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Uncovering hidden assets.

Although traditionally the domain of revenue agents, the task of reconstructing an individual's income also may be performed by private accounting practitioners. In fact, providing litigation support through the practice of forensic or investigative accounting can become a significant and profitable part of one's practice.

For example, one party in divorce litigation may suspect hidden sources of income or concealed assets. In such cases, an analysis of spouse's personal finances through indirect methods may be enlightening. Similarly, a plaintiff may have won a judgment against a defendant in a contract or tort action and then found it difficult to locate assets against which the judgment may be satisfied. In this case, the services of a forensic accountant could be effective in locating the defendant's concealed assets.

This article will analyze the audit techniques used by Internal Revenue examiners in an effort to identify and described those methods that may prove useful to the private investigative accountant. Although these methods will be described from the IRS point of view, they can be adapted easily to almost any investigative assignment.

Chapter 800 of the Internal Revenue Manual, "Tax Guidelines for Internal Revenue Examiners," identifies two general approaches for determining income: the Direct (or Specific Item) Method and the various indirect methods.

Direct Method

The Service uses the Direct Method to show that specific taxable transactions either were omitted or were reported incorrectly. Thus, it is quite common for revenue agents to review real estate transactions at the county courthouse, as well as other public records. The existence of any unreported transactions would raise pertinent inquiries.

In general, the Direct Method is most useful where the taxpayer has made sales to a small number of customers. The details of each specific transaction then can be aggregated and compared with the total amount reported. Conversely, when there are many small sales to a large customer base (e.g., grocery stores, restaurants, etc.), it is too difficult and too time consuming to use the Direct Method.

Indirect Methods

Revenue agents may elect to use an indirect method of determining taxable income in a variety of situations. If the taxpayer's conduct indicates the possibility of an intentional omission of income, indirect methods may be appropriate. The type of conduct or "badges of fraud" that alert the agent to the need for additional scrutiny include the following:

* An unsatisfactory explanation of the taxpayer's failure to report substantial amounts of specific items of income.

* Concealment of assets, e.g., bank or brokerage accounts.

* Failure to follow normal business practices, e.g., not depositing receipts intact.

* Hiding sources of receipts of income through deception.

* Reporting bogus tax deductions.

* Keeping no books or two sets of books.

* Making false statements to an agent.

* Stalling an agent's examination by refusing to answer relevant questions or by continually canceling appointments.

It should be noted that the Internal Revenue Manual cautions that the existence of one or more "badges" does not indicate necessarily that the tax return was misstated intentionally. Instead, "badges of fraud" indicate the need for additional audit work.

The use of indirect methods of determining taxable income are not limited to potential fraud situations. Revenue agents also find indirect methods useful in more "innocent" circumstances such as:

* Use of a single-entry bookkeeping system.

* Loss or destruction of accounting records.

* Nonagreement of records with the tax return.

* Proof of the existence of a net operating loss.

* Test of the accuracy of the taxpayer's records.

The most useful of the indirect methods are: (1) the Net Worth Method, (2) the Source and Application of Funds Method, (3) the Bank Deposits Method, (4) the Percentage Computation Method, and (5) the Unit and Volume Method. Since these indirect methods are less familiar to the general practitioner, the remainder of this article will focus on the use of these indirect methods for reconstructing income. Each of these methods has its own advantages and limitations. The choice of method will depend upon the particular facts and circumstances in each case.
Table 1

 12-31-91 12-31-92

Total assets $275,000 $500,000
Total liabilities 75,000 80,000
Ending net worth $200,000 $420,000
Opening net worth 200,000
Increase in net worth $220,000

Plus: Nondeductible
expenditures 10,000
Less: Nontaxable income (5,000)

Adjusted Gross Income $225,000


The Net Worth Method

As the name implies, the Net Worth Method is a balance sheet approach to estimating income. This method estimates a taxpayer's income by establishing his or her networth at the beginning and at the end of a taxable year. The change in net worth, as adjusted for nondeductible expenditures and nontaxable income, represents the Adjusted Gross Income of an individual taxpayer.

Example 1: The revenue agent establishes that, at the beginning of 1991, a taxpayer has total assets of $275,000 and total liabilities of $75,000. At the end of 1992, total assets amount to $500,000, and total liabilities increase to $80,000. The agent determines that the taxpayer received $5,000 of nontaxable income and incurred nondeductible expenses of $10,000.

Using the Net Worth Method, the taxpayer's Adjusted Gross Income for 1992 of $225,000 is calculated as shown in Table 1.

If the taxpayer is an individual, the balance sheet for this purpose would include all personal assets (e.g., residence, furniture, jewelry, personal auto, etc.) and personal liabilities (e.g., home mortgage, personal loans, etc.).

Judicial Approval and Restrictions

Although the Net Worth Method is not specifically authorized or defined in the Code or regulations, IRC 446(b) allows the IRS to compute taxable income when it is not properly reported on the tax return.

Approval of the Net Worth Method. In Holland v U.S., the Supreme Court upheld IRS use of the Net Worth Method in determining taxable income. The Court permitted the Service to make an inference that the taxpayer's income was underreported when the net worth (after the necessary adjustments had been made) increased and was greater than the reported taxable income. This is true even if the books and records seem correct, since the IRS is allowed to corroborate or test the accuracy of the taxpayer's books and records.

Restrictions on Use of the Net Worth Method. To protect taxpayers from careless or inaccurate net worth computations, the Supreme Court has imposed certain safeguards or requirements on the Service when it uses the Net Worth Method:

* The Service must establish the beginning net worth with reasonable certainty, thus setting a base from which to compute changes in the taxpayer's net assets.

* Taxpayer's admissions also must be established reasonably.

* A likely source of the unreported taxable income must be established reasonably.

* When the taxpayer suggests sources of nontaxable income, such as loans and gifts that could show the net worth calculation to be in error, the Service must investigate these "leads."

Defenses Used in Contesting the Net Worth Method

In Holland, the Supreme Court was very concerned that the Net Worth Method could cause serious harm to the innocent. The Court believed that the use of indirect methods in tax evasion cases was expanding so rapidly that it was necessary to issue warning signals as to the dangers involved when using the Net Worth Method.

The problem areas or difficulties, as noted by the Court in Holland, were (1) the cash-on-hand defense; (2) the government's failure to investigate leads; and (3) a likely source of income for the taxpayer. Although all three areas also could prove to be obstacles for the private forensic accountant, the "cash hoard" defense is the most formidable.

Cash on Hand. As previously mentioned, the opening net worth must be reasonably established as a starting point. The most common defense in a net worth case is the "cash hoard" story. Any understatement discovered by the agent is reduced by any asset that was available at the beginning of the period under question but not included in the net worth computation.

In Moceri v Commissioner, a self-described bootlegger convinced the Tax Court that he had no income-producing activities during the period in question. Instead, he was able to show that he not only had the means to accumulate a cash hoard but also that the cache was large enough to explain the increases in his net worth and his living expenses. Moceri was supported in his case by (1) his indictment as a member of a gang believed to be involved in bootlegging; (2) testimony from his wife that they lived modestly; (3) estimated earnings from bootlegging to be over $1,000,000; (4) evidence that the taxpayer carried large amounts of cash (he was arrested in 1951 carrying $1,800 in cash); and (5) evidence that Moceri had loaned $13,000 to his sister. (The court felt a fugitive who had to rely on his cash accumulation likely would not loan his last dollar to a relative.) Moreover, the IRS found no evidence of gainful employment. Therefore, Mr. Moceri was able to overcome the purported understatement of income.
Table 2

 1991 1992

Application of Funds

Increase in bank balance $ 6,250 $ 500
Purchase of stocks 3,000 4,000
Downpayment on residence 50,000 -0-
Purchase of automobile -0- 22,250
Monthly mortgage payments 12,000 12,000
Credit card payments 1,500 5,000
Loan repayments 500 1,000
Other personal living expenses 10,000 12,000

Total Application of Funds $83,250 $56,750

Less: Known Sources of Funds
Cash on hand 3,000 -0-
Interest on bank account 500 950
Loan 10,000 -0-
Wages 35,500 37,500

Total Known Sources of Funds $49,000 $38,450

Funds from Unreported Sources $34,250 $18,300


Although the "cash hoard" defense was successful in Moceri, such was not the case in Roberts v Commissioner. In Roberts, the taxpayer was inconsistent in several different instances about his cash holdings. At the beginning of the IRS audit he stated his cash on hand was usually between $500 and $2,000. However, he reported $8,000 and $12,000 in cash on two financial statements supplied to banks on two separate occasions. Then at trial, Roberts testified his cash cache was $250,000, $150,000 and $100,000 on December 31 of 1977, 1978 and 1979, respectively. The Court also noted that the $100,000 increase in loans payable during this period indicated the lack, rather than the presence, of a cash hoard. Ultimately, the taxpayer's testimony was too inconsistent for the Tax Court to believe. The court ruled in favor of the government's net worth computation.

Government's Failure to Investigate Leads. In Holland, the government was successful in refuting the taxpayer's cash hoard defense. However, the Supreme Court obviously was disturbed that the Service had failed to investigate the Hollands' story that a portion of the cash came from the sales of two cafes and other transactions. Circumstantial proof, such as the indirect reconstruction of taxable income techniques, requires the "negation" of "reasonable explanations" submitted by the taxpayer.

Even with this problem, the government prevailed on one count of tax evasion in the Holland case. It had gathered sufficient evidence to convince the jury, and later the Supreme Court, that the assets allowed in the net worth computations were all the Hollands owned during the periods in question. In effect, the purported transactions were so distant and remote that they could not have affected the computation.

A Likely Source of Taxable Income. The final "safeguard" used to refute the Net Worth Method stems from taxpayer's possession of a likely source of income. In Holland, the Court noted that proof of understated income was not enough to prove that the income was taxable. In addition to an understatement, the government had to show that there was "a likely source, from which the jury could reasonably find that the net worth increases sprang."

In U.S. v Massei, the Supreme Court, in a per curiam opinion, addressed the issue of whether the absence of a likely source of income was crucial when the government had negated all possible sources of nontaxable income. The conclusion was precise and logical. The Court held that, when all possible nontaxable sources have been investigated by the government and negated, no proof is required for a likely source of the increases in net worth.

Since the private investigative accountant typically is not concerned with the source of character of income, this defense against the Net Worth Method of income reconstruction is not likely to pose a significant obstacle.

Source and Application of Funds Method

A variation on the Net Worth Method, the Source and Application of Funds Method, provides the forensic accountant with another tool for reconstructing income. Also referred to as the Cash Transactions Method, this approach compares all known expenditures with all known receipts for a given period. The theory underlying this method is that if a person's expenditures during a given year exceed the person's known sources of funds for that year, it may be inferred that the excess expenditures represent unreported income.

In making the actual computation, increases and decreases in assets and liabilities along with nondeductible expenditures and nontaxable receipts are used. This computation is the same for individuals, partnerships and corporations, and it is based on the following formula:

Application of funds (expenditures)

Less: Known sources of funds

Equals: Funds from unreported sources

A revenue agent will generally use the Source and Application of Funds Method in the following situations:

* If only one or two years are under examination;

* If the taxpayer has several assets and/or liabilities which do not change during the year;

* If deductions claimed for nonbusiness examinations appear out of proportion to the income reported or if unreported income is indicated;

* If comparative balance sheets are available;

* If little or no apparent net worth is evident and most of the expenditures of funds constitute nondeductible personal living expenses.

Example 2: The forensic accountant establishes the existence of a creditor's key expenditures during 1991 and 1992. Using the Source and Application of Funds Method, the creditor's funds from unreported sources for 1991 and 1992 are calculated as shown in Table 2.

Defenses Against the Source and Application of Funds Method

The defenses regarding the Net Worth Method are equally applicable to the Source and Application of Funds Method. In some cases, a net worth statement may be prepared to rebut a defense that the funds used for expenditures were derived from the conversion of an asset not considered in the Source and Application of Funds Method.

The Bank Deposits Method

The Bank Deposits Method is another indirect method of proving unreported income. Similar to other indirect methods, the Bank Deposits Method computes income by showing what happened to a person's funds.

This method is based on the theory that if a person receives money, only two things can be done with the money: it can be deposited or it can be spent in the form of cash. Using these assumptions, income is proved through an analysis of bank deposits, canceled checks and currency transactions.

A basic formula for the bank deposits method is as follows:

Total deposits to all accounts Less: Transfers and redeposits Equals: Net deposits to all accounts Plus: Cash expenditures Equals: Total receipts from all sources Less: Funds from known sources Equals: Funds from unreported sources

The IRS recommends that revenue agents use the Bank Deposit Method for examining returns of taxpayers who deposit most of their income and pay most business expenses by check. The Bank Deposit Method also may be an effective way of verifying gross receipts reported when the books and records are not available, when the records are incomplete and may not reflect adequately the correct gross receipts, or when the taxpayer uses a bank deposit method in preparing the tax return.

Example 3

An investigative accountant is engaged by a divorce attorney to establish the financial resources available to the client's spouse. Using the Bank Deposits Method, the investigative accountant calculates the spouse's funds from undisclosed sources for 1991 and 1992 as shown in Table 3.

Defenses Against the Bank Deposits Methods

As might be expected, the common defense in a bank deposit case challenges the character of the documented deposits. Taxpayers often contend that the deposits are non-income items, such as loans, inheritances or insurance proceeds. Another possible defense is that the deposits either are not current income or are a duplication of current income. Finally, a taxpayer could argue that the deposits belong to a person or entity other than the taxpayer.

The Percentage Computation Method

Unlike the Net Worth Method and the Bank Deposits Method, which can be used for individuals as well as business entities, the Percentage Computation Method has application only to businesses. With the Percentage Computation Method, income determinations are made by the use of percentages or ratios considered typical to the business. By reference to similar businesses or situations, percentage computations are secured to determine sales, cost of sales, gross profit or even net profit. Likewise, by the use of some known base and the typical percentage applicable, individual items of income or expense may be determined.

The U.S. Court of Appeals for the Sixth Circuit upheld the use of the Percentage Computation Method in Kurnick v. Commissioner. The IRS examined the Kurnicks' income tax returns because the gross profit shown on their returns on retail liquor sales was much less than that realized by similar retail liquor stores throughout the state of Michigan. With a few adjustments for inventory variations, the IRS accepted the liquor inventory figures reflected on the tax returns. Then the IRS reconstructed profits by applying a 10% markup on liquor purchases. The result was substantial unreported gross income.

Limitations on the Percentage Computation Method

In Kurnick, the taxpayers raised two defenses. First, they claimed that the Percentage Computation Method used did not take into consideration losses due to leakage, breakage or pilfering. Secondly, they contended that during the liquor shortage they were forced to buy from the state certain types of liquor (such as brandies and liqueurs) which were later sold at a loss. The taxpayers were unable to present any evidence to support their positions.

The IRS recognizes that the Percentage Computation Method has limitations and the examiners are instructed to exercise good judgment in using this method. The Percentage Computation Method often is used in conjunction with another method such as the Net Worth Method to add further credence to the IRS' position on the reconstructed income. Some of the limitations in making comparisons when using the Percentage Method ultimately could become the taxpayer's defenses. To be meaningful, comparisons should account for the following factors:

* Type of merchandise handled or service rendered;

* Size of operation (large chain versus small independent owner);

* Locality (large urban area versus small rural community);

* Period covered (variations from year to year due to the economy); and

* General merchandising policy (large volume-small markup-little service versus small volume-large markup-more service).

The Unit and Volume Method

In many instances, gross receipts may be determined or verified by a Unit and Volume Method. This method applies price and profit figures to the known or reconstructed volume of business, based either on information from the taxpayer's records or from third-party sources, such as regulatory agencies to which the taxpayer is required to report the units produced or the volume of sales.

Nino's Pizza Shop, Inc. v Commissioner reflects the application of the Raw Materials Consumption variation of the Unit and Volume Method. The IRS computed the shop's gross receipts by estimating the number of pizzas which could be made from the amount of flour purchased by the shop. The records of the shop's suppliers were used to compute the purchases. This resulted in understatements of income of $102,158, $170,084 and $101,587 in 1980, 1981 and 1982, respectively.

The taxpayers argued that the IRS overstated the number of pizzas that could be made out of a 100-pound bag of flour. They also contended that they sold some of their flour at cost to a local doughnut shop and that they gave some flour to a friend. However, they were unable to carry their burden of proof.

Another variation of the Unit and Volume Method is illustrated in Agnellino v Commissioner, which involved the reconstruction of income a motel received. The IRS used the "sheet count" method to compute motel income. To determine the number of guests, the number of sheets used was divided by two. An average daily room rate per guest was applied to compute gross income.

Conclusion

Given the vast and increasing volume of litigation in today's society, the demand for the services of a forensic accountant is certain to increase. By adapting some of the audit techniques commonly used in IRS fraud investigations, the private accountant easily can expand his or her practice to include investigative accounting services.

References

1 I.R.M. 4231. 940

2 See generally Treas. Reg. 1.446-1(a), I.R.M. 4231, 710, and I.R.M. 4235, 641.4

3 Holland v U.S., 75 S.Ct. 127 (1954)

4 Ibid. at 134

5 Ibid. at 134

6 Ibid. at 136

7 Ibid. at 137

8 Moceri v Comm., TC Memo 1969-33

9 Roberts v Comm., 53 TCM 517 (1987)

10 Holland v U.S., 75 S.Ct. 127, 135 (1954)

11 Ibid. at 136

12 U.S. v Massei, 1 AFTR2d 1004 (USSC, 1958)

13 I.R.M. 4231 835(2)

14 I.R.M. 4231, 838

15 I.R.M. 4231, 840

16 Kurnick v Comm., 232 F.2d 678 (CA-6, 1956)

17 I.R.M. 4231, 842

18 Nino's Pizza Shop, Inc. v Comm., 55 TCm 1343 (1988)

19 Agnellino v Comm., 9AFTR 2d 1423 (CA-3, 1962)

John F. Taylor, MACC, CPA, CFE, is Director of Taylor CPA Review. He has extensive experience preparing candidates for the CPA exam as well as teaching college accounting and auditing classes. He is a graduate of the University of Tennessee and holds a Masters of Accountancy from East Tennessee State University.

Kent N. Schneider is Associate Professor of Accountancy at East Tennessee State University in Johnson City, Tennessee. He holds a JD degree from the University of Missouri and a MAcc degree from the University of Oklahoma. He has published in numerous professional journals.
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Title Annotation:detremining an individual's income
Author:Taylor, John F.; Schneider, Kent N.
Publication:The National Public Accountant
Date:May 1, 1993
Words:3722
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