TAXLITIGATOR – Tax Controversy (Civil & Criminal) Report

This is the third of a six part series devoted to utilization of various indirect methods of determining the income of a taxpayer.

Financial Status Audit Techniques (FSAT). There are various audit and investigative techniques available to corroborate or refute a taxpayer’s claim about their business operations or nature of doing business. Audit or investigative techniques for a cash intensive business might include an examiner determining that a large understatement of income could exist based on return information and other sources of information. The use of indirect methods of proving income, also referred to as the FSAT, is not prohibited by Code Section 7602(e)^[i]. Indirect methods include a fully developed Cash T, percentage mark-up, net worth analysis, source and application of funds or bank deposit and cash expenditures analysis. However, examiners must first establish a reasonable indication that there is a likelihood of underreported or unreported income. Examiners must then request an explanation of the discrepancy from the taxpayer. If the taxpayer cannot explain, refuses to explain, or cannot fully explain the discrepancy, a FSAT may be necessary.

The Bank Account Analysis compares total deposits with the reported gross income. for all accounts, whether designated as personal or business. The examiner will review the taxpayer’s business and personal bank accounts (including investment accounts); i.e., statements, deposit slips, and canceled checks, etc. looking for unusual deposits (size or source), the frequency of deposits, deposits of cash, specific deposits that do not follow the taxpayer’s normal routine or pattern, nontaxable deposits such as loans and transfers, commingling of personal and business activities, and cash-backs when a deposit occurs.

The examiner will attempt to total the deposits and reconcile deposits of nontaxable funds and transfers between accounts focusing on transfers in, out, and between accounts as previously unknown accounts may be identified. Checks deposited by the taxpayer but later returned by the bank (e.g., the maker of the check did not have sufficient funds in the account to pay the check) are categorized as nontaxable transactions. Nontaxable funds, transfers-in, and returned deposits need to be subtracted from total deposits to get “taxable deposits.” The examiner will determine disbursements by adding the opening bank balance to the total deposits and then subtracting out the ending balance. To the extent possible, cancelled checks will be reviewed to determine whether nondeductible expenditures (personal expenses, investments, payments on asset purchases, etc.) are included with business expenses and if so, the amount. If cancelled checks are unavailable, transactions will be traced from the bank statement to the check register and the original document. Significant commingling of accounts may warrant a more in-depth analysis by the examiner. When nondeductible expenditures are deducted from the total disbursements the remainder should approximate the deductible business expenses on the tax return (other than non-cash expenses such as accruals and depreciation).

If the analysis results in the identification of excess deposits over the reported gross income, the excess represents potential unreported income. If specific transactions or deposits can be identified as the source of the understatement, the examiner may assert a specific item adjustment to income supported by the direct evidence of excess deposits. If the specific transactions or deposits creating the understatement are not identified, an adjustment to taxable income may be made based on the circumstantial evidence. If the business expenditures paid by check are less than the deducted business expenses on the return, then the taxpayer may be overstating expenses, paying expenses by cash (unreported income), or paying expenses from an undisclosed source of funds. If the analysis indicates significant commingling of funds, then the internal controls are weak and the books and records may be unreliable.^[ii]

When to Anticipate an Indirect Method. Circumstances that might support the use of an indirect method include a financial status analysis that cannot be easily reconciled – 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 deposits; 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, the examiner will attempt to 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 as required by Code section 446(b).

When considering an indirect method, the examiner will look to the industry or market segment in which the taxpayer operates, whether inventories are a principle income producing activity, whether suppliers can be identified and/or merchandise is purchased from a limited number of suppliers, whether pricing of merchandise and/or service 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.

[i].  See IRM 4.10.4.3.3.4. (08-09-2011)

[ii].  Internal Revenue Manual 4.10.4.6.1 sets forth the requirements for examining income and FSATs. The 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). “Examination techniques” include examining and testing the taxpayer’s books and records, analytical tests, observing, and interviewing the taxpayer. These techniques are unique to the use of a formal indirect method and will not routinely trigger the limitation of Code Section 7602(e).

CORY STIGILE – For more information please contact Cory Stigile – stigile@taxlitigator.com  Mr. Stigile is a principal at Hochman, Salkin, Rettig, Toscher & Perez, P.C., a CPA licensed in California, the past-President of the Los Angeles Chapter of CalCPA and a Certified Specialist in Taxation Law by The State Bar of California, Board of Legal Specialization. Mr. Stigile specializes in tax controversies as well as tax, business, and international tax. His representation includes Federal and state controversy matters and tax litigation, including sensitive tax-related examinations and investigations for individuals, business enterprises, partnerships, limited liability companies, and corporations. His practice also includes complex civil tax examinations. Additional information is available at http://www.taxlitigator.com