Methods of Proof

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Methods of Proof

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9.5.9  Methods of Proof

9.5.9.1  (11-05-2004)
Overview

  1. This section will explain the various methods of proof available to the special agent in determining a subject's correct taxable income, and how to properly document each method of proof. The following methods of proof will be discussed in this section:
    • Specific Items
    • Net Worth
    • Expenditures
    • Bank Deposits
    • Cash Method
    • Percentage Markup
    • Unit and Volume

     

9.5.9.2  (11-05-2004)
Introduction

  1. "Proof" is the establishment by evidence of a requisite degree of belief concerning a fact in the mind of the trier of fact or the court. Proof is the logically sufficient reason for assenting to the truth of a proposition advanced. In its judicial sense, it is a term of wide import and encompasses everything that may be adduced at a trial, within the legal rules, for the purpose of producing a conviction in the mind of judge or jury.
  2. "Evidence" is a much narrower term. It includes only such proof as is admissable at trial by the act of the parties or through such concrete facts as witnesses, records, or other documents. Proof is the end result or effect of evidence, while evidence is the medium or means by which a fact is proved or disproved.
  3. Direct evidence proves a fact, without an inference or presumption, and conclusively establishes that fact without reference to any supporting evidence. Direct evidence is evidence of the precise fact in issue and is distinguished from circumstantial i.e., "indirect, " evidence.
  4. Tax crimes are often acts of individual greed and, therefore, very little "direct evidence" is usually available. Depending on the facts and circumstances of each investigation, the subject's correct taxable income may be established by " direct" or several "indirect" methods of proof, usually using circumstantial or "indirect" evidence.

9.5.9.2.1  (11-05-2004)
Direct (Specific Item) Method

  1. Among the various methods of proving unreported or underreported taxable income, the specific item method is the most preferred. Most subjects report their income and expenses by the specific item method using books and/or records in which their financial transactions are contemporaneously recorded. Their transactions are usually summarized and shown on the tax return.
  2. There are three broad categories of schemes which are suited to the specific item method of proof:
    1. understatement of income
    2. overstatement of expenses
    3. fraudulent claims for credits or exemptions

     

  3. A false tax return may include any or all of these schemes. Unreported Income can be proved using the basic or aggregate approaches (see subsections 9.5.9.4.3 through 9.5.9.4.3.2 below).
  4. Small amounts of expenses claimed on the false return sometimes have to be allowed or accepted because the special agent is unable to properly trace or document the actual amounts, or he/she lacks the time to do so.

9.5.9.2.2  (11-05-2004)
Indirect Methods

  1. Indirect methods require the special agent to gather and present evidence to support the allegation. The special agent will use evidence to determine what income should have been reported on the subject's return and compare that to the amount shown on the return, if a return was actually filed.
  2. Sources of income may not be identifiable, as in a specific item method of proof. Therefore, taxable income often has to be computed indirectly based upon the taxpayer's application or use of funds.
  3. The courts have upheld the use of the net worth, expenditures, bank deposits and cash methods of proving income, on the theory that proof of unexpended funds or assets may establish a prima facie understatement of income which requires a defendant to overcome the logical inference drawn therefrom.
  4. With respect to the establishment of a prima facie investigation by such evidence, courts have been careful to point out that findings of fraud have been sustained if, but only if, the defendant has offered no adequate explanation of the discrepancies between (on the one hand) expenditures, bank deposits, and increases in net worth and (on the other hand) the amount of income reported by the defendant.
  5. Another indirect method of proof is the percentage markup method of proof. Pending the establishment of judicial precedents, the percentage markup method of proof should only be used as a primary method of proof, on a limited basis, and not used to corroborate other methods. (See subsection 9.5.9.9, Percentage Markup Method of Proving Income.)
  6. The unit and volume method of proof can be utilized when the number of units handled and the price or profit charged per unit is known.

9.5.9.3  (11-05-2004)
Distinguishing Between Accounting Systems, Accounting Methods, and Methods of Proving Income

  1. For many years, there has been much confusion regarding the synonymous use of the terms "accounting system, " "accounting methods," and "methods of proving or determining income." It is not unusual to hear reference made to the net worth and expenditures method as a method of accounting when, in fact, it is a method of proving income.
  2. There are two basic accounting systems, i.e., the single entry system and the double entry system, but there are various methods of accounting, e.g., accrual, hybrid, installment, and long-term or completed contract methods. The most frequently used methods of proving or determining income are the specific item, net worth, expenditures, bank deposits, cash and percentage markup methods of proof.
  3. For the purpose of criminal prosecution, taxable income must be computed by way of the accounting method regularly used by the subject to compute his/her income. In Morrison v. United States, 270 F. 2d 1 (4th Cir. 1959), it was necessary to establish not only that the tax liabilities at issue were understated, but that the understatement was attributable, at least in part, to the fact that the subject’s returns were not honestly prepared. Proof of the latter fact could only be accomplished by adopting and consistently applying the subject’s method of accounting.
  4. If no method of accounting has been regularly used by the subject, or if the method used does not clearly reflect income, special agents may use whichever method they believe clearly reflects the subject’s income. Whatever method is used, it must be used for all prosecution years.

9.5.9.4  (11-05-2004)
Specific Item Method of Proving Income

  1. Where the government is using the specific item method of proof (in an investigation of alleged tax evasion), the government attempts to document specific transactions that were not completely or accurately reflected on the subject's income tax return. Additionally, the government must show that the specific omissions of income were made willfully for the purpose of understanding the subject's income tax liability.
  2. The specific item method offers the most direct method of proving unreported income. The specific item method is the preferred method of proving income because it is the easiest to understand, include in a prosecution report, and present at trial. Additionally, the specific item of proof method is the hardest for the subject to rebut.

9.5.9.4.1  (11-05-2004)
Types of Evasion

  1. Omitted income, fictitious deductions, false exemptions, or false tax credits are means whereby taxes may be evaded.
  2. Omitted income results from a subject's failure to report any of the numerous items of taxable income set forth in the Internal Revenue Code (IRC).
  3. During investigations of proprietors and/or their businesses, sales or gross receipts are the most frequently encountered item of omitted income.
  4. During investigations of individuals, omitted income is frequently encountered in the form of salaries, interest, dividends, commissions, gains from the sale of property, and fees.
  5. Overstatement of expenses results from the subject's attempt to reduce taxable income by claiming false or inflated expenses. During investigations of proprietors and/or their businesses, overstated expenses can be hidden in any expense reported on the tax return. During investigations of individuals, the overstated expenses are most frequently encountered on Schedules A, C, D, and F. Additionally, subjects attempt to evade income taxes by claiming false deductions and exemptions. In all of the investigations described above, the specific item method of proof is ideally suited to proving the violation.

9.5.9.4.1.1  (11-05-2004)
Unreported Income from Certificates of Deposit

  1. There are two types of certificates of deposit, i.e., a standard certificate of deposit and an original issue discount certificate.

9.5.9.4.1.1.1  (11-05-2004)
Standard Certificate of Deposit

  1. A standard certificate of deposit pays interest at specific intervals over the term of the note.
  2. Although the interest may be withdrawn without penalty, the principal normally may not be withdrawn without incurring a substantial penalty.
  3. Financial institutions issue Forms 1099 INT to the owner reflecting the interest earned.

9.5.9.4.1.1.2  (11-05-2004)
An Original Issue Discount Certificate

  1. An original issue discount certificate pays interest only upon the note's maturity.
  2. Title 26 USC §1272 requires holders of this type of certificate of deposit to report the interest earned on the basis of a constant interest rate.
  3. Title 26 USC §6049 contains specifics as to when Form 1099–Original Issue Discount Certificates (OID) will be issued to holders of such certificates.

9.5.9.4.1.2  (11-05-2004)
Department of Justice, Tax Division’s Position on Original Issue Discount Certificates

  1. The position of the Department of Justice (DOJ), Tax Division is that, except for unusual circumstances, it will not recommend the prosecution of criminal investigations which are based upon the subject's failure to report interest from original issue discount certificates before maturity, except under unusual circumstances.
  2. In these investigations, a willfulness issue usually arises from the subject’s lack of actual possession, use, and enjoyment of the interest during the holding period.
  3. Similar problems should not arise in investigations involving standard certificates of deposit when the interest is made available to the subject.
  4. When preparing a prosecution report proving the omission of income from a certificate of deposit, the special agent must properly identify the type of certificates of deposit in question. Copies of Forms 1099, as well as copies of the actual certificates of deposit, must be exhibited in the prosecution report.
  5. In addition, the prosecution report should address the issue of willfulness by discussing whether the principal and interest on a matured certificate was rolled over into a new certificate of deposit, whether premature withdrawal of the principal is subject to penalties, and whether there was a premature redemption.

9.5.9.4.2  (11-05-2004)
When to Use the Specific Item Method of Proof

  1. Specific omissions of gross income are most easily shown when the subject has a small number of significant sources of income. During the investigation, the special agent determines the specific amount of income reported from each source and then compares those figures with the total amount of income documented in the subject's books and records, and reported on his/her tax return. The following examples illustrate the appropriate use of the specific item method of proof:
    1. While investigating a physician, the special agent found all receipts from patients had been reported but that amounts paid by insurance companies on behalf of patients were omitted. By contacting the various insurance companies, specific omissions of income were determined.
    2. While investigating a self-employed subject who re-upholstered furniture, the special agent noted an inconsistency between reported income and living expenses. An analysis of reported gross receipts showed the subject reported small amounts of income received from individual customers. An analysis of the subject's bank records showed checks deposited from a large department store. Further investigation revealed that the subject failed to report substantial income earned on a contract basis with the department store.

     

  2. When the subject of an investigation generates small amounts of income from numerous customers or clients, as would be the investigation with subjects owning bars, restaurants, and grocery stores, it is difficult, if not impossible, to match reported amounts of income with specific sources of income. In these situations the specific item method may not be the best method to use; indirect methods may be more appropriate

9.5.9.4.3  (11-05-2004)
How to Use the Specific Item Method of Proof

  1. There are two approaches to the specific item method of proof, i.e., the basic approach and the aggregate approach. Depending upon the facts and circumstances of the investigation, the special agent will use one of the two approaches to prove unreported income.
  2. The basic approach to the specific item method of proof requires the special agent to trace the reported items of income through the subject's books and records to the tax return. Upon doing so, the special agent can specifically identify the unreported income items.
  3. The aggregate approach to the specific item method of proof simply requires that the special agent identify the total amount of income the subject should have reported in any given year. The special agent then compares the total amount of income with the aggregate amount of income reported on the return, and arrives at an understatement of income.

9.5.9.4.3.1  (11-05-2004)
Basic Approach

  1. The basic approach to the specific item method of proof involves a two step process:
    I. First, the special agent identifies the sources and amounts of reported income and expenses shown on the tax return by reconciling them to the subject's records.
    II. Second, he/she determines the correct amounts of income, expenses, and credits using the subject's records, bank records, investment account records, and/or contacts with third parties and compares the correct amounts to those reported on the tax return. The comparison will yield specific items of unreported income and false or inflated expenses or credits.

     

    1. The reconciliation of reported gross receipts to the subject's records. In examining the return of a self-employed geologist, the special agent reconciles reported gross receipts with the subject's records as follows:
    2. Determine specific items of omitted income. By contacting each of the subject's three reported clients in the above example, the special agent was able to determine the correct income from those clients. An analysis of bank records disclosed a fourth customer, which the special agent also contacted.

     

    Source Date Amount Total
    Actor Company 01/27/1998 $3,000.00  
    Actor Company 08/14/1998 $5,000.00  
          $8,000.00
    Barber Company 01/05/1998 $6,000.00  
    Barber Company 03/20/1998 $4,000.00  
    Barber Company 06/14/1998 $2,000.00  
          $12,000.00
    Chef Company 05/01/1998 $2,500.00  
    Chef Company 07/22/1998 $1,500.00  
          $4,000.00
    Total Reported Schedule C Gross Receipts $24,000.00

     

    Source Date Check No. Amount Reported Amount Omitted
    Actor Company 01/27/1998 4517 $3,000.00  
    Actor Company 06/09/1998 6248   $17,000.00
    Actor Company 08/14/1998 9704 $5,000.00  
    Barber Company 01/05/1998 204 $6,000.00  
    Barber Company 03/20/1998 413 $4,000.00  
    Barber Company 06/14/1998 785 $2,000.00  
    Barber Company 10/14/1998 1032   $19,000.00
    Chef Company 05/01/1998 817 $2,500.00  
    Chef Company 07/22/1998 1042 $1,500.00  
    Chef Company 11/14/1998 1324   $2,000.00
    Driver Company 12/02/1998 205   $13,000.00
    Total Reported Schedule C Gross Receipts $24,000.00  
    Total Omitted Schedule C Gross Receipts   $51,000.00

     

9.5.9.4.3.2  (11-05-2004)
Aggregate Approach

  1. When it is not possible to specifically identify the items of income which were not reported on a subject's tax return, due to a lack of accurate books and records, the special agent may use the aggregate approach to the specific item method of proof in calculating the subject's correct taxable income. This approach requires that the special agent specifically identify all of the subject's items of income and then compare that amount to the subject's total reported taxable income. For example, if the subject's return shows gross receipts of $150,000, the special agent may develop a specific item investigation by showing through third-party documentation that the subject has actually received $200,000 in gross receipts during the same period. The special agent does not have to identify the specific items of income that were not reported ($50,000) as he/she has specifically identified the individual items that make up the gross receipts and determined that amount exceeds the aggregate amount of gross receipts reported on the subject's income tax return. The following example will illustrate the aggregate approach to the specific item method of proof:
    Example:    
    Gross Receipts Reported $150,000
    Receipts Documented by Third Party Contacts:
      Witness A $ 50,000
      Witness B 100,000
      Witness C 50,000
    Corrected Gross Receipts $200,000
    Less: Reported Receipts (150,000)
    Equals: Unreported Gross Receipts $ 50,000

     

  2. As shown by the above example, the special agent can use the aggregate approach and prove that gross receipts are understated without examining the subject's books and records. However, if the subject's books and records are available, the special agent must attempt to reconcile them to the tax return.

    Note:

    The basic approach to the specific item method of proving income should be used whenever possible. The aggregate approach to the specific item method of proof should only be used when specific sources and amounts of income reported on a tax return cannot be identified.

     

9.5.9.5  (11-05-2004)
Net Worth Method of Proof

  1. An investigation utilizing the net worth method of proof differs from a specific item method in that direct comparisons of income, expenses, and credits can not be made. The net worth method of proof utilizes evidence of income applications such as asset accumulation, liability reduction, expenditures, and other financial data to indirectly establish correct taxable income.
  2. An accounting is made showing how funds generated from income were applied by identifying increases to net assets and various expenditures.
  3. After making adjustments for exemptions, itemized deductions, nontaxable income, and nondeductible losses, the courts permit the IRS to infer, indirectly, that the remainder is taxable income.
  4. By comparing this to taxable income reported on the subject's return, if a return was actually filed an understatement of taxable income can be determined.
  5. The net worth method is a very effective way of proving taxable income in criminal income tax investigations. The formula for calculating the subject's correct taxable income can be broken down into four steps:
    1. The special agent must first calculate the change in a subject's net worth (assets less liabilities). This is done by determining the subject's net worth at the beginning and end of a period of time (a taxable year or years) and then subtracting the beginning period's net worth figure from the ending period's net worth figure. This computation will yield a change in net worth (either an increase or decrease in net worth).
    2. The amount of this change in net worth is then adjusted for personal living expenses, nondeductible losses, and nontaxable items to arrive at a corrected adjusted gross income figure.
    3. The corrected adjusted gross income figure is then adjusted for itemized deductions or the standard deduction amount, and then for exemptions, to arrive at a corrected taxable income figure.
    4. Finally, by comparing the corrected taxable income figure with the taxable income reported on the tax return, the special agent can determine whether the subject failed to report any taxable income.

     

9.5.9.5.1  (11-05-2004)
Authority for Net Worth Method

  1. There is no statutory provision defining the net worth method and specifically authorizing its use by the Commissioner. However, every judicial circuit has endorsed the net worth method of proof and the Supreme Court has approved its use in a number of investigations. The following is a listing of some of the more prominent of those investigations:
    1. Holland v. United States, 348 US 121 (1954)
    2. Friedberg v. United States, 348 US 142 (1954)
    3. Smith v. United States, 348 US 147 (1954)
    4. United States v. Calderon, 348 US 160 (1954)
    5. Massei v. United States, 355 US 595 (1958)
    6. United States v. Johnson, 319 US 503 (1943)

     

  2. These investigations outline the broad principles governing the prosecution and review of investigations based on the net worth method of proving income.

9.5.9.5.1.1  (11-05-2004)
Legal Requirements to Establish a Prima Facie Net Worth Investigation

  1. The Supreme Court, while firmly approving the net worth method of proof, cautioned, in Holland v. United States, 348 US 121, 125 (1954), that " it is so fraught with danger for the innocent that the courts must closely scrutinize its use."
  2. The Supreme Court set forth three requirements that the government must satisfy prior to using the net worth method of proof:
    1. establish an opening net worth with reasonable certainty
    2. negate reasonable explanations by the subject inconsistent with guilt
    3. establish that the net worth increase is attributable to currently taxable income - Id. at 132 - 137.

     

  3. Net worth increases are determined by establishing a net worth at the beginning of a given year and then comparing this beginning net worth with the net worth at the end of the year. The opening net worth is the point from which net worth increases are measured. While every effort should be made to identify all of the assets and liabilities of the subject at the starting point, the government does not have to establish the opening net worth with mathematical certainty.
  4. Without a doubt, determining how much cash an individual has "on hand" at the beginning or end of a year is an extremely difficult task. To require mathematical certainty would eliminate the possibility of using the net worth method of proof.
  5. The thoroughness of the investigation is crucial in determining whether the government has established the subject's opening net worth with reasonable certainty. When the government chooses to proceed against a subject using the net worth method of proof, "the government assumes special responsibility of thoroughness and particularity in its investigation and presentation." United States v. Hall, 650 F. 2d 994, 999 (9th Cir. 1981).
  6. Success in overcoming attacks on the legal sufficiency of the evidence supporting an opening net worth is directly related to the extent and thoroughness of the investigation. Although not a model, the Mastropieri investigation does furnish an excellent example of a number of steps that must be taken to establish an opening net worth. US v Mastropieri, 685 F. 2d 776, 779 (1982). For example, in Mastropieri:
    • The special agent canvassed 47 banks, 71 brokerage firms, and 13 lending institutions. In addition, the special agent searched the local property records of Bronx, Nassau, Queens, Kings, and Suffolk counties for the years during the investigation and prior to 1967.
    • The special agent checked records of the IRS and the county clerk and interviewed unnamed friends and relatives of the subject.

     

9.5.9.5.2  (11-05-2004)
When to Use the Net Worth Method

  1. The net worth method of proof is most often used when one or more of the following conditions exist:
    1. the subject maintains no books and records
    2. books and records are not available
    3. books and records are inadequate
    4. subject withholds books and records

     

  2. The fact that the subject’s books and records accurately reflect the figures on the return does not prevent the use of the net worth method of proof. The government can look beyond the self-serving declarations in the subject’s books and records and use any evidence available to refute the accuracy thereof.
  3. In addition to being used as a primary method of proving taxable income in civil and criminal income tax investigations, the net worth method can be used:
    1. to corroborate other methods of proving income
    2. to verify accuracy of reported taxable income

     

9.5.9.5.3  (11-05-2004)
Method of Accounting

  1. The net worth method of proof is not limited by the subject's method of accounting. The net worth statement may reflect the subject's corrected taxable income by whichever method of accounting (cash, accrual, etc.) is appropriate. Reflecting a certain accounting method in the net worth computation is accomplished by including certain accounts in the net worth statement and omitting others. For instance, to compute the income of a physician on the cash basis, patient accounts receivable and business accounts payable at the beginning and end of each year would be omitted. If the physician used the accrual method of accounting, these accounts would be included in the net worth computation.
  2. In preparing a net worth statement or summary for use in a criminal investigation, special agents should ensure that:
    1. The subject's method of accounting is used.
    2. The cost of assets and actual amounts of liabilities are used and that values other than cost, i.e., market value or reproduction value, are not considered in the net worth computation.
    3. Estimated nondeductible expenditures are eliminated from the net worth computation, unless the subject agrees to the estimated amount or it is proper to include some minimum estimated personal living expense figures.
    4. Generally accepted accounting principles are followed.
    5. Technical adjustments that increase income are eliminated, e.g., unintentional errors or omissions relating to capitalized expenses, depreciation, revaluation of the basis of property, and changing inventory basis, or doubtful items such as unidentifiable commingled funds.

     

9.5.9.5.4  (11-05-2004)
Overview of the Net Worth Method of Proof Formula

  1. The net worth formula expanded:
    Assets:
    Cash on hand  
    Cash in Accounts    
    Checking    
    Savings    
    Brokerage    
    Securities    
    Vehicles (motor homes, airplanes, motorcycles, etc.)
    Business Equipment  
    Real estate investments  
    Personal items    
    Negotiable instruments  
    Subtract: Liabilities and Accumulated Depreciation
    Loans    
    Notes    
    Accounts payable    
    Credit card balances    
    Mortgages    
    Accumulated depreciation  
    Equals: Net Worth
    Subtract: Prior Year's Net Worth
    Equals: Increase (Decrease) in Net Worth
    Add:Adjustments for Personal Expenditures and Nondeductible Losses

    Note:

    Personal living expenses (including payments that may later be allowed as itemized deductions or adjustments to arrive at adjusted gross income)

    Federal income taxes paid
    Life insurance premiums  
    Nondeductible portion of capital losses
    Gifts of property made by subject
    Losses on the sale of personal assets  
    Subtract: Adjustments for Nontaxable Items
    Federal tax refunds  
    Gifts and inheritances received by subject
    Veteran's benefits    
    Nontaxable portion of pensions and annuities
    Tax-exempt interest  
    Capital loss carryover  
    Net operating loss carryover  
    Honest mathematical and bookkeeping errors
    IRA and Keogh Plan payments  
    Other nontaxable income  
    Equals: Corrected Adjusted Gross Income
    Subtract: Allowable Itemized Deductions or Standard Deductions
    Personal Exemptions  
    Equals:Corrected Taxable Income
    Subtract: Reported Taxable Income
    Equals: Unreportable Taxable Income

     

  2. In determining the value of assets, all assets in the computation are entered at cost or other tax basis. Fluctuations in fair market value are of no consequence in determining taxable income. Paper gains or losses resulting from changes in fair market value of assets are not taxable or deductible until said gain or loss is realized.

9.5.9.5.5  (11-05-2004)
Establishing the Starting Point

  1. The key to a successful net worth investigation is establishing a reliable beginning net worth (opening net worth) which includes all of the assets and liabilities on hand. It is this starting point from which all future increases or decreases will be calculated. This starting point is normally referred to as the base year. In a net worth computation, it is extremely important to firmly establish a beginning net worth (starting point or base year) with the best evidence available.
  2. In calculating annual net worth, be aware that an inverse relationship exists between one year and the next. If the subject's opening net worth is understated, there is a resulting overstatement of the increase in net worth for the following year. Conversely, if the subject's opening net worth is overstated, there would be a resulting understatement of the increase in net worth for the following year.
  3. The first step to establishing a firm starting point is to determine the date (opening or base year) best suited for the investigation. The interview with the subject will strengthen the starting point. While questioning the subject, the special agent should attempt to develop all information relating to the subject's assets and liabilities for the years involved. The subject should be questioned about the value of any item which cannot be determined from available books and records, e.g., cash on hand as of a particular date, personal living expenses, assets held in the names of others, gifts, inheritances, loans, and other nontaxable sources of income.
  4. The establishment of cash on hand is critical. The inability to establish a firm and accurate amount of cash on hand can be fatal to the investigation. Uncertainty about the amount of cash on hand is a common defense in net worth investigations. It will be easier to refute this defense if the special agent has established a firm beginning and an ending cash on hand amount is established. Cash on hand is almost always proved by circumstantial evidence.
  5. The best source of information in establishing an accurate cash on hand figure may be obtained from the subject during an interview. The special agent may not always have the opportunity to interview the subject in every investigation. However, when the opportunity does exists, the special agent should attempt to establish the beginning and ending cash on hand. In determining a firm cash on hand figure, the following subsections offer insight into possible techniques to employ during a subject interview.
  6. During the subject interview, the subject should be questioned in detail about cash on hand. The questioning should be preceded with an explanation of what constitutes cash on hand and elicit the subject's answer as to cash on hand. Cash on hand is coin and currency (bills, Federal Reserve notes, etc.) in the subject's possession, i.e., on the subject's person, in the subject's residence, or other place, in nominee hands, or in a safe-deposit box. It does not include any money the subject has on deposit in any account with any type of financial institution.
  7. The special agent should use caution in using terms such as cash because people often refer to money on deposit in banks as cash on hand. The special agent should be specific and explain that he/she is referring to undeposited coin and currency in all locations.
  8. Most people have difficulty recalling specific dates and amounts, especially when several dates are involved, and they extend back for a number of years. Direct questions, such as "How much cash on hand did you have on December 31, ____" will frequently be answered with "I don't know" or "I can't remember that far back" . In such investigations, the special agent should persist in questioning about whether the subject had a depository for coins or currency and/or whether the subject placed any coins or currency in the possession of another person. The speciaI agent should obtain a description of the depository. If the depository is a safe-deposit box or home safe, the special agent should relate the questions to when and where the box was rented or purchased. The special agent should obtain a description of the depository and a description of the funds (their denomination and quantity) to determine whether it was possible to have such a sum of money in that particular depository.
  9. The special agent may determine the amount of cash on hand by asking questions about the maximum amount of cash that the subject could possibly have had at any particular time. For example, such questions as, "Did you ever have more than $100 in cash on hand? More than $5,000? More than $10,000?," may result in admissions that can establish the total amount of cash on hand at a particular date.
  10. Discussing the accumulation and purpose of the cash on hand may establish the minimum and maximum amount on a particular date. Determining the ultimate disposition of this cash on hand can provide a lead to a specific amount of cash on hand on a particular date. For example, a statement like "I used all my cash on hand to pay for my house in 1994" indicates how much cash the subject had on the date of payment. It also provides a cut-off date for cash on hand, since the subject evidently had no more cash after using all the cash on hand to pay for the house. The special agent should question the subject further to elicit an admission that the subject did not have any additional cash on hand as of the specified date.
  11. The special agent's questioning should be directed toward developing:
    1. the maximum amount of cash on hand (undeposited currency and coin) claimed at the starting point and at the end of each year under investigation
    2. the amount of cash on hand at the date of the interview (This data is sometimes useful in computing cash on hand for earlier years.)
    3. how was the cash on hand accumulated and from what sources
    4. where the cash was kept
    5. who knew about the cash
    6. whether anyone ever counted the cash
    7. when, where and for what was any cash spent
    8. whether any record is available with respect to the alleged cash on hand
    9. the denominations of the cash on hand
    10. was the cash shown on any net worth or personal financial statements
    11. ask to see the cash on hand

     

  12. In addition to questioning the subject about cash on hand, also:
    1. question the subject about prior years' earnings
    2. obtain prior years' tax returns to determine if no return was filed or if the returns indicate little or no income in prior years
    3. determine if the subject had financial difficulties prior to the starting point, e.g., compromises of overdue debts by the subject; foreclosure procedures against the subject; collection actions against the subject, etc.
    4. obtain copies of financial and or net worth statements
    5. question the subject as to the contents of any safe-deposit boxes
    6. question the subject concerning all taxable and nontaxable sources of income
    7. obtain loan records
    8. determine consistent use of checking and savings accounts
    9. determine if there are recurring overdrafts on non-sufficient funds (NSF) charges or other bank penalties
    10. determine the minimum payments on any credit card balances
    11. determine if there was ever a divorce and division of assets

     

  13. In addition to interviewing the subject, the following investigative steps should be taken when establishing a firm starting point in a net worth investigation:
    1. The special agent should interview the subject's spouse, relatives, and close associates to determine if the subject received loans, gifts, or inheritances in prior years. The interview of the subject's spouse should include cash on hand and sources of taxable and nontaxable income so that the subject cannot claim the increases resulted from funds the spouse received.
    2. The special agent should canvass banks and stockbrokers to determine whether the subject has or had any accounts that could be a source of funds, or whether he/she submitted any financial statements to the financial institution. When reviewing bank records, the special agent should determine whether the subject has ever had checks returned for insufficient funds.
    3. The special agent should examine financial statements presented for credit or other purposes at a time prior to or during the periods under investigation. The special agent can obtain these types of documents from banks, loan companies, bonding companies, and the other operating divisions of the IRS (offers in compromise and financial statements).
    4. The special agent should check the following records for potential assets, liabilities, and sources of funds:
      • real estate records to determine if the subject owns or has owned property that could be a source of funds
      • bankruptcy, foreclosure, and repossession record (If the subject filed for bankruptcy, this could be used as a starting point for net worth).
      • divorce records
      • social security records for prior earnings and receipt of any funds from social security
      • welfare records
      • probation records
       
    5. The special agent should determine the subject's borrowing habits, especially borrowing at high interest rates.
    6. The special agent should analyze available Federal and state tax returns. Tax returns can be obtained from the IRS, the state where the subject resided, the subject's accountant and/or return preparer, or financial institutions where the subject has applied for and/or obtained loans.
    7. In the event the special agent is unable to firmly establish a starting point through the above-described steps, the special agent may have to rely upon an indirect approach to establishing a starting point. This can be accomplished by using a Source and Application of Funds computation.

     

9.5.9.5.5.1  (11-05-2004)
An Indirect Approach for Establishing a Starting Point

  1. Another method of establishing a starting point for cash on hand is to analyze the subject's available finances for the years leading up to the starting point. Such a "source and application of funds" approach can also be used to bridge the years to the starting point from some point in time when cash on hand has been firmly established. The following is an example of how a source and application of funds computation can be used to establish a firm starting point in a net worth investigation.
    1. The subject filed bankruptcy in 1993. Immediately following the bankruptcy, the subject did not have any assets or liabilities. The starting point for the investigation is December 31, 1996, the prosecution years are 1997 and 1998. For the purposes of using the source and application of funds computation in determining a firm starting point (cash on hand figure on December 31, 1996), the years 1993 through 1996 would be treated as one unit.

     

  2. First, the special agent must determine the total amount of funds available (taxable and nontaxable) during 1993 through 1996. From this amount, he/she will subtract the subject's personal expenditures for the period. This will yield the maximum amount of funds available for the subject's net worth at the beginning of 1997.
  3. Second, the special agent subtracts the subject's beginning net worth figure (the amount the investigation revealed as of December 31, 1996, without the cash on hand figure) from the total funds available for net worth. This will account for non-personal living expenditure payments by reflecting the payments made to increase assets and decrease liabilities.
  4. Funds used to purchase assets disposed of prior to the starting point can be included as funds applied, if their disposition is traced and the funds from the disposition are accounted for as funds available. The advantage of using this method is that the beginning net worth can be used as funds applied. If the subject has a large beginning net worth, it may be possible to overcome the subject's reported income for prior years and show that he/she could not have had cash on hand at the starting point. This can also be used to establish a maximum possible cash on hand figure. It is important that the subject be given credit for all sources of funds available (both taxable and nontaxable) in the period for which the source and application method is used.
  5. When using the one unit source and application of funds method to establish a firm starting point, the beginning net worth must be adjusted for any asset purchased and completely paid for prior to the source and application years. This is necessary because no funds were applied during the source and application period to purchase the asset. This point is illustrated in the following example:
    1. The subject purchased and paid off a residence 10 years prior to the starting point. The cost of the residence $20,000, is included in the beginning net worth. The source and application of funds only covers a period of six years prior to the starting point. The beginning net worth must be adjusted by subtracting the cost of the residence because the residence was purchased with funds acquired by the subject prior to the years included in the computation. This is illustrated as follows:

     

    Funds available (1991–1996) $105,000
    Less: Funds applied to personal living expenses -50,000
    Equals: Maximum funds available for an increase in net worth 55,000
       
    Beginning net worth per investigation