Methods of Proof, continued

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Methods of Proof cont.
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Methods of Proof cont.

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9.5.9  Methods of Proof (Cont. 1)

9.5.9.7 
Bank Deposits Method of Proving Income

9.5.9.7.1 
Authority For Bank Deposits Method

9.5.9.7.1.1  (11-05-2004)
Legal Requirements To Establish A Prima Facie Bank Deposits Investigation

  1. As a result of the Gleckman decision, the following evidentiary facts are used to establish a prima facie bank deposits investigation:
    1. The subject was engaged in an income-producing business, activity, or profession.
    2. The subject made periodic deposits of funds into his/her bank accounts, or into nominee bank accounts over which he/she exercised control.
    3. The deposits into the above referenced accounts reflect current year income and an adequate investigation of deposits was made by the investigating special agent to negate the possibility that deposits arose from nontaxable sources.
    4. Unidentified deposits have an inherent appearance of income.

     

  2. The fact that a subject deposited a sum of money in a bank account does not prove the funds deposited therein were taxable. The fact that the subject received and cashed a large check, in and of itself, does not prove the funds received were taxable. In order to establish those funds represented taxable income, the following must be shown:
    1. The subject has a business or other regular income source.
    2. The subject made regular deposits into an account.
    3. The subject draws against the account for personal use.
    4. There is testimony that the subject has income.
    5. Deposited amounts exceed exemptions and deductions.

     

  3. The courts have held there is no necessity to disprove the accuracy of the subject's books and records as a prerequisite to the use of the bank deposits method.

9.5.9.7.2  (11-05-2004)
When to Use Bank Deposits Method

  1. The bank deposits method of proof is recommended as the primary method of proof when:
    1. The subject's books and records are not available.
    2. The subject's records are not complete and do not adequately reflect their correct income.
    3. The subject deposits most of his/her income and uses bank deposits to calculate gross receipts on their return.

     

  2. In addition to being a primary method of proving income, the bank deposits method is also used to corroborate other methods of proof and to test-check the accuracy of reported taxable income.

9.5.9.7.3  (11-05-2004)
Method of Accounting

  1. The use of the bank deposits method of proof is not affected by the subject's method of accounting. The bank deposit analysis may reflect the subject's corrected taxable income by whichever method of accounting is used by the subject. Reflecting a certain accounting method in the bank deposit computation is accomplished by including certain accounts in the bank deposit analysis and omitting others. For instance, to compute the income of a physician who uses the cash basis method, 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 bank deposit analysis.
  2. When a subject reports income on the accrual basis, adjustments must be made in computing gross receipts and deductions to include accrued income and accrued expenses, both of which have not been reflected in deposits or actual expenditures.
  3. Under the accrual basis, credit sales are included in income when the sales are made, not when the money is collected; purchases and expenditures are deducted when the liability is incurred rather than when the account is actually paid.
  4. These accounting adjustments are made by adding or deducting the increase or decrease in receivables and payables. Rather than compute the increase or decrease in the account receivables during a year, simply add the ending accounts receivable figure and deduct the beginning accounts receivable figure in computing gross income. The beginning accounts receivable figure is subtracted from the bank deposits computation of income because the accounts were collected and the proceeds deposited during the year. The ending accounts receivable figure is then added to the bank deposits computation because the funds are taxable and have not been accounted for in the subject's deposits, expenditures, or cash hoard.
  5. The same rationale applies to beginning accounts payable which were deducted in the prior year and ending accounts payable that need to be deducted in the taxable year in which they are accrued.

9.5.9.7.4  (07-01-2002)
Complete Bank Deposits Method of Proof Formula

  1. The full bank deposits method of proof formula is followed by sections that explain each formula heading and subheading:
    BANK DEPOSIT METHOD OF PROVING INCOME
    TOTAL DEPOSITS
    Bank Accounts: (Business/Personal/Nominee)
    checking accounts
    savings accounts
    IRA and Keogh accounts
    credit union
    investment trusts
    other accumulation accounts
    brokerage accounts
    certificates of deposits
    ADD: INCREASE IN CASH ON HAND
    ADD: NON-NEGOTIATED INSTRUMENTS PURCHASED OR RECEIVED DURING YEAR AND HELD AT YEAR END
    cashier's checks
    money orders
    customer's checks
    US savings bonds
    ADD: OTHER
    amounts automatically withheld from wages
    withheld taxes, health/life insurance premiums
    retirement funds, savings, other payroll deductions
    ADD: CURRENCY EXPENDITURES
    business
    personal (including cash gifts)
    capital (investment)
    ADD: NON-CASH INCOME
    payments in kind
    forgiveness of debt in lieu of payment
    property in lieu of payment
    constructive dividends
    ending acccounts receivable (if on accrual basis)
    SUBTOTAL (TOTAL FUNDS AVAILABLE)
    LESS: NON-INCOME DEPOSITS AND ITEMS
    currency withdrawals
    transfers between accounts and re-deposited items
    checks to cash (and cashed third-party checks)
    loans, gifts, inheritances received
    beginning accounts receivable (if on an accrual basis)
    decrease in cash-on-hand
    exclusions under IRC
    return of capital (Basis of stock and capital items)
    capital losses — carry forwards
    bank errors and missing checks
    federal tax refunds and insurance proceeds
    savings accounts withdrawals
    IRA and Keogh payments
    life insurance proceeds
    US savings bonds redeemed
    social security payments received
    veterans benefits received
    nontaxable portion of pensions and annuities
    cost basis of property sold
    child support payments received
    travel expense reimbursement
    repayments of loans made by others
    ADD: CAPITAL LOSSES EXCEEDING $3,000
    EQUALS: SUBTOTAL GROSS INCOME (if there is no cost of goods sold)
    LESS: COST OF GOODS SOLD
    beginning inventory
    Add: purchases
    Add: ending account payable re: inventory purchases (if accrual basis)
    Less: beginning accounts payable re: inventory purchases (if accrual basis)
    Less: ending inventory
    Equals: cost of goods sold
    EQUALS: GROSS INCOME
    (if cost of goods sold is involved)
    LESS: TOTAL BUSINESS EXPENSES
    Add: business expenses per return
    Add: additional expenses identified
    Add: ending accounts payable re: business expenses (if accrual basis)
    Less: fraudulent expenses identified
    Less: beginning accounts payable re: business expenses (if accrual basis)
    Equals: total business expenses
    EQUALS: TOTAL INCOME
    LESS: ADJUSTMENTS TO INCOME
    IRA deduction
    spouse IRA deduction
    moving expenses
    one half self employment tax
    self employed health insurance deduction
    Keogh retirement plan and SEP deduction
    penalty on early withdrawal of savings
    alimony paid
    total adjustments to income
    EQUALS: CORRECTED ADJUSTED GROSS INCOME
    LESS: ITEMIZED DEDUCTIONS/STANDARD DEDUCTIONS (AS CORRECTED) AND PERSONAL EXEMPTIONS (AS CORRECTED)
    EQUALS: CORRECTED TAXABLE INCOME
    LESS: REPORTED TAXABLE INCOME
    EQUALS: ADDITIONAL TAXABLE INCOME FOR CRIMINAL PURPOSES

     

9.5.9.7.4.1  (11-05-2004)
Total Deposits

  1. In the analysis of bank deposits, the sums deposited (or credited) to all of the subject's various accounts are totaled to determine gross deposits. This includes any interest and dividends credited to the subject during the investigation period. When the subject holds bank accounts in fictitious names, or with special titles such as trustee account or trading account, deposits to those accounts must also be included in the subject's total deposits. The analysis of bank deposits is not limited to bank checking and savings accounts, but includes deposits to:
    1. savings and loan accounts
    2. credit union accounts
    3. brokerage accounts (all credits to accounts)
    4. investment trusts
    5. individual retirement accounts and Keogh plan accounts
    6. certificates of deposits

     

  2. If the subject itemized checks on a deposit slip and then deducted an amount for "less cash," only the net amount deposited should be considered in computing income.

9.5.9.7.4.1.1  (11-05-2004)
Unidentified Deposits

  1. The source of individual deposits can often be identified by the subject's admissions, deposit slips, bank ledger sheets, transfer letters, bank microfilm, and the testimony of witnesses.
  2. In the event there are unidentified bank deposits, the following elements are required before treating unidentified bank deposits as current taxable receipts:
    1. evidence showing the existence of an income-producing business or activity
    2. regular or periodic deposits having the inherent appearance of current receipts; occasional or irregular deposits may also be considered as current income if evidence supports this assumption

     

  3. In the Gleckman investigation, deposits were principally derived from unidentified sources and the investigation was successfully prosecuted. It is far easier to present a bank deposits investigation to a jury when many of the deposits have been specifically identified as current taxable income. For example, when multiple specific omitted sales are traced to the subject's bank accounts, but other deposits of a similar nature remain unidentified, the government's investigation is strengthened immeasurably. Through the specific identification of multiple omitted deposits, the special agent's assertion that unidentified deposits of a similar nature are current taxable income becomes more credible.

9.5.9.7.4.1.2  (11-05-2004)
Currency Deposits

  1. Currency deposits are subject to claims that the source of the deposits came from a cash hoard. If the subject raises this claim and it cannot be refuted, the amount of cash deposits in question must be included under "Non-income Deposits and Items" and subtracted from the bank deposits computation.
  2. However, this type of claim can often be refuted. By firmly establishing the beginning cash on hand, a special agent can rule out the cash hoard defense.
  3. The computation of gross receipts is based upon the assumption that most deposits are derived from a taxable source. The subject should be interviewed to determine whether or not there were any deposits made into the accounts from non-taxable sources. The special agent should follow-up on any lead offered by the subject or uncovered during the course of the investigation that indicates certain deposits were from a non-taxable source.

9.5.9.7.4.1.3  (11-05-2004)
Starting Point

  1. In a bank deposits investigation, the starting point refers to the cash on hand at the beginning of the first year under investigation.
  2. Establishing a firm starting point is necessary in all bank deposits investigations involving cash deposits, currency expenditures, and increases or decreases in cash on hand. The special agent has the same obligation to firmly establish beginning cash on hand while employing the bank deposits method of proof as in the net worth method of proof. He/she is required to show that the income being charged to the subject is current taxable income and not funds accumulated in prior years in the form of a cash hoard. Additionally, establishing a firm ending cash on hand will enable the special agent to determine whether there has been an application of cash (in the investigation of an increase in cash on hand) and/or whether the subject has a source of non-taxable funds (in the investigation of a decrease in cash on hand). See subsection 9.5.9.5.5

9.5.9.7.4.1.4  (11-05-2004)
Brokerage and Security Accounts

  1. Deposits (credits) to a brokerage account are not treated any differently than any other type of deposits. However, when analyzing security account deposits, it is necessary to be familiar with what documents are available and with the terms associated with these statements. These include:
    1. Confirmation slips — issued by brokerage houses to verify purchases and/or sale of stocks.
    2. Margin account— a type of brokerage account through which the account holder is extended credit. Stocks can be purchased at a given percentage of their actual cost, the balance being owed to the brokerage firm. The account holder maintains a debit balance in this account.
    3. Cash account — within a certain number of days (usually 3 banking days) after purchasing stocks, the account holder must remit the entire purchase price to the brokerage firm. No credit or debit balance is maintained.
    4. Street holdings — an account holder can purchase stocks through his/her brokerage firm and leave those stocks in the account. These shares are held by the brokerage firm on behalf of the account holder. The actual certificates being in the name of the brokerage firm. These stocks appear on the brokerage statements as security holdings or are noted as securities positions (PSN).
    5. Personal holdings — after purchasing stocks through a brokerage firm, an individual may have those stocks delivered to him/her to become personal holdings. Certificates in the person's name are issued and sent to him/her along with a cover letter or securities delivered slip. Those shares will no longer appear on the brokerage statements as securities positions. Personal holdings of an individual must be traced through the appropriate stock transfer agent. Use the Moody's Handbook of Common Stocks as a reference to determine the stock transfer agent for a particular stock.
    6. Securities delivered — noted as SEC DEL, indicates when the stocks were delivered or sent to the account holder to become personal holdings.
    7. Securities received — noted as SEC REC, indicates when the account holder send funds to the brokerage firm to cover the purchase of stocks or a debit balance. It does not necessarily mean currency.
    8. Cash disbursed — noted as CSH DSB, indicates when the brokerage firm issues a check to the account holder.

     

  2. One important difference between many brokerage statements and bank statements is that, when a stock is sold, the amount of the sale appears as a credit to the account on the date of the sale. If the account holder requests a portion of the proceeds of the sale to be paid to him/her by check, those proceeds are then shown as cash disbursed/check for that same date. The net deposit amount does not appear on the statement. When analyzing brokerage statements, the special agent must manually make the computation to net the deposit. Only the net amount should be picked up as a deposit.

9.5.9.7.4.2  (11-05-2004)
Cash on Hand Increase

  1. An increase in the subject's cash on hand is treated as a currency expenditure. Since the subject may contend that the unexplained deposits into the bank accounts came from a cash hoard, it is crucial to thoroughly establish and document any increase in the subject's cash on hand.
  2. The special agent must begin by documenting the cash on hand at the starting point and then document cash on hand at the end of each year under investigation. The cash on hand increase (or decrease) is then determined for the first year of the investigation by subtracting the cash on hand at the starting point from the cash on hand at the end of the first investigative year. (Cash on hand decreases will be discussed later.)
  3. It is important to interview the subject early in the investigation to accurately identify a maximum cash accumulation for each year under investigation. See subsection 9.5.9.5.5.(11)
  4. All of this information is necessary to establish the consistency and reliability of the subject's statements. Usually, no direct evidence of cash on hand is available. Statements made about the source, amount, and use of funds can be corroborated or refuted with additional evidence.

9.5.9.7.4.3  (11-05-2004)
Non-Negotiated Instruments Purchased During the Year and Held at Year-End

  1. Non-negotiated instruments purchased or received during the year and held at the end of the year must be properly accounted for in the bank deposits formula. Non-negotiated instruments include:
    1. cashier's checks
    2. money orders
    3. US savings bonds
    4. travelers checks
    5. non-negotiated income checks

     

  2. When non-negotiated instruments are purchased by check, total deposits are increased by the amount of the non-negotiated instruments. Non-income items are increased by a like amount. This is similar to a transfer as money deposited in the bank is being converted to a non-negotiated instrument.
  3. If the subject receives a monetary instrument as a gift and has not negotiated it at year-end, total deposits and non-income items are each increased by the amount of the instrument.
  4. Total deposits are not increased to reflect the value of non-negotiated instruments purchased in currency. This amount is included as a currency expenditure in the bank deposits formula.
  5. Technically, if a cash basis subject received checks as income and had not negotiated them at year-end, they must be added to total deposits to accurtely calculate income. The checks are income in the year they are received. However, if this is the subject's normal business procedure, then the relevance of this "timing" issue should be discussed with the Criminal Tax (CT) Counsel.

9.5.9.7.4.4  (11-05-2004)
Amounts Automatically Withheld from Wages

  1. Amounts that are automatically withheld from the subject's wages must be included when using the bank deposits method, unless they are included in deposits to another account. These items include withheld taxes, health and life insurance premiums, retirement fund contributions, savings account allotments, Federal Insurance Contributions Act (FICA), child support and or alimony payments, loan payments, and any other payroll deductions made by the employer for the benefit of the employee. The special agent should include only those items that are not included elsewhere in the computation. An example of an item that may appear elsewhere in the computation would be automatically withheld savings account allotments. These allotments would be picked up with the total deposits to the savings account.

9.5.9.7.4.5  (11-05-2004)
Currency Expenditures

  1. All documented cash expenditures, regardless of the source of the currency, are added to total deposits. Even in the most thorough investigations, there are certain currency expenditures that are impossible to document. These expenditures, i.e., groceries, laundry, meals, gasoline, etc., cannot be added to total deposits unless they are fully documented. Only those currency expenditures which are documented, either directly or indirectly, can be included in the bank deposit computation.
  2. If the subject claimed business expenses on his/her return in excess of the amount of business expenses he/she paid by check, the balance should be treated as a cash expenditure and included in the bank deposits computation.
  3. If the subject alleges additional currency business expenses not claimed on the return, these should be allowed, after adding a like amount to the cash expenditures figure in the computation.
  4. Any documented expenditure made by the subject (business or personal) should be analyzed to determine what portion of that expenditure was made by check. If the amount of the expenditure exceeds payments made by check, the balance should be considered a cash expenditure and included in the bank deposits computation.

9.5.9.7.4.6  (11-05-2004)
Non-Cash Income Items

  1. In addition to currency expenditures, all non-cash items should be added to deposits. These items include:
    1. payments in kind
    2. forgiveness of debts in lieu of payments
    3. property received in lieu of payments
    4. constructive dividends
    5. accounts receivable increase, if the subject is on the accrual basis

     

9.5.9.7.4.7  (11-05-2004)
Non-Income Deposits and Items

  1. All potential nontaxable sources of funds should be discussed with the subject during the initial interview. If the subject refuses to communicate with the special agent outside the presence of an attorney, consider contacting the subject's attorney. Explain to the attorney that if their client has received funds from nontaxable sources that could explain the apparent understatement of income, it would be to the subject's advantage to come forward with this information.
  2. It is the government's responsibility to elicit all available information concerning the subject's claims as to his/her nontaxable sources of funds. The special agent should attempt to obtain this information early in the investigation. The sooner the subject's claims can be verified or refuted, the sooner the special agent can determine whether or not there is a viable investigation.
  3. All potential nontaxable sources of funds should be thoroughly investigated by questioning the subject's spouse, relatives, friends, and associates.
  4. The special agent should examine all available documents, i.e., (banking records, public records etc.,) and follow-up leads that could identify potential nontaxable sources of income and/or commingled funds.
  5. The special agent should determine the source or disposition of funds related to the acquisition and/or sale of assets.
  6. Nontaxable items will often appear as large or unusual deposits in the bank accounts.
  7. All funds from nontaxable sources must be accounted for when using the bank deposits method of proof to calculate the subject's potential understatement of income.
  8. Deducting nontaxable funds ensures that all deposits, cash expenditures, and increases in cash on hand which are included in the subject's gross income are derived from taxable sources. Failure to eliminate all known non-income deposits and items results in an overstatement of income and could prove fatal to the criminal investigation. Examples of non-income deposits and items include:
    1. income earned in prior years
    2. cash on hand decrease
    3. loan proceeds received
    4. repayments of loans made to others
    5. gifts
    6. inheritances
    7. re-deposited items
    8. transfers between accounts
    9. return of capital
    10. cashed third party checks
    11. checks to cash and currency withdrawals
    12. other non-income deposits and items specifically excluded by the USC
    13. life insurance proceeds
    14. tax-exempt interest
    15. Federal income tax refunds
    16. US savings bonds redeemed (cost basis)
    17. Social Security payments
    18. veterans' benefits
    19. nontaxable portion of pensions and annuities
    20. payments made to individual retirement accounts

     

9.5.9.7.4.7.1  (11-05-2004)
Checks to Cash and Currency Withdrawals

  1. Currency withdrawals from accounts and checks payable to cash are generally treated as non-income items and must be discarded when computing gross income. Unless there is strong evidence to the contrary, the government usually cannot disprove the defense that the currency was:
    1. re-deposited by the subject later in the tax period
    2. used as a source of currency expenditures already included in the bank deposits computation
    3. used for a business expense paid in currency not previously claimed
    4. used to increase cash on hand

     

9.5.9.7.4.7.2  (11-05-2004)
Automated Teller Machines and Debit Card Transactions

  1. Automated Teller Machines (ATM) withdrawals are considered to be currency withdrawals. However, when an ATM card is used as a debit card to pay a merchant, the amount debited and paid to that merchant is not considered a currency withdrawal. (This is really an electronic check.)

9.5.9.7.4.8  (11-05-2004)
Cash on Hand Decrease

  1. Cash on hand is one of the most common and troublesome areas in any indirect method computation. Because a cash hoard defense is so difficult to refute, subjects frequently claim their cash hoard was of a sufficient amount to account for any understatement of income. The special agent must anticipate this potential defense and be able to prove that the subject had a large sum of cash which is not represented in the bank deposit computation.
  2. Evidence that may negate the existence of a cash hoard includes:
    1. written or oral admissions of the subject to the special agent(s) which indicate a small amount of cash on hand
    2. financial statements prepared by the subject showing a low net worth
    3. compromises of overdue debts by the subject
    4. foreclosure proceedings against the subject
    5. collection actions against the subject
    6. tax return (or no returns filed) indicating little or no income in prior years
    7. loan records
    8. consistent use of checking and savings accounts
    9. recurring overdraft on NSF charges or other bank penalties.
    10. minimum payments on credit card balance

     

  3. It may be possible to reconstruct the subject's cash on hand from prior earnings records. If cash on hand for an earlier period can be reasonably established, income earned from that period forward to the starting point could be used to establish a maximum available cash on hand. (See IRM 9.5.9.5.5.1, An Indirect Approach for Establishing a Starting Point).
  4. If an investigation discloses an increase or decrease in cash on hand during the prosecution period, an adjustment to the bank deposits formula must be made. If there is an increase to cash on hand, it is added to deposits and currency expenditures in the bank deposits computation; at the same time, any decrease in cash on hand is considered a non-income item.

9.5.9.7.4.9  (11-05-2004)
Loan Proceeds

  1. Loan proceeds received by the subject must be accounted for as a non-income item. The key word in the above sentence is "received." The subject must have physically received the funds.
  2. If a subject has a mortgage on his/her home, the mortgage was paid directly by the lender to the seller of the home. Since no funds passed through the subject's hands, there is no need to account for any loan proceeds in this transaction.
  3. However, if the subject had obtained a loan from a lender and actually received the loan amount in cash, a check that was subsequently cashed, or by way of a transfer of funds to the subject's account, the loan proceeds must be accounted for as a non-income item.

9.5.9.7.4.10  (11-05-2004)
Loan Repayments Received

  1. If the subject made a loan in prior years and contends that part of the understatement of income is in fact a repayment of that loan, the special agent must document the repayment of principal by contacting the borrower. All repayments of principal loaned by the subject should be treated as a non-income item.

9.5.9.7.4.11  (11-05-2004)
Gifts and Inheritances

  1. Monetary gifts, cash, checks, etc. must also be included as a non-income item in the bank deposits formula.
  2. The special agent should document the gift and determine whether the donor was financially able to make the gift. Obtain all of the necessary documents and other information from the donor. Check for filed gift tax returns, if applicable.
  3. If the subject received an inheritance, obtain all necessary documents and information from the executor or administrator of the estate to verify the inheritance. Check for filed estate tax returns and check the probate records of deceased relative's estate. Any such inheritance is also treated as a non-income item.

9.5.9.7.4.12  (11-05-2004)
Transfers Between Accounts

  1. Transfers between accounts should be classified as non-income items.
  2. A subject who maintains several accounts, or one who has opened and closed accounts during the years under investigation, generally will have transfers between accounts. A detailed examination of deposit slips and account statements should be made to determine all possible transfers between accounts.

9.5.9.7.4.13  (11-05-2004)
Return of Capital

  1. Generally, any return of capital is classified as a non-income item in the bank deposits method. However, the treatment of assets sold in a bank deposits investigation differs depending on the nature of the asset, i.e., whether it was a personal asset, a business asset, or stock.
  2. When the subject sells a personal asset there is no allowable loss relative to the transaction. Instead, such transactions are treated as a return of capital which is limited to the cost basis or adjusted basis of the asset, if there is a gain, or the sale price if there is a loss. The following example is an illustration:

    If the subject purchased a vehicle in 1995 for $20,000 and sells it in 1996 for $15,000, the special agent would treat the $15,000 as a return of capital in the bank deposits formula for 1996. If the subject managed to sell the same vehicle for $30,000, the special agent would allow the subject a $20,000 return of capital reduction to the bank deposits computation.

     

  3. The above stated tax treatment applies only to personal assets that are sold. Using the same example above, if the subject traded in the 1995 vehicle on a 1999 model that cost $30,000, there is no return of capital. The subject did not physically receive the money. The return of capital was rolled into the new vehicle.
  4. The sale of a business asset or of stock is treated somewhat differently because it can result in an allowable taxable loss. The proper way to treat these assets is to use the cost (or adjusted basis) as the return of capital.
  5. When stocks and/or other business assets are sold, and the sale results in a net capital loss, that loss must be limited to $3,000 in accordance with USC loss limitations. This is done by adding back any disallowed loss to the bank deposits formula. See ADD: Capital losses exceeding $3,000 in the formula. See subsection 9.5.9.7.4.
  6. In order to compute the return of capital on a stock transaction, the special agent must first determine the subject's basis in the stock. If the stock sale (gain or loss) was reported on the subject's return, use the method the subject elected on their return when computing the gain or loss for the stock transaction.
  7. If stock sales are not reported on the return, and stock sales have been made during the period under investigation, the special agent should analyze any available evidence and determine if it is possible to identify the shares that were sold. If the subject only bought the stock on one occasion, then multiply the number of shares purchased by the purchase price and add in the sales commission. The total is divided by the number shares purchased to arrive at the basis per share. This figure is then multiplied by the number of shares sold to arrive at the basis for the shares sold. This figure is then subtracted from the sales price realized, not including the sales commission, and the resulting figure is the subject's gain or loss on the sale.
  8. An attempt to identify the shares sold can also be made by contacting the brokerage firm and comparing the date on the stock certificates being held with the information available on the statements. An example of this would be if the subject purchased 200 shares of SAYS stock in January 1996 with a basis of $10 per share. Then, in February 1996, the subject purchases 50 more shares of stock with the basis of $5 per share. In March 1996, the subject sells 100 shares of stock. It cannot automatically be assumed the 100 shares sold were the initial 100 shares purchased. However, if the brokerage firm is contacted and they are holding only the certificate for the 50 shares purchased in February 1996, then it can be concluded that the subject did indeed sell the initial 100 shares purchased.
  9. If the brokerage firm is not holding the stock certificates, and the special agent cannot determine from the available records which shares were sold, the special agent must resort to computing the gain or loss using the method which is most advantageous to the subject. This involves computing the basis of the stock using the Last-in, First-out (LIFO), First-in, First-out (FIFO), and Average methods. The sales commission should be included when computing the basis of the stock purchased. However, when stock is sold, the commission is not included in the computation. This computation is only made when the basis of the stock cannot determine the basis from available records.

9.5.9.7.4.14  (11-05-2004)
Cost of Goods Sold

  1. When dealing with a subject who reports business activity through a Schedule C, it may be necessary to include a cost of goods sold computation when utilizing the bank deposits method.
  2. A reduction in inventory is a situation where there is a deduction and no cash outlay. Whenever inventories are a factor in determining income, it is necessary to make an adjustment for changes in inventory, unless the subject ignored them on the return. This requires that the special agent compute the cost of goods sold. This is done by adding purchases to the beginning inventory and subtracting the ending inventory. The cost of goods sold is then included in the computation of gross income. These steps are illustrated in the bank deposits formula.

9.5.9.7.4.15  (11-05-2004)
Business Expenses

  1. All business expenses and costs must be allowed to the subject whether paid by check or in cash. If the analysis of checks or other evidence leaves doubt about the disbursements, it is preferable to allow all items, except those which are undeniably nondeductible, i.e., items such as personal expenses, investments, and gifts. When canceled checks are not available for analysis and classification, every effort should be made to identify any and all items which constitute allowable expenses whether paid out of a bank account or from undeposited cash.
  2. Often, the total business expenses on a Form 1040, Schedule C will exceed the expenses for which checks or specific evidence of cash disbursements are found. In these instances, the amounts claimed by the subject should be allowed by assuming the difference was paid in cash. Increasing currency expenditures in the bank deposits formula offsets the effect of allowing business expenses paid in cash as a deduction.
  3. If personal or capital expenditures are improperly classified as business expenses, the deduction for business expenses will be overstated, gross receipts will be unaffected, and net taxable income will be understated. Without proof that personal or capital items were claimed fraudulently as business expenses, they cannot be disallowed.
  4. The allowable depreciation on all known depreciable assets must also be deducted. Depreciation is treated separately, since this is a deduction from which no cash outlay is required in the year the deduction is taken.

9.5.9.7.4.16  (11-05-2004)
Adjustments to Income

  1. All the available adjustments to income must be allowed in computing adjusted gross income. This would include applicable Individual Retirement Plan (IRA), Keogh and Simplified Employee Pension Plan (SEPP) deductions, moving expenses, one half of the self employment tax deduction, the self employed health insurance deduction, penalty on early withdrawal of savings, and alimony paid.

9.5.9.7.4.17  (11-05-2004)
Personal Deductions and Exemptions

  1. All allowable personal deductions, itemized or standard, and exemptions must be deducted from adjusted gross income to arrive at taxable income.
  2. Per statute, itemized deductions and personal exemptions may be subject to limitation or phase out depending on the subject's income. The special agent should make adjustments to these amounts as necessary.

9.5.9.7.4.18  (11-05-2004)
Technical Adjustments

  1. In a criminal investigation, reported taxable income can be increased only by the amount of the criminal adjustments. If an error was made in the preparation of a subject's return and income is understated, the amount must be included as a non-income item in arriving at taxable income for criminal purposes.
  2. If the subject unintentionally overstated expenses, no adjustment is necessary. The subject would be allowed the expenses per the return. Each non-fraud item must be separately allowed as claimed on the return or as corrected whichever is to the best interest of the subject. Technical adjustments in favor of the government cannot be made, offset, or netted against technical adjustments in favor of the subject.

9.5.9.7.5  (11-05-2004)
Schedules and Summaries in Bank Deposits Investigation

  1. The schedules and summaries in Exhibits 9.5.9–3 through 9.5.9–6 are illustrative of those which may be submitted during trials when the bank deposits method of proof is used.
  2. Exhibit 9.5.9–3, Bank Deposit Statements — Schedule A, shows the computation of taxable income of John and Mary Roe. The computation of this same income by the net worth method was previously shown in Exhibit 9.5.9–1, Net Worth Statement.
  3. Comparison and study of these two schedules will be beneficial since corrected taxable income can be calculated using multiple methods of proof, one tending to corroborate the other.
  4. Exhibit 9.5.9–4, Bank Deposits Statement — Schedule B, shows a computation which may be used to determine the amount of currency disbursements to be added to total deposits.
  5. Exhibit 9.5.9–5, Summary — Analysis of Checks and Currency Disbursements, is a summary of disbursements made by check and by currency. This schedule should be studied together with the net worth statement and the bank deposits schedule.
  6. An analysis of deposits is the vital part of a bank deposits investigation and too much importance cannot be placed upon its accuracy. Exhibit 9.5.9–6, Analysis of Deposits to Checking Account, is illustrative of a schedule that may be used to show the results of this analysis.

9.5.9.7.6  (11-05-2004)
Defenses in Bank Deposits Investigation

  1. The chief defense contentions in bank deposits investigations (other than lack of criminal intent) are:
    1. that the sporadic nature or unconventional amounts of the deposits indicate that prior accumulated funds, not current receipts, or non-taxable funds are involved
    2. that the deposits reflect, in whole or in substantial part, non-income items or income items attributable to other years
    3. that the deposits are a duplication of current year income items already accounted for by the subject

     

  2. The proof concerning what cash a subject had on hand at the beginning of the taxable year in question is relevant to the bank deposits method of proof.
  3. If the deposits or expenditures are from funds accumulated in prior years, they do not represent current income.
  4. However, if all the requirements set forth in IRM 9.5.9.7.4.8, Cash on Hand Decrease, are met, the lack of proof of the amount of cash on hand would not preclude prosecution.

9.5.9.8  (11-05-2004)
Cash Method of Proving Income

  1. The cash method of proof is an indirect method of proof of undeclared income which focuses on expenditures made in currency. The cash method is simply a variant of the expenditure method of proof. The cash method is based on the same kind of investigation and analysis performed in the expenditures method, however, it represents a different presentation of the results of the investigation.
  2. The cash method of proof seeks to identify unreported cash income.
  3. The cash method of proof examines the extent to which a subject’s cash expenditures exceed his/her known cash sources. To the extent the subject uses more cash than that which can be traced to his/her non-taxable and declared cash sources, the surplus cash must be taxable unreported income.

9.5.9.8.1  (11-05-2004)
Authority for Using the Cash Method

  1. Like the net worth and expenditures methods, there is no statutory provision defining the cash method of proof and expressly authorizing its use by the Commissioner. The courts have approved the use of this method in United States v. Hogan, 886 F. 2d 1497 (7th Cir. 1989).

9.5.9.8.2  (11-05-2004)
When and How the Cash Method Is Used

  1. Special agents should resort to the cash method of proof when a subject’s unreported income comes entirely in the form of cash. The cash method is most appropriate in investigations involving bribery, drug dealing, cash skimming from businesses, and similar situations where unreported income is in the form of cash.

    Note:

    The cash method of proof is not as well recognized and widely used as the other indirect methods of proof. Accordingly, it should only be used when the other methods of proof are not available.

     

  2. The cash method is effective when the subject has limited sources of income and deposits the income from these sources in a bank account where non-cash uses can be traced.
  3. Sources of cash include cash returned on deposits, checks written to cash, cash withdrawn from financial accounts, cash contents of a safe deposit box, and cash on hand
  4. The special agent must establish the following in support of the cash method of proof:
    • Subject’s opening net worth and cash on hand.
    • Subject’s expenditures during the period(s) under investigation.
    • The likely source of the unreported income.
    • All potentially nontaxable sources of income. To negate nontaxable sources of income, the special agent must investigate all reasonable leads.

     

9.5.9.8.3  (11-05-2004)
Comparison of the Cash Method and Expenditure Method

  1. The following similarities exist between the cash and expenditures methods:
    • The methods are used in investigations in which a subject consumes his/her income rather than using the income to increase year end assets.
    • The methods require that there is a sufficiently defined starting point to determine the extent to which pre-existing cash or conversion of assets provided a source of cash to be expended in the tax years examined to account for non-taxable sources of income.
    • The methods examine the extent to which expenditures in a tax year exceed non-taxable sources of income and taxable sources of income which the subject has reported.

     

  2. The following differences exist between the cash and expenditures methods:
    • The cash method focuses only on cash uses and cash sources, and is designed to identify unreported income in the form of cash.
    • The subject’s opening and closing net worth do not need to be established except when the net worth contains assets that are converted into sources for cash during the year(s) under investigation.

     

9.5.9.8.4  (11-05-2004)
The Cash Method of Proof Formula

  1. The cash method of proof formula is as follows:
      All Cash Uses
    Less Known Cash Sources
    Equals Additional Taxable Income (Unreported Income)

     

  2. Known cash sources includes cash income reported and any non-taxable sources.

9.5.9.9  (11-05-2004)
Percentage Markup Method of Proving Income

  1. This method is a computation whereby determinations are made pursuant to the use of percentages or ratios considered typical of the industry or business under investigation. By reference to similar businesses or situations, percentage computations are secured to determine sales, cost of sales, gross profit, and net profit. Likewise, via the use of some known base and the typical percentage applicable, individual items of income or expense may be determined.
  2. The percentage markup method is used on a limited basis.

9.5.9.9.1  (11-05-2004)
Use of Percentage Markup Method

  1. Special agents should resort to the percentage markup method of proof only when other traditional methods of proof have proven
    unsuccessful.
  2. With respect to specific applications of the percentage markup method of proof, its use should be limited principally to retail establishments, rather than illegal businesses, because more reliable information regarding opening and closing inventories, and the appropriate percentage markup, is generally available for retail establishments.
  3. An exception to these preferences may be narcotics trafficking investigations so long as substantial inside evidence from members of the narcotics organization is available to account for the pertinent variables inherent in narcotics trafficking and this method of proof.
  4. Special agents should include an explanation of efforts made with respect to the utilization of the traditional methods of proof and an explanation for the inadequacy or inapplicability of those methods.

9.5.9.9.2  (11-05-2004)
Application of Percentage Markup Method

  1. The percentages used in the percentage markup method may be externally derived or may be internally derived from the subject’s accounts for other periods or from an analysis of subsidiary records.
  2. Percentages may be secured from the examination of the subject’s records even though such records are only partially available.
  3. Gross profit percentages may be determined by comparing purchase invoices with sales invoices, price lists, and other similar data.
  4. Other years not covered by the investigation, or portions of years under investigation, may indicate typical percentages applicable to the entire year or years under investigation.
  5. Substantial internal evidence from which a reliable percentage markup computation can be obtained is strongly emphasized. Testimony of employees, accountants, or sales managers with direct knowledge of sales prices is important in determining not only the actual percentage markup employed in a given investigation, but also opening and closing inventories.
  6. Consideration should be given to obtaining internal documents, such as operating memoranda and subsidiary books and records.
  7. The questionable tax returns and the amounts stated therein for sales and costs of goods sold should not be used in determining the appropriate percentage markup. Use of such returns contradicts the theory that both sales and cost of goods sold are fraudulently reported on the tax returns.

9.5.9.9.3  (11-05-2004)
Limitations on Percentage Method

  1. Although the percentage method may be useful in determining or verifying income, especially when the books and records are inadequate, special agents must ensure that the comparisons are made with situations that are similar to those under investigation. Some of the factors to be considered are as follows:
    1. Type of merchandise handled—In order for a proper comparison to be made, the businesses must be dealing in the same type of merchandise or service. Comparison of the gross profit of a restaurant with that of a grocery store would be of little value and should not be used.
    2. Size of operation—In many instances, gross profit, cost of goods sold, and net profit percentage on sales will vary according to the size of a business. This is especially true with respect to expense items and the net profit compared with sales. The percentage of net profit to sales of a large department store might vary considerably from that of a small independently-owned general store.
    3. Locality—Markups and costs of operations will normally vary with the size of the city or the location of the businesses in the city. As an example, a small business in a community of 5,000 may use newspapers as a means of advertising, whereas a business doing the same volume in a city of 500,000 will normally find the cost prohibitive and confine advertising to some other medium.
    4. Period covered—Since gross profit ratios and expense ratios will tend to vary year to year with economic conditions, the comparison should normally be made with similar periods covered by the investigation.
    5. General merchandising policy—Comparison should not be made between businesses having different merchandising policies. Some businesses may operate on a large volume with a small markup and little customer service, while other businesses have the opposite merchandising policy. In situations of this kind, comparisons should be made only with those businesses having similar merchandising policies.

     

9.5.9.9.4  (11-05-2004)
Examples of Percentage Method

  1. See Exhibit 9.5.9–7, Examples of Percentage Method, for an example of the computation of the percentage markup method. The percentages used are arbitrary and are not necessarily applicable to the businesses mentioned.

9.5.9.10  (11-05-2004)
Unit and Volume Methods

  1. In many instances the determination or verification of gross receipts may be computed by applying price and profit figures to the known or ascertainable quantity of business done by the subject. This method is feasible when special agents can determine the number of units handled by the subject and also when the price or profit charged per unit is known.
  2. The number of units sold or quantity of business done by the subject may be determined in certain instances from the subject’s books, since the records may be adequate with respect to cost of goods sold or expenses, but inadequate as to sales.
  3. There may be a regulatory body to which the subject reports units of production or service. For example:
    1. A funeral director is required to report each burial to the city or town where the burial takes place.
    2. A garment manufacturer with union employees buys union labels to be sewed into the garments it manufactures.
    3. A subject may be required to report production and payroll to a trade association allied with the labor union.
    4. There are instances where the fees paid for leased machinery is based upon the units of production.
    5. A piecework system of wages for production workers might give an accurate measure of units produced.

     

  4. The use of this method lends itself to those businesses in which only a few types of items are handled, or there is little variation in the type of service performed, since the charges made by the subject for the merchandise or services are relatively the same throughout the taxable period.
  5. The following example is illustrative of the unit and volume method of computation:
    Volume of Merchandise (Manufacturer):
    Number of machines manufactured 92
    Average sales price $1,100
    Computed total sales $101,200
    Sales reported $93,500
    Omitted sales $7,700
 

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