The
calculation requires the consideration of several factors. IRC section 301(c) states that a distribution is includible in
a shareholder’s gross income to the extent that it is a dividend, as defined in IRC section 316. The balance is a return of
capital under IRC sections 301(c)(2) and 301(c)(3).
Diverted Income Treated as Dividend
The dividend amount, which will be treated as ordinary income, is limited to the amount of both the Current Earnings and Profits
(E&P) and the Accumulated Earnings and Profits, adjusted for the amount of the audit adjustments (IRC section 301(c)(1)).
Current E&P can be computed as follows:
| Taxable income on Form 1120 | $X,XXX,XXX | |
| Plus: Special deductions and NOLD | +$XX,XXX | |
| Less: Nondeductible expenses | -$XX,XXX | |
| Current E&P | $X,XXX,XXX | |
Any distributions made during the tax year are disregarded. If there are no Current E&P, consider the Accumulated E&P to determine
the dividend amount.
Accumulated E&P are the earnings and profits that have accumulated since the beginning of the corporations. They are computed
as follows:
| Current year E&P | $X,XXX,XXX | |
| Less: Distributions made | -$XX,XXX | |
| Plus: Accumulated E&P from prior years | +$XX,XXX | |
| Accumulated E&P | $X,XXX,XXX | |
The Accumulated E&P may be adjusted for any transactions that occurred during the current year that properly belonged in a
prior year’s earnings and profits. See Training Publication 6678-102, Advanced corporations, for a more detailed explanation
of the calculation of Accumulated E&P when distributions are made.
Any calculation of Current and Accumulated E&P must be adjusted for the amount of the audit adjustment. Current E&P is applied
first to the dividend determination.
Example 1
At the beginning of the tax year, a corporation reported $13,000 Accumulated E&P. Its Current E&P, as a result of the audit,
is $26,000. The examiner also identified $14,000 was diverted by a shareholder.
The diverted income is taxable as a dividend to the shareholder as the amount did not exceed the amount of Current E&P of
$26,000.
Example 2
The facts are the same as in example 1, except the examiner identified $38,000 was diverted by a shareholder.
The entire amount of diverted income is still taxable as a dividend to the shareholder as the amount did not exceed the amount
of Current E&P of $26,000 + the $13,000 in Accumulated E&P at the beginning of the tax year under audit.
Diverted Income Treated as Return of Stock Basis
If the diverted income amount exceeds both the Current and Accumulated E&P, the amount is next applied against, and therefore reduces, the shareholder’s basis in corporate stock. It is treated as a tax-free return of capital under IRC section 310(c)(2). The basis in the stock must be documented to determine the amount of diverted income that will characterized as a return of capital.
Example 3
At the beginning of the tax year, a corporation reported $13,000 Accumulated E&P. Its Current E&P, as a result of the audit,
is $26,000. The examiner also identified $41,000 was diverted by a shareholder whose basis in corporate stock is $2,000.
The diverted income is taxable as a dividend to the shareholder to the extent of the Current and Accumulated E&P; i.e., $39,000.
The remaining $2,000 of diverted income is treated as a return of capital, and reduces the shareholder's basis to zero. If
the amount of diverted income exhausts both the Current and Accumulated E&P, and the shareholder's basis in stock, then the
diverted income is retreated as a capital gain.
Example 4
The facts are the same as in example 3, except the amount of diverted income is $43,000.
The diverted income exceeds the Current and Accumulated E&P ($39,000) and the shareholder's basis ($2,000). The excess of
$2,000 is treated as a gain from the sale of exchange of property and is generally reported as capital gain.
| Diverted corporate income: | $43,000 | |
| Treated as dividend: | $39,000 | |
| Treated as return of basis in stock: | $2,000 | |
| Treated as gain from sale or exchange of property: | $2,000 | |
| 1. | Total bank deposits | $151,000 | |
| Less: | |||
| 2. | Nontaxable receipts deposited | ($35,000) | |
| 3. | Net deposits resulting from taxable receipts | $116,500 | |
| Add: | |||
| 4. | Business expenses paid by cash | $50,700 | |
| 5. | Capital items paid by cash (personal & business) | $20,300 | |
| 6. | Personal living expenses paid by cash | $7,034 | |
| 7. | Cash accumulated during the year from receipts | $5,000 | $83,034 |
| Subtotal | $199,534 | ||
| 8. | Less nontaxable income used for lines 4-7 | ($15,000) | |
| 9. | Accts. Rec.: Add the difference between the ending and beginning balances | 0 | |
| 10. | Acct. Pay.: Subtract the difference between the ending and beginning balances | 0 | |
| 11. | Gross Receipts as corrected | $184,534 | |
| Line 1: | |||
| Deposits during the year | $150,000 | ||
| Add receipts deposited in the subsequent year | $13,000 | ||
| Substract prior year receipts deposited during year | ($11,500) | ||
| Reconciled bank deposits | $151,500 | ||
| Line 2: | |||
| Loan proceeds | $12,000 | ||
| Checks to cash redeposited | $3,500 | ||
| Transfers between accounts | $6,000 | ||
| Nontaxable Veterans Administration pension | $14,000 | ||
| Total | $35,000 |
| Line 4: | |||
| Total business expenses per return | $200,000 | ||
| Noncash business expenses | $60,000 | ||
| Total business expenses requiring cash outlay per return | $140,000 | ||
| Computation of business checks for the year | |||
| Account balance at beginning of year | $10,000 | ||
| Add deposits during the year | $150,000 | ||
| Subtotal | $160,000 | ||
| Less balance at the end of the year | ($8,000) | ||
| Subtotal | $152,000 | ||
| Add checks written this year but cleared in the subsequent year | $3,000 | ||
| Subtotal | $155,000 | ||
| Less checks written in prior year but cleared this year | ($6,000) | ||
| Total checks written this year | $149,000 | ||
| Less nonbusiness checks | |||
| Checks to cash for personal expenses | $3,500 | ||
| Check transfers | $6,000 | ||
| Personal expenses paid by check | $34,500 | ||
| Capital expenditure paid by check | $15,700 | $59,700 | |
| Total business checks | $89,300 | ($89,300) | |
| Total business expenses paid by cash | $50,700 |
| Sources of Funds | Applications of Funds | ||
|---|---|---|---|
| Wages | Withholdings (W-2) | ||
| Interest Income | Investment Interest | ||
| Dividends | |||
| Tax Refunds | |||
| Alimony Received | |||
| Sch. C Receipts | $50,000 | Sch C Expenses (net of depreciation | |
| Sch C Purchases | |||
| Sch C Labor | $32,000 | ||
| Sch C Material and Supplies | |||
| Sch C other period costs | |||
| Sch. D - Gross Sales | Sch. D Asset & Investment Purchases | ||
| Sale of Business Property | |||
| IRA/Pension Distributions | Contributions to IRA, annuities & pensions, Penalties for early withdraw | ||
| Rental Income | Rental Expenses (net of depreciation) | ||
| Sch F Receipts | Sch F expenses (net of depreciation) | ||
| Unemployment Comp. | |||
| Social Security Benefits | |||
| Unreported Income (IRP) | |||
| Cash Distributions: | Contribution of Capital | ||
| -- S-Corps | -- S-Corps | ||
| -- Partnerships | -- Partnerships | ||
| -- Fiduciaries | |||
| Sale: Personal Residence | Sale of Residence Costs (Form 2119) | ||
| Sale: Personal Property | Insurance Policies | ||
| Advanced EITC | |||
| Child Support Received | |||
| Cash on Hand (beginning) | Cash on Hand (ending) | ||
| Cash in Bank (beginning) | $300 | Cash in Bank (ending) | $600 |
| Credit Cards (End. Bal.) | Credit Cards (Beg. Bal.) | ||
| Loans | Loan repayments | ||
| Nontaxable Income -gifts, inheritances, etc. | Personal Capital Acquisitions | ||
| Other sources of funds | Personal Living Expenses | $40,000 | |
| Other "cash out" items | |||
| Accrual Basis Taxpayer | Accrual Basis Taxpayer | ||
| -- Decrease in Accts/Rec. | -- Increase in Accts/Rec. | ||
| -- Increase in Accts/Pay | -- Decrease in Accts/Pay | ||
| Total Sources of Funds: | $50,300 | Total Expenditures: | $72,600 |
| Computing understatement of taxable income | ||
|---|---|---|
| Total Applications of Funds | $72,600 | |
| Total Sources of Funds | $50,300 | |
| Excess Applications over Sources (understatement of taxable income). | $22,300 | |