There are Taxpayers that understate income, overstate expenses and present fraudulent claims on their tax returns for credits and deductions. These Taxpayers run the risk of being identified by the IRS and having IRS determine the Taxpayer’s taxable income.

Taxpayers have a responsibility for substantiating entries, deductions, and statements made on their tax returns. Taxpayers meet their “Burden of Proof” by having the supporting information and receipts for the deducted expenses and by keeping adequate books and records. This is known as documentary evidence, and it includes receipts, canceled checks, or bills, to support the Taxpayer’s expenses.

Without available direct evidence, IRS otherwise reconstructs a Taxpayer’s financial portrait

There are different methods available to IRS to reconstruct a Taxpayer’s income.

1. A simple T-Account is the method most often used by IRS revenue agents when trying to determine if Taxpayer income has been underreported or not reported. The sources of cash funds are noted on the left side of the T-Account and expenditures of cash funds on the right side. An “imbalance” of the assets minus liabilities is examined year over year and has to be explained by the Taxpayer. If unexplained Net Worth increases year after year, there is a presumption that the increase in net worth originated from unreported income. The T-Account method is also known as the Net Worth Method. It was the methodology used by the US Government to convict the notorious criminal, Al Capone.
2. Requesting copies of bank statements. There could be sources of income noted in bank deposits that are not reportable as income. Examples could be an inheritance, a gift or proceeds from life insurance or a mortgage.
3. A website: Does the Taxpayer transact business over the internet? E-commerce activity must be reported as a source of income.
4. Business Ratio Analysis: IRS may compare a Taxpayer’s business ratios to other similar businesses in the same industry. The comparison of financial ratios can indicate if income is understated or expenses are overstated.
5. Information match: W-2’s, 1099s, K-1s are forms that are sent to IRS which enter into computer programs for matching the information against a Taxpayer’s tax return.

Circumstances that assist IRS in determining if there might be irregularities in a Taxpayer’s income reporting include:

• Inability to balance a Taxpayer’s financial status or financial differences that can’t be explained.
• Taxpayer has irregular books and or weak internal controls.
• Financial ratio percentages that are very high or very low for the specific business industry or that change significantly from one year to another.
• Banks deposits without an explanation or made in cash.
• Net Worth increases that are not supported by reported income.
• Non-existent books and records.

Don’t be a Victim of Your Own Making

The Methods of Proof will be used if IRS has a suspicion that a Taxpayer is failing to report income - whether it is inadvertent or a willful evasion. Taxpayers should not be in a position where an Internal Revenue Agent reconstructs his or her financial landscape. Consult your tax specialist.