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Let’s face it, an audit by the Internal Revenue Service (IRS) is not fun. What is even less fun is for the IRS to present you with an accounting that says you made far more money than what your records and your tax return says.
How can the IRS do this, and is this even legal? The answer is yes, and it essentially boils down to the fact that the IRS has the burden of proof when it comes to a taxpayer’s income.
What the IRS uses – and has succeeded in tax court proceedings – are indirect methods of proving income accounting. Indirect methods come down to accounting tricks that show that a taxpayer has more income that can be proved directly through w-2s and 1099s reported to the IRS.
In this column, I will go over the major indirect methods used by the IRS and how they can affect the outcome of an income tax audit.
By far, the most common indirect method used by the IRS is the bank account statement analysis. This method typically begins with the IRS auditor requesting copies of bank statements from the taxpayer. If the taxpayer does not provide those statements in a timely manner, or at all, then the auditor will send out a summons to the bank asking it to provide the statements.
Once the auditor has the bank statements in hand, they total up what bank deposits they believe represent income and compare this to what the tax return says. After the auditor has their gross income accounting, they present this to the taxpayer and give the taxpayer a set time period to respond back about any income discrepancies they found. If the taxpayer cannot show that the income discrepancies were nontaxable income, like loans or gifts, then the taxpayer will have to pay tax on the additional income found by the auditor.
The markup method estimates income by way of markup percentages, which are typical for the type of business under audit. The IRS uses sources such as the Bureau of Labor Statistics or commercially available databases that profit and other economic data for various business types.
Once the IRS has the markup percentage for a business, let’s say a bar, they try to determine the volume of sales from the bar’s sales tax return and the industry average, then calculate what profit the bar should have received from markup percentage.
The IRS typically uses this method if the taxpayer does not have very good records and the amounts on the return are very low. After the IRS determines a reasonable income amount, the taxpayer usually has an uphill battle with IRS appeals or tax court to prove otherwise.
The source and application of funds method is an analysis of a taxpayer’s cash flows and expenditures for a tax year. This method determines income based on the theory that any excess expenses over income (a tax loss) shows that a taxpayer has some other source of income funding their loss.
A loss on a taxpayer’s tax return will prompt the IRS to question how a taxpayer is staying afloat during the loss years. The taxpayer usually then must show that they either used loan proceeds or had substantial savings.
The net worth method is based upon the theory that increases in a taxpayer’s net worth during a taxable year, which exceeds the reported income, must be from unreported income. The IRS uses this method for taxpayers who lack traditional bank accounts and mainly use cash. If your first thought was drug dealers, you are on the right track.
Oftentimes, the IRS will use the help of the Department of Justice or FBI to determine a taxpayer’s net worth.
If the IRS determines that a taxpayer has unreported income they may either open up a criminal fraud investigation or assess the civil fraud penalty, which is 75 percent of the new tax amount. The best defense against the IRS using an indirect method to determine additional income is to have a professional accounting system in the first place.
Taxpayers that get into the most trouble are small businesses that have little to no accounting measures to begin with, and, unfortunately, end up learning an expensive lesson in proper books and records.
If you are looking for tax advice or are currently under audit, and the IRS is using one the above mentioned indirect methods, we recommend you contact a tax professional immediately to reduce any tax liability that you may owe.
– Jason W. Harrel is a Partner at Calone & Harrel Law Group, LLP who concentrates his practice in all manners of taxation, real estate transactions, corporate, partnership and limited liability company law matters. He is a certified specialist in taxation, and may be reached at (209) 952-4545 or firstname.lastname@example.org.