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Examination of Income |
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Examination of Income |
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| Prior and Current Year | ||||
| Prior Year | Current Year | Change | % Change | |
| Sales | $90 | $100 | $10 | 11% |
| COGS | $27 | $30 | $3 | 11% |
| Fixed Costs | $30 | $30 | 0 | 0 |
| Net Income | $33 | $40 | $7 | 21% |
| Current and Subsequent Year | ||||
| Current Year | Next Year | Change | % Change | |
| Sales | $100 | $130 | $30 | 30% |
| COGS | $30 | $42 | $12 | 40% |
| Fixed Costs | $30 | $30 | 0 | 0 |
| Net Income | $40 | $58 | $18 | 25% |
- Expenses are expressed as a percentage of gross receipts.
- Potential underreporting of income which equals 10% or more of the reported income should be resolved with the taxpayer's assistance. Discrepancies can be caused by errors in reporting gross receipts, inventory, or purchases. See IRM 4.10.3.9.1, paragraphs 12, 13, and 14 for lists of possible errors.
- A comparison against industry norms alone, which indicates a discrepancy, is not justification for using a formal indirect method to make the actual determination of tax liability.
| Cost of Sales |
| Gross Receipts from Sales |
| The following schedule represents the gross receipts and expenses reported by a taxpayer. Assume that there are no inventories. |
| Gross Receipts | $330,000 | |
| Material | $150,000 | |
| Labor | $120,000 | |
| Subcontractors | $30,000 | |
| Cost of Goods Sold | $300,000 | |
| Gross Profit | $30,000 |
| The taxpayer's cost of goods sold to sales ratio is $300,000/$330,000 = 91%. The industry standards however is 75%. To estimate the potential underreporting of income, use the industry standard and the taxpayer's reported costs. $300,000/Gross Receipts = 75% |
| Based on the industry standards, the Gross Receipts should be about $400,000. The potential underreporting of income is $400,000 - $330,000 = $70,000. |
4.10.4.3.4 (06-01-2004)
Minimum Income Probes:
Corporations and Other "Business
" Returns
- An
examination of gross income on a
business return for a corporation or
other business entity should include
the following minimum steps:
- Complete a Balance Sheet Analysis
- Reconcile Schedules M-1 and M-2
- Evaluate the tax returns of significant shareholders or partners (greater than 20% direct or indirect ownership)
- Interview the taxpayer
- Tour of the business site
- Evaluation of the internal controls
- Test Gross Receipts or Sales
4.10.4.3.4.1 (06-01-2004)
Balance Sheet Analysis
- Prepare an analysis of the balance sheet and tax return information. The purpose of the analysis is to assist in the identification of issues to be examined. Significant changes to any accounts should be noted and resolved during the examination.
- Use CFOL information or secure copies of subsequent and prior year returns from the taxpayer to complete the comparative analysis when the examination is initiated.
- Analyze significant balance sheet accounts which show substantial increases or decreases that may indicate the misclassification of income and accounts. Examples include "loans to shareholders," suspense accounts, deferred income accounts, and reserve accounts. Tie balance sheet accounts, such as Cash, to their respective source documents, such as the bank reconciliations and Accounts Receivable to the receivable subsidiary ledger ending balance.
- Compare the adjusted trial balance to the balance sheet to ensure they match. Account grouping sheets should be requested for this analysis. This is an essential step in the examination of a double-entry set of books.
- Review the adjusting journal entries from the unadjusted trial balance to the adjusted trial balance for misclassifications, unusual debits to income accounts or possible manipulations of reported income. The adjusted trial balance should be tied to the general ledger to ensure there are no missing adjusting journal entries. The general ledger should be scanned for large, unusual or questionable items in the journal entries or adjusting journal entries, such as debit entries to income accounts or credit entries to asset accounts (i.e. Accounts Receivable that do not flow from the Cash Receipts journal).
- See IRM 4.10.3 for additional instructions.
4.10.4.3.4.2 (06-01-2004)
Schedules M-1 and M-2
- Perform a reconciliation of Schedules M–1, Reconciliation of Income/Loss Per Books with Income Per Return, or equivalent schedule and M–2, Analysis of Unappropriated Retained Earnings per Books, or equivalent schedule.
- Refer to IRM 4.10.3.6 for complete discussion.
4.10.4.3.4.3 (06-01-2004)
Required Filing Checks
-
Evaluate copies of the tax
returns of significant
shareholders or partners
(greater than 20% direct or
indirect ownership) for:
- examination potential (including issues unrelated to the corporate or partnership return),
- the proper treatment of related transactions with the corporation or partnership, including losses from related parties, and
- the likelihood of diverted funds
- Completion of the Required Filing Checks (see IRM 4.10.5) is not a violation of IRC section 7602(e).
- Copies of related shareholder/partner returns can be obtained using CFOL or MACS. If the CFOL and MACS information is insufficient, the return should be requested from either the campus or the taxpayer for inspection. See IRM 4.10.5.2.2.
- Examiners should determine if the income from the related business entity was included on the shareholder/partner's individual return. If the income was reported and there are no other issues, the return should not be opened for examination. If the income from the related business entity was not reported on the return, the examiner should open the shareholder/partner's individual return for audit.
- Independent of the potential underreported income from the business entity, the return should be opened for audit if the examiner notes that a Financial Status Analysis based on the return indicates insufficient funds to support the identified expenses, or a large, unusual, or questionable item is identified.
- Effectively, examiners should determine whether the related return warrants examination from a classification perspective; i.e., trace the transactions between the individual and related business entity, complete a Financial Status Analysis based on the return as filed and internal sources of information (see Exhibit 4.10.4-2), and review the return for other potential issues.
- Should the related individual return be opened for audit, it is subject to the minimum income probes and examiners are expected to determine whether the taxpayer has reported the correct amount of taxable income. The depth of the examination of income and the techniques used are dependent on the facts and circumstances of the case.
4.10.4.3.4.4 (06-01-2004)
Initial Interview
- This interview, wherever possible, should be held with the partnership's Tax Matters Partner (TMP) or the corporate officer most familiar with the day-to-day operations of the business. From the taxpayer's perspective, an interview with an Internal Revenue agent may be overwhelming. Therefore, initial interviews should be professional and not overbearing; the taxpayer should be afforded 100% credibility.
- IRC section 7521(c) states that examiners cannot require a taxpayer to accompany an authorized representative to an examination interview in the absence of an administrative summons. However, the taxpayer’s voluntary presence can be requested through the representative. Should an examiner find that a representative has unreasonably delayed or hindered an examination, an examiner can bypass the representative and deal directly with the taxpayer. See Exhibit 4.10.4-5, Bypassing Powers of Attorney.
- Question the TMP, corporate officer, or representative concerning possible loans, gifts, or other nontaxable funds, known errors/omissions on the return, unreported sources of income and ask for any information necessary to resolve issues identified during the pre-audit analysis.
- Question the TMP, corporate officer or representative about Cash on Hand and Accumulated Funds. See IRM 4.10.4.3.3.2, IRM 4.10.4.6.8.3, and Exhibit 4.10.4-1 for additional discussion.
- Question the TMP, corporate officer or representative about internal controls. Segregation of duties and flow of money should be established to determine any potential control weaknesses which could result in diversion of funds.
- IRC section 7521(b) (2) requires examiners to suspend interviews when taxpayers state that they wish to consult with a representative or otherwise seek advice. The taxpayer’s right of consultation will be strictly honored and interviews will be suspended and rescheduled accordingly. This provision does not apply to interviews initiated by administrative summons and will not be used to repeatedly delay or hinder the examination process.
4.10.4.3.4.5 (06-01-2004)
Tour of Business Sites
(Corporations and Other
"Business " Returns)
-
Conduct a tour of the business
site. Generally, the principal
location and any other locations
acquired during the period under
examination should be visited.
The purpose of a tour is to:
- gain familiarity with the taxpayer’s business operation and internal controls,
- identify potential sources of income, and
- confirm the existence of assets.
- The results of a tour and any observations and/or comments should be documented in the examination workpapers.
- See IRM 4.10.3.3 for complete discussion.
- This requirement applies to Field examinations only.
4.10.4.3.4.6 (06-01-2004)
Evaluate Internal Controls
- Evaluate the internal controls to gain an understanding of the taxpayer’s business operations and control features. See IRM 4.10.3.4.
-
While there is no exhaustive
definition of weak internal
accounting controls, which will
impact the scope of the
examination of income, examples
include:
- books and records that cannot be reconciled to the tax return
- transactions that are not properly authorized
- recorded transactions are not valid
- existing transactions are not recorded
- transactions are improperly valued
- transactions are improperly classified
- transaction are recorded at the improper time
- transactions are incorrectly summarized
- transactions all made by the same person or related parties
- recording and handling of assets by the same person or related parties
-
Example
: a
taxpayer's business consists of
small home repairs and
construction projects. The
taxpayer files a S-corporation
tax return. The books and
records tie to the
S-corporation's income tax
return and the invoices tie into
the gross receipts shown on the
return. The S-corporation return
reflects a net profit of $5,000.
The S-corporation did not pay
the taxpayer a salary, but the
taxpayer's spouse earned $30,000
in wages from an unrelated
business (as reported on the
shareholder's 1040 tax return).
Although the cash flow analysis
suggests sufficient funds to
support the S-corporation's
expenses, most of the gross
receipts are cash and the
internal controls are weak
because the taxpayer's spouse
maintains the books.
- The S-corporation and shareholder income tax returns are considered related because the returns are for entities over which the taxpayer has control and which can be manipulated to divert funds or camouflage transactions. Therefore, the examination of the S-corporation cannot be completed without also examining the taxpayer's individual return.
- Once an audit of the related individual return is initiated, the examiner should request the personal bank records (statements, cancelled checks and deposit slips) for both spouses to determine if any corporate funds were diverted.
- If, after reviewing these records, the examiner believes there is a reasonable indication that there is a likelihood of unreported income, a formal indirect method may be used to make the actual determination of tax liability.
-
The
workpapers will document:
- the conclusions reached by the analysis of internal controls,
- the impact on the scope of the examination, and
- the impact on the depth of the examination of income.
4.10.4.3.4.7 (06-01-2004)
Test Gross Receipts or Sales
- Test the information obtained in the initial interview and from the evaluation of the internal controls to gain a complete understanding of the taxpayer’s business operations and control features.
- Reconcile the bank records. The depth of bank record inspection will depend on the reliability of internal controls and the judgment of the examiner. Consider the results of the analysis of the primary shareholders’ or partners’ individual returns. See IRM 4.10.3.7. The initial IDR may include a request for the business bank records, including the statements, deposit slips and cancelled checks.
- See IRM 4.10.3.9 for a complete discussion and listing of audit techniques.
4.10.4.3.5 (06-01-2004)
Minimum Income Probes:
Delinquently Filed Returns &
Nonfilers
- Delinquent returns filed at a campus or with an examiner are subject to the same minimum requirements for the examination of income as are timely filed returns.
- If a Financial Status Analysis (or another analysis) based on a return secured from a nonfiler as part of an examination indicates that there is a likelihood of unreported income, then an in-depth examination of income should be completed and a formal indirect method used to make the actual determination of tax liability if warranted.
- For more information regarding nonfilers, refer to IRM 4.12, Nonfiler Returns.
-
Substitutes for return(s) filed on
behalf of a nonfiler under IRC
section 6020(b) will require a
reconstruction and examination of
income. The examiner should secure
and review available internal
information to use in the
determination of the scope of
examination of income. (See Exhibit
4.10.4–2.) The examiner should also
have Bureau of Labor Statistics (BLS)
information available for comparison
to the nonfiler’s record of gross
income. Examiners should attempt to
use the nonfiler’s books and records
to prepare a preliminary schedule of
gross income. Based upon the
nonfiler’s schedule of gross income,
available internal information and
BLS data, the examiner must
determine the subsequent audit scope
using the following criteria:
IF THEN The nonfiler’s schedule of gross income prepared from his/her books and records is consistent with all financial activities of the nonfiler and available internal information, The substitute for return may be prepared using the nonfiler’s record of gross income. The results and conclusions reached should be documented in the examination workpapers. IF THEN The nonfiler’s schedule of gross income prepared from his/her books and records is inconsistent with the financial activities of the nonfiler and/or available information, A more in-depth examination of income is warranted. See IRM 4.10.4.5 below for suggested elements of an in-depth examination income for an individual nonfiler. Note: Collectibility consideration should be given to each situation in which the examination scope may be expanded.
4.10.4.4
(06-01-2004)
Results of Minimum Income Probes
- After
completion of the minimum income probes,
the examiner must evaluate the
information collected to this point and
determine the scope of the examination
of income, using the following criteria:
IF THEN The results show that the taxpayer reported all taxable income from known sources, the books and records can be reconciled to the tax return, all financial activities are in balance, and the bank deposits do not exceed reported income, The examination of income may be limited to the Minimum Income Probes. The results and conclusions reached should be documented in the examination workpapers. IF THEN The results indicate the potential of unreported income due to inaccurate reporting of taxable income from known sources, the books and records cannot be reconciled to the tax return, a material imbalance in the Financial Status Analysis that cannot be reconciled, excess unexplained bank deposits, or inadequate internal control, A more in-depth examination of income is warranted. See subsection 4.10.4.5 below for suggested guidelines for an in-depth examination of income.
4.10.4.4.1 (06-01-2004)
Material Understatements and
Managerial Involvement
- If the examination of income reveals an understatement of income in a given year, the case should be discussed with the group manager. The purpose of the discussion is to consider possible expansion of the examination scope/depth, audit techniques to be used, and the potential of fraudulent activity by the taxpayer.
- This discussion is mandatory in any examination with an understatement of income greater than $10,000.
- This discussion should be noted on Form 9984, Examining Officer's Activity Record. A summary of the content and resulting decisions should be documented in the workpapers.
-
Group Managers should be engaged
with their examiners in the
development of unreported income
issues. Involvement can be
demonstrated by:
- Becoming familiar with the factual development and documentation,
- Discussing cases with examiners to assist in the determination of the depth of the examination of income and the techniques that should be used,
- Assisting examiners to determine whether the facts support the conclusion that there is a reasonable likelihood of unreported income justifying the use of a formal indirect method to make the actual determination of tax liability.
- Issuing summonses when necessary, and
- Contacting TIGTA immediately when a taxpayer threatens to report an RRA '98 Section 1203 violation for harassment.
- Management involvement should be annotated on Form 9984, Examining Officer's Activity Record.
4.10.4.4.2 (06-01-2004)
Inadequate Books and Records
- Whenever the taxpayer’s books and records are deemed inadequate for purposes of an examination of income, the examiner should consider the issuance of an inadequate records notice at the conclusion of the examination. See IRM 4.10.8.15 for procedures to issue an inadequate records notice.
4.10.4.5
(06-01-2004)
In-Depth Examinations of Income
- If, as a result of completing the minimum income probes, the examiner identified inaccurate reporting of income from known sources, cannot reconcile the income reported on the tax return to the taxpayer's books and records, cannot reconcile a Financial Status Analysis, identified unexplained bank deposits, determined that the taxpayer's internal controls are inadequate, or determined for any reason that there is reasonable indication of additional unreported income, then a more in-depth examination of income will be made.
4.10.4.5.1 (06-01-2004)
Guidelines for In-Depth
Examinations of Income
- The depth of the in-depth examination of income will be tailored to each taxpayer. Sensitivity to the taxpayer’s reaction to additional in-depth probes must be balanced with the need for the proper and fair administration of tax laws.
- The in-depth examination of income is distinguishable from the minimum income probes by the use of third party contacts to obtain information or evidence to reconcile income issues.
- Where indicated, examiners should first pursue specific items of income that can be documented with direct evidence. These adjustments are easiest to defend and may eliminate the need to use a formal indirect method to make the actual determination of tax liability. This approach is appropriate when the taxpayer maintains books and records, adjustments may be due to technical issues (such as timing or character of funds), or the potential sources of the unreported income are limited (such as an insurance agent who underwrites for several companies). The specific item approach is not useful if the taxpayer’s gross receipts are generated from numerous sources or in small amounts, such as a grocery store.
- The use of a formal indirect method to make the actual determination of tax liability should be pursued when the taxpayer’s books and records are missing, incomplete, or irregularities are identified; or the Financial Status Analysis indicates a material imbalance after consideration of specific adjustments identified during the examination. Choosing the formal indirect method most suitable for the examination is extremely important. See IRM 4.10.4.6.2. for addition discussion.
-
Procuring evidence, and its
evaluation, are an integral part of
the process. Refer to the following
IRM sections:
- IRM 4.10.7.3, Evaluating Evidence, which includes discussions of oral testimony, observations, and documentary evidence.
- IRM 4.10.7.4, Arriving at Conclusions, which includes a discussion of taxpayer credibility and reasonable determinations.
4.10.4.5.2 (06-01-2004)
In-Depth Examinations of
Income—Individual Taxpayers
- Follow-up on evidence of potential sources of additional unreported income. This audit technique does not trigger the provisions of IRC section 7602(e) regarding the use of Financial Status Audit Techniques; thus, there is no requirement that the Service to have a reasonable indication of a likelihood of unreported income.
-
Attempt to resolve an unbalanced
Financial Status Analysis.
- Reduce the unexplained understatement of income by any excess of net bank deposits over reported gross receipts discovered during the bank account analysis.
- Include any audit adjustments made due to failure to substantiate claimed expenses. NOTE: The Financial Status Analysis should be continually revised as new information about business and personal expenses becomes available.
- Update estimated personal living expenses as information becomes available. However, it is inappropriate to affirmatively ask the taxpayer to identify actual personal living expenses or complete Form 4822, Statement of Annual Estimated Personal and Family Expenses. For purposes of the Financial Status Analysis, estimated personal living expenses are sufficient. Refining personal living expenses for actual costs should be limited to completion of a formal indirect method to make the actual determination of tax liability. See IRM 4.10.4.6.1.2.
-
Discuss any potential understatement
of income with the taxpayer and/or
representative. The taxpayer may
have information that was not
previously disclosed to the examiner
that will resolve the imbalance.
- Consideration should be given to credible oral testimony, such as reasonableness of gifts of cash from relatives. (See IRM 4.10.7.3.2 for in-depth discussion of oral testimony and documentation requirements.)
- Loan proceeds should be documented with the loan application and records of disbursement. The documents should be reviewed to confirm the amount and terms of the loan, as well as determining if the information on the loan application is consistent with information on the return. Differences should be reconciled and may lead to additional sources of income.
-
When appropriate, third party
contacts should be made to
corroborate oral testimony.
Information should be collected, to
the greatest extent practicable,
directly from the taxpayer to whom
it relates. However, external
sources of information (third
parties) can be used to update the
Financial Status Analysis, verify
expenses, or corroborate the
taxpayer's oral testimony and
explanations.
- Under Section 7602(c) of the Code, third party contacts may not be initiated before giving advance notice to the taxpayer that contacts other than with the taxpayer may be made.
- Request that the taxpayer complete Form 6014, Authorization — Access to Third Party Records for Internal Revenue Service Employees. This form gives a third party written authorization from the taxpayer to provide information directly to the examiner.
- Use standard Form Letter 1995, Third Party Contact Letter to Request Information, to request information from third parties.
- Issue an administrative summons to the third party if the taxpayer is not cooperative. Pursuant to IRC section 7602(a), the Service has the authority to issue a summons to any person who has information for any bona fide civil tax audit, collection purpose or criminal investigation of any offense connected with the administration or enforcement of the internal revenue laws. To enforce an administrative summons, the Service must demonstrate that (1) there is a legitimate purpose; (2) the inquiry is relevant to the purpose; (3) the information is not already in the possession of the Service; and (4) the administrative steps required by the Code and regulations have been followed. See United States v. Powell, 379 U.S. 48, 57-58 (1964).
- A variety of external sources of information are available. For example, a credit application completed by the taxpayer to secure a bank loan may reflect income consistent with the audit adjustment. See Exhibit 4.10.4–3 for additional examples of external sources of information.
- Information from third parties may be secured via telephone with the taxpayer present. This is the easiest and most efficient method. Depending upon the information sought, oral testimony may be all that is needed to resolve the issue.
- In some circumstances interviewing the third party should be considered. A summary of the interview or statement made should be prepared and signed by the third party. If a more formal written statement is desired, an affidavit (Form 2311) should be used. See IRM 4.10.7.3.2, Oral Testimony, for detailed discussion.
- Information from third parties will be verified, to the extent practicable, with the taxpayer or representative before action is taken. (See IRM 4.10.1.6.12 for more information on taxpayer notification requirements.)
4.10.4.5.3 (06-01-2004)
Audit Techniques for the
In-Depth Examinations of Income:
Corporations, Other "Business"
Returns
- The minimum income probes described in IRM 4.10.4.3.4 are comprehensive. Therefore, examiners should use their judgment when determining which audit techniques are most suitable for additional in-depth income probes. Refer to IRM 4.10.3.5.5 and 4.10.3.5.6.
- Bank records serve as backup documents to the taxpayer's records and can also provide leads to transactions not disclosed in the books and records. A complete discussion is included in IRM 4.10.3.7. The extent of the bank account reconciliation will depend on the circumstances of the case and will be more important when records are inadequate, nonexistent, or possibly falsified.
- An apparent understatement of income for a corporation or other business entity will normally require a concurrent in-depth examination of the related shareholders or partners. Refer to IRM 4.10.5.4 for suggested elements for an in-depth examination of income for an individual shareholder/partner. Refer to IRM 4.10.4.6 below for general guidance for using formal indirect methods.
- When appropriate, third party contacts should be made to corroborate oral testimony. See IRM 4.10.4.5.2(4) for complete discussion.
4.10.4.5.4 (06-01-2004)
Results of an In-Depth
Examination of Income
-
After completion of the in-depth
examination of income, the examiner
should decide the next step using
the following decision criteria:
a. IF THEN The taxpayer or third parties have successfully explained the reason for the understatement. Document the results in the workpapers and conclude the examination of income without adjustment. b. IF THEN The adjustments to income and understatement meet the criteria for referral to Criminal Investigation. A referral should be made to Criminal Investigation. c. IF THEN The taxpayer agrees to the proposed adjustments to income. There is no indication of additional unreported income. Document the results in the workpapers and make the adjustment, resolve other issues, and close the case agreed. d. IF THEN The taxpayer does not agree to the proposed adjustments to income and the adjustments are not based on estimated personal living expenses. Document the results in the workpapers and close the case unagreed. e. IF THEN The taxpayer does not agree to the proposed adjustments to income and the adjustments are based on estimated personal living expenses. Consider using one of the formal indirect methods to make the actual determination of tax liability. (A case should not be closed unagreed if adjustments to income are based on estimated Personal Living Expenses.)
4.10.4.6
(06-01-2004)
Formal Indirect Methods of
Determining Income
- The formal indirect methods used to determine tax liabilities involve the development of circumstantial proof of income through the use of bank deposits, source and application of funds, ratio analyses, or changes in net worth.
- The
purpose of this section is to provide
guidance for examiners when using formal
indirect methods of reconstructing
income. The five basic formal indirect
methods of reconstructing income
discussed are:
- Bank Deposits and Cash Expenditures Method
- Source and Application of Funds Method
- Markup Method
- Unit and Volume Method
- Net Worth Method
-
Subsection 4.10.4.6, Formal Indirect
Methods of Determining Income, is
organized into the subsections listed
below. Key court decisions which allow
for the use of formal indirect methods,
when to use a specific method, formulas,
and examples are included in the
discussions of the different methods.
Common defenses which an examiner may
encounter in cases where a formal
indirect method is used are also
discussed.
4.10.4.6.1 Authority to Use Formal Indirect Methods 4.10.4.6.2 Using Formal Indirect Methods to Reconstruct Income 4.10.4.6.3 Bank Deposits and Cash Expenditures Method 4.10.4.6.4 Source and Application of Funds Method 4.10.4.6.5 Percentage of Markup Method 4.10.4.6.6 Unit and Volume Method 4.10.4.6.7 Net Worth Method 4.10.4.6.8 Potential Taxpayer Defenses Against Formal Indirect Methods of Computing Income
4.10.4.6.1 (06-01-2004)
Authority to Use Formal Indirect
Methods (Financial Status Audit
Techniques)
- Neither the Code or the regulations define or specifically authorize the use of the formal indirect methods. IRC section 446(b), however, provides that if no method of accounting has been regularly used by the taxpayer, or if the method used does not clearly reflect income, the computation of taxable income shall be made under such method as, in the opinion of the Secretary, does clearly reflect income.
- If the examiner has a reasonable indication that unreported income exists, the IRS has been granted the authority, through the development of case law, to use a formal indirect method of reconstructing income to determine whether or not the taxpayer has accurately reported total taxable income received.
- The [formal] indirect method need not be exact, but must be reasonable in light of the surrounding facts and circumstances. Holland v. United States, 348 U.S. 121, 134 (1954).
4.10.4.6.1.1 (06-01-2004)
Limitation on Use of Formal
Indirect Methods (Financial
Status Audit Techniques)
- Formal indirect methods and the techniques used to support their development are collectively known as "Financial Status Audit Techniques " and trigger IRC section 7602(e), which states that " the Secretary shall not use financial status or economic reality examination techniques to determine the existence of unreported income of any taxpayer unless the Secretary has a reasonable indication that there is a likelihood of such unreported income."
- "Financial Status Audit Technique" was defined as the use of formal indirect methods in the Government Accounting Offices's report, "More Criteria Needed on IRS' Use of Financial Status Audit Techniques," GAO/GGD-98-38.
4.10.4.6.1.2 (06-01-2004)
Limitation on Use of
Examination Techniques:
Personal Living Expenses
- "Examination techniques" include examining and testing the taxpayer's books and records, analytical tests, observing, and interviewing the taxpayer. None of these techniques are unique to the use of a formal indirect method and do not trigger the limitation of IRC section 7602(e). The refinement of the personal living expenses (PLE) for actual costs (rather than estimates), however, is an intrusive examination technique that should only be used after the decision to use a formal indirect method to determine the actual tax liability has been made.
- Form 4822, Statement of Annual Estimated Personal and Family Expenses, may be used as a guide by the examiner for determining the taxpayer's personal living expenses. The form lists the typical expenses incurred by most individuals.
- It is inappropriate to ask the taxpayer to complete the form independently. The examiner must make sure the taxpayer understands what is required to accurately complete each expense item. The discussion required to complete the form can often provide the examiner with information about the taxpayer, which may help clarify potential issues and adjustments.
- Care should be taken to avoid duplicating amounts when modifying estimates for actual costs.
4.10.4.6.1.3 (06-01-2004)
Use of Bureau of Labor
Statistics Data to
Reconstruct Taxable Income
- In certain cases, as described below, income may be reconstructed using Bureau of Labor Statistics (BLS) data. The analysis is completed using the tables for annual expenses, not income, because determining the expenses represents a better reflection of the actual costs to maintain a household.
- The BLS data can be accessed at www.bls.gov, select " Inflation and Consumer Spending." Tables specific to year, region within the United States, and individual expenses are available.
- BLS data cannot be used as a substitute for reconciling the taxpayer's books and records. If the taxpayer provides information, or information becomes available, which shows that income in a specific amount was earned, BLS data cannot be used to increase income to the national average.
- In court proceedings involving individuals, IRC section 7491(b) may shift the burden of proof. Section 7491(b) provides that the Service will have the burden of proof for any item of income where income is reconstructed using only BLS data or other statistical information on unrelated taxpayers.
4.10.4.6.1.3.1
(06-01-2004)
When to Use Bureau of
Labor Statistics Data
-
BLS data should be used as a
method to calculate taxable
income where the following
three conditions are met.
- The taxpayer is in a business or income producing activity other than as an employee. Evidence of employment and wages earned, such as a filed Form W-2, constitutes evidence precluding the use of BLS unless the taxpayer can be placed in an unrelated income producing activity that could have generated unreported income. See Senter v. Commissioner, T.C. Memo 1995-311.
- The taxpayer must be a nonfiler. If the taxpayer filed a tax return and reported income, then the examiner must use other recognized methods (specific item, indirect methods) to confirm or reconstruct additional income. BLS statistics are not a substitute for obtaining and considering relevant evidence in reaching a determination.
- The taxpayer must be uncooperative with the examiner during the audit. Examples of noncooperation include a taxpayer who is not willing to meet with the examiner or provide any information or records regarding income producing activities, whether or not the examiner has been able to actually identify that activity. Examiners must use judgment to determine whether the taxpayer is cooperative. Examiners must use all available administrative tools, including the summons enforcement, to gather necessary information before BLS data is used.
4.10.4.6.1.3.2
(06-01-2004)
Case Law for Using
Bureau of Labor
Statistics Data
- In Miller v. Commissioner, T.C. Memo 1993-121, the taxpayer filed tax returns for 1982-1985, but they contained virtually no information other than his name, address, occupation, filing status, and the number of exemptions claimed. The various line items on the returns either stated "none" or were footed to statements containing specific objections based upon amendments to the United States constitution. The taxpayer signed the returns, but added a disclaimer. The taxpayer was totally uncooperative during the audit and did not provide books or records. Bank records were used to reconstruct the taxpayer's business receipts and expenses. Because the bank records reflected virtually no personal expenditures, BLS cost-of-living data was used to determine income attributable to some other untraced source from which personal expenses were paid in addition to the reconstructed gross business receipts. The Court sustained the use of BLS data under these circumstances, except where the BLS figures appeared to be duplications of expenses paid from the bank accounts.
- In Portillo v. Commissioner, 932 F.2d 1128 (5th Cir. 1991), the examiner relied upon a filed Form 1099 to determine that a taxpayer had additional unreported income. The taxpayer agreed he had additional income, but not the amount reported on the Form 1099. Ultimately, the filer of the Form 1099 was only able to document the portion of additional income with which the taxpayer agreed. The statutory notice of deficiency reflected the entire amount shown on the Form 1099. The Court found that the notice of deficiency was arbitrary because it merely matched the taxpayer's return with the Form 1099, assuming the taxpayer's return was false and the Form 1099 was correct. In such circumstances, the Service is obligated to investigate.
- In Senter v. Commissioner,T.C. Memo 1995-311, the taxpayer failed to provide requested information or appear for scheduled meetings. The taxpayer's correspondence with the examiner raised " protestor" type arguments. The taxpayer did not comply with, and objected to, administrative summonses, but the examiner did not seek enforcement. The notice of deficiency reflected unreported income determined using prior year reported earnings adjusted by the Consumer Price Index (CPI). The Court held this determination of unreported income to be arbitrary and erroneous. Some predicate (preexisting) evidence establishing income was necessary to support a determination of unreported income.
4.10.4.6.2 (06-01-2004)
Using Formal Indirect Methods to
Reconstruct Income
- Examiners are cautioned that the use of a formal indirect method will be determined on a case by case basis. The use of a formal indirect method to make the actual determination of tax liability is not a substitute for reconciling whatever books are maintained by the taxpayer to the tax return. The use of a [formal] indirect method, however, is not precluded by the presentation of books and records. See Lipsitz v. Commissioner, 21 T.C. 917 (1954).
4.10.4.6.2.1 (06-01-2004)
When to Use a Formal
Indirect Method
-
The
use of a formal indirect method
to make the actual determination
of tax liability should be
considered when the factual
development of the case leads
the examiner to the conclusion
that the taxpayer's tax return
and supporting books and records
do not accurately reflect the
total taxable income received or
the examiner has established a
reasonable likelihood of
unreported income. The following
list, which is not intended to
be all inclusive, identifies
circumstances that would support
the use of a formal indirect
method.
- A Financial Status Analysis that cannot be balanced; i.e., the taxpayer's known business and personal expenses exceed the reported income per the return and nontaxable sources of funds have not been identified to explain the difference;
- Irregularities in the taxpayer's books and weak internal controls;
- Gross profit percentages change significantly from one year to another, or are unusually high or low for that market segment or industry;
- The taxpayer's bank accounts have unexplained items of deposit;
- The taxpayer does not make regular deposits of income, but uses cash instead;
- A review of the taxpayer's prior and subsequent year returns show a significant increase in net worth not supported by reported income;
- There are no books and records. Examiners should determine whether books and/or records ever existed, and whether books and records exist for the prior or subsequent years. If books and records have been destroyed, determine who destroyed them, why, and when.
- No method of accounting has been regularly used by the taxpayer or the method used does not clearly reflect income. (IRC section 446(b).)
4.10.4.6.2.2 (06-01-2004)
Selecting a Formal Indirect
Method
- The selection of a formal indirect method is critical to effectively and efficiently determine the tax liability. For example, although the Bank Deposits and Cash Expenditures Method and the Source and Application of Funds Method are frequently used, they are not the most effective methods if cash is not deposited and/or the cash outlays cannot be determined unless voluntarily disclosed by the taxpayer. Realistically, it may be difficult to identify significant personal acquisitions or expenditure that the taxpayer has deliberately camouflaged. These weaknesses can be overcome by using a formal indirect method based on the taxpayer's business activities to make the actual determination of tax liability; i.e., the Markup Method or Unit and Volume Method.
-
The
following factors should be
considered when selecting a
formal indirect method:
- The industry or market segment in which the taxpayer operates;
- Inventories are a principle income producing activity;
- Suppliers can be identified and/or merchandise is purchased from a limited number of suppliers,
- Merchandise and/or service pricing is reasonably consistent,
- The volume of production and variety of products,
- Availability and completeness of the taxpayer's books and records,
- The taxpayer's banking practices,
- The taxpayer's use of cash to pay expenses,
- Expenditures exceed income,
- Stability of assets and liabilities, and
- Stability of net worth over multiple years under audit.
4.10.4.6.2.3 (06-01-2004)
Documenting the Decision to
Use a Formal Indirect Method
-
The
reasons why the examination of
income was expanded to include
the use of a formal indirect
method to make the actual
determination of tax liability
should be documented in the
workpapers, as well as why a
specific method was selected.
The documentation should include
a narrative explaining how the
evidence in the file establishes
the likelihood of unreported
income, and justifying the use
of a formal indirect method. The
documentation should include:
- a summary of the facts relevant to the decision,
- procedures and audit techniques used up to that point,
- manager's comments (if appropriate),
- any other information relevant to the decision, and
- conclusions.
-
Document likely sources of
taxable income. It is not
essential to pinpoint the
specific source, but only to
indicate the possibility of, or
the opportunity for, likely
sources of taxable income. To
the extent that the possible
source(s) can be identified, the
more credible the results of a
formal indirect method will be.
Possible sources can be
demonstrated by:
- specific omissions,
- demonstrating that the taxpayer's business had the capacity to generate more gross receipts, or
- comparisons over time.
- The documentation should be prepared concurrent to the decision; i.e., before using a formal indirect method to make the actual determination of tax liability.
4.10.4.6.2.4 (06-01-2004)
Management Approval
- Group Manager approval is not required when initiating the use of a formal indirect method.