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Indirect methods of income reconstruction.

The Role of the CPA When Taxpayers Maintain Inadequate Records

Robert Carney, Ph.D., CPCU Associate Professor of Finance College of Business Administration University of Wisconsin-La Crosse La Crosse, Wisc.

John Gardner, Ph.D., CPA Professor of Accountancy College of Business Administration University of Wisconsin-La Crosse La Crosse, Wisc.

Kenneth Winter, Ph.D., CPA Assistant Professor of Accountancy College of Business Administration University of Wisconsin-La Crosse La Crosse, Wisc.

Income reconstruction, by indirect methods, is an area of tax practice with which many CPAs are not familiar. Typically, a CPA becomes involved in an income reconstruction case during an audit if the CPA is representing a client, is retained by an attorney to assist the attorney in representing the attorney's client or acts as an expert witness. In civil tax liability cases, the failure of the taxpayer to maintain the "accounting records" required by the Code necessitates the reconstruction of income.

This article will review the requirements that a taxpayer maintain adequate books and records; address the principal indirect methods of income reconstruction; examine the CPA's role in the income reconstruction process; and, because the Service has required procedures and methodologies for indirect income reconstruction, discuss the practices used by IRS personnel.

Maintenance of Books and Records

If all taxpayers kept available the books and records required by law, there would be no need for indirect methods. Because some taxpayers do not keep sufficient books and records, while others will not make them available to the IRS, indirect methods are an important tool for the IRS. Although indirect methods do not produce updated books and records, they are legal avenues of proof of underreported income available to the Service?

Sec. 446(a)requires that the computation of taxable income be based on the method of accounting under which the taxpayer "regularly computes his income in keeping his books." Sec. 446(b) provides, however, that if a taxpayer does not regularly use a method of accounting or if the accounting method "does not clearly reflect income,'' the IRS may make the computation under a method that will best meet the test(s)under Sec. 446.

Indirect methods of income reconstruction do not constitute "methods of accounting." Rather, they are the means of providing the Service with economic information on which to base calculations of adjusted gross income (AGI) under the taxpayer's method of accounting or a method of accounting that most clearly reflects income?

According to Regs. Sec. 1.446-l(a)(4), all taxpayers must maintain accounting records that will ensure that a correct tax return can be filed. This requirement is supported by Regs. Sec. 1.6001 - 1 (a), which provides in part that "any person subject to [income] tax... shall keep such permanent books of account or records, including inventories, as are sufficient to establish the amount of gross income, deductions, credits, or other matters...."

Challenge to the adequacy of books and records arises during a tax audit. The IRS prefers to use direct methods to challenge adequacy as they are the best method of proof. If direct methods or data are not available, however, the Service may use indirect income reconstruction--unless the courts have already accepted the taxpayer's books and records as reliable. Indirect methods of reconstruction of income are ordinarily employed during investigations of civil fraud and criminal tax evasion when books and/or records are not available or are nonexistent.3

The IRS Process

When the issue of possible civil and criminal sanctions arises during an audit, the IRS may employ indirect methods and direct evidence from information returns or third parties' records to establish the existence of underreported income for either criminal or civil fraud or nonfraud civil cases. The flowchart on page 547 describes the IRS decision process for fraud cases. Typically, a revenue agent will make a decision about a course of action based on a preexamination analysis, a personal interview with the taxpayer and relevant documentary evidence. The revenue agent will recommend that the Service

--issue a no-change report, which effectively ends the case,

--proceed for the tax due and interest;

--proceed with civil fraud; or

--proceed with criminal fraud.

When the information appears to warrant proceeding under criminal fraud, the agent will make the recommendation to the IRS Criminal Investigation Division (CID). After an investigation by a CID special agent, a recommendation will be made to the Justice Department to seek criminal sanctions or return the case to the Examination Division. The Examination Division could continue the civil case, which might result in the assertion of the civil fraud penalty. When a criminal case is pursued, civil action will be delayed until the criminal case is completed?

As highlighted in the flowchart, there are several levels of IRS and/or Justice Department review, any of which can defeat the decision to prosecute. During this entire process, the IRS provides opportunities to disprove the Service's assertions.5

When a taxpayer is charged with criminal tax fraud for "willfully attempt[ing]... to evade or defeat any tax imposed by this title," he may be prosecuted under Sec. 7201. The taxpayer may also be charged under Sec. 7206111 for willfully filing a false tax return or penalized for civil tax fraud under Sec. 6663(a).

Indirect Methods

The IRS will rely on the indirect process, which provides only circumstantial evidence,6 when direct methods cannot be employed. The audit process often begins with a preexamination analysis that includes a cash-T (described below}. If the results of this analysis suggest the existence of underreported income, a more detailed methodology will be employed: cash expenditures, net worth, bank deposit or a hybrid/combination approach.7

When the results of the preliminary analysis suggest that further review is appropriate, the cash expenditures method is most commonly employed.8 The IRS believes taxpayers easily understand this method? For those cases that the IRS takes to court, the net worth method--with its reliance on changes in assets and liabilities--is most frequently used to prove underreporting of income? The bank deposit method is least likely to be employed because it is considerably more extensive than either of the others and it requires the suspect taxpayer to have left a "banking trail." According to the IRS audit manual, an IRS agent will ordinarily use only one method to reconstruct income. The manual stresses that if two or more methods are used and conflicting results occur, "the examiner should consider the relative reliability of each method and base findings on the method which is judged to be most reliable in the particular case under consideration. Case law also suggests that a particular indirect method may be used as corroborating evidence for direct items or to support another indirect method, or to challenge the validity of a taxpayer's books and records.

* Cash-T analysis The IRS auditor develops the cash-T analysis from data that is initially gleaned from the tax return. The cash-T compares the taxpayer's sources of funds to the application of funds identified on the return. As a result, the total "use of funds" will exclude personal expenditures that are not reported on the tax forms. The revenue agent will schedule a personal interview with the taxpayer and request the production of relevant documents. When the balances from the cash-T are close in amount, the revenue agent is alerted to emphasize income issues during the personal interview. Based on additional information gained during the interview(s), an agent is able to complete the cash expenditures analysis and estimate the amount of any underreported income. An example of a cashT analysis is shown in Appendix A, Table 1, on pages 538 and 540.

* Cash expenditures analysis

The cash expenditures or source and application of funds technique {Appendix A, Table 3, page 541) is an indirect method of proving the existence of underreported taxable income.13 It extends the cash-T method to include nondeductible expenditures. This method, although different in format, will result in the same conclusion as the net worth method. According to one eminent authority, both methods must incorporate increases {or decreases) in net worth and personal living expenditures in their analyses. Essentially, they differ only in their method of presenting and substantiating the conclusions. When the Service employs the cash expenditures method, using the formula below, it attempts to establish that the taxpayer could not have spent the amount he did in a given year unless he had more taxable income than was reported.[14]

Total application of funds - Total source of funds =

Underreported income

Note that underreported income is assumed to exist only if the difference is a positive number.

The IRS manual [15]includes a list of specific examples of both applications and sources of funds used in the cash expenditures method.

* Applications:

1. Increases in assets.

2. Decreases in liabilities.

3. Personal living expenses.

4. Economic losses (e.g., nondeductible portion of capital loss).

[] Sources:

1. Decreases in assets.

2. Increases in liabilities.

3. Taxable and nontaxable income:

a. AGI.

b. Nontaxable receipts.

4. Deductions that do not require funds. Appendix B on pages 543-544 contains a detailed list of the sources and applications of funds. Note that "deductions that do not require funds," like depreciation, are technically not sources of funds but are noncash expenses.

* Net worth method

The Supreme Court sanctioned the use of the net worth method in 1954 in Holland. The theory behind it is simple accounting: assets minus liabilities equals net worth. Net worth at the beginning of the period plus net income equals net worth at the end of the period. (Because the net worth method has been applied for over 40 years, it uses net worth rather than modern accounting terminology such as owner's equity.)Applying the net worth method is more difficult than the other methods because not all income is taxable, nor are all expenses deductible. Furthermore, some expenses are deductible for AGI while others are deductible in reaching taxable income. Thus, AGI equals ending net worth plus all expenses that do not affect AGI minus nontaxable income and beginning net worth. The IRS uses the following computational format.

Step 1: Assets - Liabilities = Net worth

Step 2: Net worth at the end of the year - Net worth at the beginning of the year --

The change in net worth

Step 3: The change in net worth +

All expenses or losses not changing AGI - All nontaxable income --

Corrected AGI

Step 4: Corrected AGI - Reported AGI z

Underreported AGI

A fifth step can be added when deductions and exemptions are removed to get from AGI to taxable income.[18] Note, however, that this step is not considered in this article because deductions require direct proof. Appendix B lists examples of the changes in step 3.

According to the IRS manual, the net worth method is probably the most common indirect method of proving underreported income in court.[19] The net worth method is used to corroborate results from other indirect methods, to test the accuracy of reported income or to stand on its own as the principal evidence against a taxpayer. The net worth method may be used to contradict taxpayer declarations that their books and records support the reported income.20 Using other methods in the audit does not preclude using this method in subsequent court proceedings.

The IRS recommends the use of the net worth method, rather than other indirect methods [like cash expenditures), when there are two or more years under examination, or the taxpayer has had several changes in assets and liabilities during the year.[21] The net worth method should be used in these situations because the account balances at the end of each year can be determined more readily than changes in accounts during the year.[22] It is crucial that the data from steps 1 and 2 be evaluated for all years. Each year for which the IRS maintains that additional tax is due will result in a separate charge. The guilt or innocence of the taxpayer in one year is not evidence of guilt in other year8.23

* Important elements in income reconstruction In order to establish an income reconstruction case by the cash expenditures and/or net worth methods, the Service must follow the procedures described below.[24]

1. Establish an opening net worth with reasonable certainty and demonstrate that the taxpayer's income did not result from cash on hand, or the conversion of assets on hand at the beginning of the period. [25]. The opening net worth or starting point must be established to insure that the taxpayer is not erroneously charged with spending that resulted from only what was earned or accumulated in prior years.:6 The IRS is not required to prove the exact amount of net worth at the beginning of the year. It is sufficient to establish beyond a reasonable doubt that cash on hand or other existing net assets do not account for the estimated underreported income.

2. Incorporate in the analysis all relevant transactions that were reported by the taxpayer on his tax return.[27] Direct methods are employed to challenge specific elements on the tax return.

3. Establish a likely source of income, and/or eliminate nontaxable sources of income. It is not sufficient to show only that the taxpayer spent more than he reported. The Service must establish a reasonable source of funds that were expended but not reported or eliminate all likely sources of nontaxable income. Without a reasonable source for the excess expenditures, no proof of expenditures exists regardless of the size of the excess expenditures that were calculated.28 Obviously, a likely source is more powerful evidence than the negation of nontaxable resources.

4. Investigate within reason all leads independently developed or offered by the taxpayer. The taxpayer may maintain that he began the year with a "cash hoard," or received cash gifts, inheritance or other tax-exempt income that allowed for the seemingly excessive spending.

The IRS's calculations of available funds at the beginning of the year as well as the final determination of the existence and amount of underreported income are presumed to be correct. However, the determination of underreported income by indirect methods is not sufficient to prove willful intent in a clear and convincing manner.[29] All leads provided by the taxpayer must be investigated and all likely sources of nontaxable income must be eliminated. The IRS begins this process very early. One focus of the initial interview is the potential existence of a "cash hoard."

Establishing opening net worth with a reasonable certainty is difficult because books and records are often inadequate. The beginning assets and liabilities must be established in a manner consistent with the taxpayer's method of accounting. Both business and personal assets must be included in the evaluation. The most difficult beginning asset to verify is cash because it is hard to trace. The Service may attempt to accomplish this goal by offering as evidence the taxpayer's behavior, such as defaulting on a loan, which is inconsistent with persons who have excess cash or liquid assets. The IRS also may use past tax returns to demonstrate that insufficient after-tax income existed to accumulate the cash or assets claimed. Even though a court may not accept the existence of a cash hoard without proof, it will require the 1RS to demonstrate that a cash hoard does not

* Application of the cash expenditures and net worth methods Appendix A, on pages 538-541, demonstrates the cash expenditures and net worth methods as they apply to a hypothetical taxpayer, R. When applying either method to the facts involved, two common elements of the analysis are particularly noteworthy.

First, the final results under either method are exactly the same. Although the methods may appear to be quite different, they must lead to identical results from a given set of facts.

Second, these examples begin with the AGI as reported by R and not with taxable income. The cash expenditures analysis builds on the cash-T by adding the nondeductible personal living expenses to the deductible expenses already included on the return, and also by including changes in loan balances and receipts that are determined from the production of relevant documents and the interviews. The amount by which the total use of funds exceeds the total source of funds, including reported AGI, represents underreported income.

The net worth method calculates the amount of underreported income by comparing R's reported AGI to a corrected amount indirectly determined. The corrected AGI figure is calculated by adding deductible and nondeductible personal living expenses and capital losses in excess of $3,000 to the reported AGI and subtracting nontaxable income.

There are, however, elements of the analysis that are different for each method. For example, R's principal payments are not included in the net worth method because they are not a personal expense, but they are included as a use of funds in the cash expenditures method. Both methods reveal the exact same amount of underreported income. The reason for the difference is the basis of the two methods: net worth and cash. Paying (or receiving) a loan does not change net worth but it does change cash totals. Thus, to arrive at the appropriate answer the two methods must treat principal payments differently.

For the cash expenditures method, when an asset is sold the adjusted basis of the asset is always included as a source of funds. If the asset is sold for a gain, the gain would have been included in AGI and therefore considered a source of funds. If the asset is sold for a loss, the nondeductible portion of the loss (the economic loss)is included as an application of funds. The deductible portion of the loss would have reduced AGI. The net effect 546 will be to include as a source of funds the total funds received from the sale.[31] For the net worth method, the nondeductible portion of the capital loss is an addition to the change in net worth in step 3 of the IRS computation (above). Capital gains do not affect the net worth method unless any part of the gain is nontaxable. Only the nontaxable portion of capital gains is subtracted from step 3.32

Finally, a CPA and the IRS should arrive at identical results given a data set, even though their solution paths may be different. Two authorities have suggested that the defense should always prepare its analysis independent of the IRS.33 If the results are not identical, the CPA should review both analyses for some common errors. For example, in the net worth method, personal payments for clothing could be incorporated in the analysis by an increase in personal assets. Con-. versely, they could be included as a personal living expense and not reflected as an increase in the personal asset balance. To do both creates a potentially serious error.

One commentator34 employs only nondeductible personal living expenses in the application of the cash expenditures and net worth methods because he works with taxable income and not AGI. The IRS employs both deductible and nondeductible personal living expenses since it uses only AGI. Either approach, if properly applied, will lead to identical calculations of underreported income. However, using only nondeductible expenses with AGI or deductible and nondeductible expenses with taxable income will misstate underreported income.[35] Some differences in analysis do not change the amount of underreported income. An example of the latter is accumulated depreciation. Most IRS documents show it as a liability when it is properly a contra-asset. Of course, changing accumulated depreciation from a liability to a contra-asset would have no impact on net worth and therefore no impact on taxable income.

The CPA's Role

Although all practitioners are indirectly involved in income reconstruction through the client evaluation or risk assessment process, many CPAs are not familiar with the income reconstruction methods, and will ordinarily become directly involved in one of two ways. First, they may represent a client during an audit at either the agent or appellate level. Second, they may be hired to assist an attorney in "challenging" the IRS's reconstruction of income either at the audit level or in preparation for trial. The work product of CPAs who are directly hired by attorneys is protected as part of privileged communications.[36]

CPAs must be very cautious in becoming involved with clients who may have underreported income. Income reconstruction methods are useful in identifying such potential problem clients. Generally, a CPA may rely in good faith without verification on the data that a taxpayer provides in the process of tax return preparation.37 But preparers should also evaluate their clients' lifestyles and tax return information as part of the process in accepting or rejecting them. The cash-T analysis is an excellent way to document the tax preparer's diligence. Additionally, a CPA should use a signed tax return questionnaire that asks a client to verify that there is no underreported income or deductions that do not comply with the requirements of the Code or regulations that adequate books or records must be maintained. Such procedures will help insure that the CPA does not become the "victim" in a subsequent legal procedure if he prepared the return.[38]

If a CPA's client is being audited, certain "minimal" precautions must be taken. First, if the practitioner suspects that there may be (or is) underreported income, the client should be advised to consult with a competent attorney. The CPA should also consult with his own attorney (and may need to withdraw from an engagement) if he becomes aware of unreported (or underreported) income. This is especially important in light of potential civil and criminal sanctions under the Federal or state laws and potential susapension or disbarment from practice under Treasury Department Circular 230. It is important, of course, not to violate any Federal law regarding confidentiality or Rule 301 of the Code of Professional Conduct.39 Clients should be advised not to disclose books or records that are not requested by the IRS and to have their Fifth Amendment privilege protected in the event criminal charges are brought against them.40

If the IRS is interviewing a client, it is important to alert the client to the possible focus of an indirect income reconstruction. The CPA should discuss with the client the potential problems that may arise from the indirect income reconstruction and should recommend that the client consider legal assistance.[41]

A CPA also may play an important role in evaluating the use of the indirect income reconstruction methods employed by the IRS. If the taxpayer's books and records are not adequate, the taxpayer may have to offer alternative explanations for the funding source for the unreported taxable income. The taxpayer must prove that someone else made the expenditures or that the funds expended came from nontaxable sources, or that assets held at the beginning of the period were liquidated.42

When taxpayers become aware that they are being investigated or charged based on an indirect method, they commonly offer as a defense the existence of a "cash hoard" from which they financed the excess expenditures. An accountant should independently determine whether it is possible for the taxpayer to have accumulated a cash hoard.43

The CPA also can work to identify errors in the IRS's application of the indirect methods. The tax preparer should be aware, however, that simply showing errors in calculations will not necessarily eliminate the legal presumption that the Service's calculations and data are correct.

CPAs also may be called as witnesses by the IRS or the client. If they have prepared the tax return, the defense may attempt to "blame" them for any errors. Finally, an attorney who employs a CPA directly may call up the practitioner to act as an expert witness to challenge the validity of the Service's assertions.44


It is essential that CPAs be aware of the technical aspects of the income reconstruction methods before they begin representing high risk clients or working directly for attorneys in the fraud area. Practitioners must also be aware of their potential exposure to penalties arising from the Code or any other liabilities or responsibilities they may assume or incur with indirect income reconstruction cases.

Technical Sections to Accept Non-CPA Section Associates May 1

All technical division executive committees have authorized affiliation Beginning May 1, non-CPAs employed by CPA firms and meeting other eligibility requirements (The CPA Letter, December 1991J may affiliate with the AICPA's technical sections in the areas of management consulting services (formerly management advisory services), information technology, personal financial planning, and tax. Non-CPA "section associates" will be afforded the same technical section benefits as CPA members.

Associates of the Management Consulting Services (MCS) section will receive each new MCS Practice Aid and MCS Special Report as well as a quarterly newsletter. They also will have access to a referral service to share information and expertise with other MCS section members. For more information, call the division at 1201) 9383503.

section associates of Information Technology lIT) will be entitled to substantial discounts on software and hardware purchases from selected vendors, a quarterly newsletter, technology planning aids, and other relevant publications. Additional benefits include a forum to exchange ideas and experiences with peers and leaders in the field, special events held in connection with the AICPA's Microcomputer Conference, and demonstration copies of software to help in the selection of appropriate computer programs. For more information, call Nancy Cohen at (212)575-5393.

Affiliation with the Personal Financial Planning (PFP) section provides such benefits as the three-volume PFP Manual and other publications, a bimonthly newsletter, a discounted registration fee to the division's annual technical conference, a formalized public-awareness program, and legislative support. For more information, call the division at 1-800-TO-AICPA.

The Tax Division section offers practical support to individuals with an interest in taxes. The annual Tax Practice Guides and Checklists package is distributed each fall, as are other practice guides and helpful publications throughout the year. Additional benefits include The Tax Adviser (a monthly magazine) and the Tax Division Newsletter. Agendas and minutes of selected committees are available, and discounts for selected publications are also offered. For more information, call William Stromsem at (202) 737-6600.

The fees for section associates are $150 for MCS, $165 for IT, $180 for PFP, and $150 for Tax. Section associates will also receive subscriptions to the Journal of Accountancy and The CPA Letter. For applications, write to: AICPA Membership Administration, TA892, 1211 Avenue of the Americas, New York, N.Y. 10036-8775, or call (201) 938-3 100 and ask for operator TA892. Affiliation will begin as soon as fees are received and will expire on July 31, 1993, at which time section associates can renew their affiliations on an annual basis.
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Author:Winter, Kenneth
Publication:The Tax Adviser
Date:Aug 1, 1992
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