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August 2012 Tip of the Month

Letting the IRS Do It Their Way

How does the IRS reconstruct income if the taxpayer won’t or can’t produce records?  It actually has a variety of approaches.  They include the:

  • Net worth method in which the agency determines income based on the change in a taxpayer’s net worth (assets less liabilities) over the period covered by an examination by accounting for all nondeductible expenditures paid by the taxpayer and deducting all non-taxable sources of funds.  The reported net income is then compared with the change in net worth, and any shortfall is deemed unreported income.

  • Sources and application of funds method which is based on the assumption that the amount by which a taxpayer’s known sources of income is taxable income unless the taxpayer can show that it came from a non-taxable source.

  • Bank deposit method rests on the theory that a taxpayer’s bank deposits most frequently represent the taxpayer’s income, with the taxpayer being asked to prove that the excess deposits represent non-taxable sources of income.

  • Mark-up method determines income as a percentage by applying a mark-up percentage pertinent for a particular industry or business to gross sales to obtain the gross profit.

As you can see, there are a variety of indirect and direct approaches the IRS can use to reconstruct income in the absence of a taxpayer’s books and records.  Often the results can be a determination that far exceeds what the income actually was, and, frequently, fraud is alleged.  Failing to keep records is about the worst strategy for avoiding taxes or hiding income, since it will often result in charges of tax evasion.  We try to help clients establish sound record keeping systems and suggest tax planning that is legal and effective to avoid or defer unnecessary tax liability.