By Charles E. Price and Leonard G. Weld

In Brief

Big Time Estimating

The IRS has an array of methods available to reconstruct income if it suspects a taxpayer may have filed a fraudulent return or has not filed one. Courts will allow the use of income reconstruction if the taxpayer has no records or if the records do not clearly reflect income. If the IRS meets its level of responsibility in presenting the reconstruction, the derived income and tax liability are presumed correct and the taxpayer has the burden of overcoming that presumption. To rebut the IRS's position, the taxpayer need not prove the correct tax due, just that the reconstruction method used was arbitrary, capricious, or erroneous. The taxpayer can do this by showing nontaxable sources for the reconstructed income, such as gifts, inheritances, sale of assets at a loss, or loan proceeds. Depending on the strength of the evidence, the IRS may file civil or criminal charges against the taxpayer. In addition, the IRC provides several penalties for underpayment of tax.

orensic accounting is a practice whereby accountants use their business skills to investigate fraud, embezzlement of funds, theft of assets, or perhaps find evidence of hidden assets in divorce cases. One of the most useful tools available for the application of this skill is income reconstruction. But, the sword cuts both ways.

Authority to Reconstruct Income

The power to reconstruct income is based on IRC section 446(b). Subsection (b) states that, if the taxpayer does not use a method of accounting that clearly reflects income, the method for computation of taxable income can be determined by the Treasury Secretary. Treasury regulations section 1.446-1(a)(4) explains that every taxpayer must maintain accounting records to support the filing of a correct return. The regulations require accounting records to perform three essential functions:

* Account for inventory,

* Properly classify between expense and capital accounts, and

* With respect to depreciable assets, record additions to those accounts for improvements.

The obligation to maintain records is reiterated in IRC section 6001, which states that anyone liable for tax must keep records and file returns in accordance with rules and regulations the secretary may prescribe. The only reprieve for the taxpayer has come through the Cohan rule.

In a landmark case, George M. Cohan v. Comr. [39 F.2d 540 (CA-2 1930)], Mr. Cohan could not substantiate $55,000 in entertainment and travel expenditures. The IRS did not allow any part of the deduction because there was no substantiating documentation. The trial court concurred. However, the appeals court ordered the trial court to estimate a reasonable amount that could be deducted. The appeals court held that when some amount has definitely been spent, the IRS can use an estimated amount if the taxpayer has no records. The court gave the IRS the freedom to bias the estimate against the taxpayer "whose inexactitude is of his own making."

Using the Cohan rule, courts have allowed partial deductions for union dues, wages, utilities, and postage. The deduction depends on the credibility of the taxpayer and corroborating testimony. After 1962, the Cohan rule was no longer applicable to travel and entertainment expenses because of the explicit requirements of IRC section 274. However, Treasury regulations section 1.274-5T(c)(5) states that if records are lost due to circumstances beyond the control of the taxpayer, the taxpayer has the right to a deduction based on a "reasonable reconstruction of his expenditures."

The courts have refused to apply the Cohan rule when the taxpayer could have obtained duplicate records, but failed to do so. The courts will not estimate deductions when there is neither a reasonable basis for an estimate nor a reasonable method to allocate an expense into deductible and nondeductible portions.

Deduction of expenses is, however, only half of the equation. Taxpayers are also responsible for the proper inclusion of income items. Calculation of gross income is often accomplished through the use of income reconstruction.

The IRS is not permitted to use income reconstruction in every circumstance. Properly kept records that show actual income cannot be disregarded by the IRS. Several tax court cases have established that mere suspicion that records do not accurately reflect income is not a sufficient reason to use income reconstruction, even if the records are not completely accurate. However, the burden of proof is on the taxpayer to show that the records clearly reflect income.

The IRS does not require that a preparer verify information against the taxpayer's actual records. Treasury regulations section 1.6694­1(e) states that the preparer may "rely in good faith" on information provided by the taxpayer. "The preparer is not required to audit, examine, or review" documents or records, but the preparer must make "reasonable inquiries" if the information seems to be incorrect or incomplete.

Income reconstruction can also be used as a verification tool. If the taxpayer uses an unorthodox accounting system, income reconstruction can provide confirmation of taxable income. If records are lost or stolen, income reconstruction may be the fastest method of calculating income.

Methods of Income Reconstruction

Income reconstruction methods are divided into two groups: direct and indirect. Direct methods are used to show a specific taxable transaction was either omitted or reported incorrectly. Indirect methods provide circumstantial evidence about cash flow or accumulation of assets rather than a specific transaction.

Direct Methods

When the taxpayer has only a few business transactions or sells to only a few major customers, a direct method may be the most useful. Courthouse records can provide evidence of real estate transactions. Billing invoices from major customers may give an indication that all sales have not been reported. State motor vehicle records can reveal sales or transfers. Insurance records may show jewelry or art objects sold and removed from policy riders. Instances such as these would be called "specific omissions." If the IRS establishes that income was omitted from the return, it is up to the taxpayer (not the IRS) to prove the income is not taxable.

A simple bank deposit analysis may reveal deposits with no reported source. The deposit analysis may lead to unreported hobby income or sales of securities. The taxpayer should be prepared to explain the source of the deposits. Loans, gifts, garage sales, inheritances, transfers from other accounts, employee business expense reimbursements, insurance proceeds, nontaxable damages, and U.S. savings bonds cashed for education can all explain an unidentified deposit.

Indirect Methods

The principal indirect methods are the net worth method, sources and applications of funds, sales markup, bank deposits, and unit volume computations. The IRS may use one or more of the above methods to reconstruct income or a different method for each year under examination. The taxpayer has no right to choose the method used.

Net Worth Method. This method is a balance sheet approach to estimating income. The simple premise is that net worth at the beginning of the period plus income equals net worth at the end of the period. The IRS may also add an estimate of nondeductible living expenses, since they are normally paid from taxable income. If the reported income cannot explain the increase in net worth plus living expenses, there must be an undisclosed source of income.

In Holland v. U.S. [75 S.Ct. 127 (1954)], the U.S. Supreme Court sanctioned the use of the net worth method. However, the court established several safeguards to protect the taxpayer from its misuse. First, the IRS must determine beginning net worth with reasonable certainty. A windfall for the IRS is when the taxpayer has just finished a bankruptcy proceeding and net worth can be established as zero. Second, the IRS must track down all relevant leads furnished by the taxpayer to explain the source of the unreported income and thus prove the taxpayer's innocence. Finally, the IRS must establish a likely source for the unexplained income or reasonably negate the possibility the income came from nontaxable sources.

Sources and Applications of Funds. This method is also called the cash expenditures method or the excess expenditures method. Sources and applications are generally useful when the taxpayer spends most of his or her income rather than purchases assets. Deductible expenses that are far out of proportion to reported income are an indication of unreported funds. The method is easier to use if there is little or no change in net worth and there are only one or two years in question. The basic premise is expressed in the formula: Total applications (expenditures) minus total sources of funds equals unreported income, unless the income number is negative. Sources of funds include increases in liabilities and noncash expenses. Applications include decreases in liabilities and personal living expenditures.

The IRS still must perform a net worth analysis to establish the taxpayer is not spending out of savings or liquidating investments. As in a net worth case, the IRS must investigate all reasonable leads and establish a likely source for the unreported income.

Percentage Markup. Also called the sales or unit markup method, this method is used only when a business is under examination. The first key to using the markup method is to establish with certainty either the cost of goods sold or some other key expenditure common to the industry. Then use the simple formula from financial accounting: Net sales less cost of goods sold equals gross margin. The second key is to establish an industry-wide percentage for gross margin or the key expenditure. If invoices from suppliers are available, e.g., $180,000 and industry gross margin is 70%, the cost of goods sold is 30%. Therefore, sales should be $600,000 ($180,000/30%). If the reported sales are significantly less than $600,000, closer examination is warranted.

The industry percentage must be carefully chosen to match the taxpayer's business for type of merchandise, size of business, rural vs. urban location, seasonal variations, and merchandising policies (e.g., high volume, low markup). If the taxpayer's business sells a variety of goods, the product mix must be taken into account.

Bank Deposits. This method is generally used when a business is examined or the IRS suspects the taxpayer operates a business without reporting income. To rely on the bank deposits method, the IRS must--

* establish the taxpayer engaged in an income-producing activity,

* establish the taxpayer made regular periodic deposits into an account, and

* make an adequate investigation to distinguish between taxable and nontaxable deposits.

Even if the IRS makes some classification errors, the court can still accept the overall use of the bank deposits method. The IRS assumes the taxpayer's gross income is the total of the deposits less obvious loan proceeds, transfers, and other nontaxable income. All business expenses, other allowable deductions, and exemptions are subtracted from gross income and the result is taxable income. Checks cleared through the account are the best source of business expenses. When there are cash deposits rather than check deposits, the IRS must establish the taxpayer's beginning cash position to meet its obligation of adequate investigation of nontaxable deposits.

Unit Volume Computation. Unit volume computation can be as simple as the "sheet count" to determine the number of hotel guests. At the other end of the spectrum, the IRS has used the amount of flour purchased and chemical analysis of pizzas to compute the dollar sales that should have been reported by a restaurant owner/operator. The audit training guide for small restaurants tells what kind of pizzas to purchase for analysis, how to obtain a past year's retail prices, how to sample a customer's pizza preferences, and how to use all that information to estimate sales.

Charges and Penalties

In addition to the tax imposed on unreported income, the IRS can levy fines and penalties. If the unreported income is from an unincorporated business activity, the taxpayer is also liable for the self-employment tax. Under IRC section 6673, the tax court may award damages to the IRS of up to $25,000 for delaying Tax Court proceedings or taking a frivolous or groundless position.

IRC section 6651 imposes penalties for failure to file a tax return and failure to pay tax. The limit of each penalty is 25% of the tax due. IRC section 6662 provides an accuracy-related penalty of 20% of the underpayment in tax. The penalty applies to any portion of an underpayment attributable to--

* a disregard of the rules or regulations,

* substantial understatement of income tax, or

* substantial valuation misstatement.

The IRC section 6662 penalty does not apply to an underpayment when a penalty is imposed under IRC section 6663, the civil fraud penalty. The penalty for civil fraud under IRC section 6663 is 75% of the underpayment attributable to fraud.

IRC section 7201 provides penalties for criminal fraud. Any person who willfully attempts in any manner to evade income tax is guilty of a felony and, upon conviction, shall be fined not more than $100,000 ($500,000 in the case of a corporation), or imprisoned not more than five years, or both, together with the costs of prosecution.

Under IRC section 6654, Failure to Pay Estimated Tax, interest based on the amount and period of underpayment, may also be assessed in addition to the tax owed. There are exceptions for the taxpayer who has paid at least 90% of the tax shown on the return or 100% of the tax on the preceding year's 12-month return.

Burden of Proof

When the IRS uses income reconstruction, it is usually attempting to show the taxpayer has intentionally omitted income either by understating income or failing to file a return. To impose the fraud penalty, the IRS must show the taxpayer knew the contents of the return when it was signed, knew that it was false, and filed the return with the fraudulent intent to evade tax. The IRS can also impose fraud penalties if the taxpayer failed to file a return.

The primary difference between civil and criminal fraud is the issue of willfulness. Both have the presence of specific intent to evade a tax. Civil fraud, however, contains no willful intent. Also, there is a different burden of proof depending on whether the IRS alleges civil or criminal fraud. In a civil case, the court only requires clear and convincing evidence of fraud. In a criminal case, the IRS must prove each element of a crime beyond a reasonable doubt. Acquittal from a criminal charge carries no weight in a subsequent civil trial, since the burden of proof is less. In addition, a guilty plea in a criminal trial prevents the taxpayer from contesting a charge brought in a civil trial.

The U.S. Supreme Court has held that willfulness requires actual knowledge an action is not in compliance with the law. Therefore, if a taxpayer actually believes a bonus check is not taxable, the taxpayer is not guilty of a crime [Cheek v. U.S., 111 S. Ct. 192 (1991)].

The IRC does not define fraud, but courts have provided guidelines. Fraud (civil or criminal) is an actual, intentional wrongdoing with the specific purpose to evade a tax believed to be owed [Mitchell v. Comr., 118 F.2d 308 (CA-5 1941)]. If the fraud can be proved to be willful, it is criminal. If there is specific intent but no willfulness, the fraud is considered civil (if fraud is asserted). Since willfulness is a state of mind, it is proved either by admissions made by the taxpayer or by circumstantial evidence. Willfulness may be inferred from conduct that has the likely effect to mislead or conceal. Conduct that establishes willfulness includes--

* maintaining a double set of books or records,

* making false entries,

* creating false documents,

* supplying false information to a return preparer,

* destroying records,

* concealing assets or sources of income,

* keeping a safe deposit box under an assumed name,

* claiming to be exempt from taxes, or

* failing to file tax returns.

However, understatement of income does not establish willfulness, unless it is part of a consistent pattern. The court also evaluates the taxpayer's education when determining willfulness. The higher the level of education or sophistication in business dealings, the more willfulness can be attributed to the acts listed above.

When the IRS uses income reconstruction to allege a deficiency and substantive evidence is introduced that shows the taxpayer received unreported income, the determination is presumed to be correct. The taxpayer must then prove the determination is incorrect and provide a nontaxable source for the unreported income. To rebut the presumption of correctness, the taxpayer must establish by a preponderance of the evidence that the determination is arbitrary, capricious, or erroneous [Delaney v. Comr., 743 F.2d 670 (CA-9 1984)]. If the taxpayer can show an error in the reconstruction, the presumption of correctness disappears, and the burden of proof returns to the IRS. The taxpayer need not establish the correct amount of the tax due, as in a refund suit (see below), only that the income reconstruction was erroneous.

Finally, in a tax refund case, there is a presumption of correctness attached to the findings of the commissioner. The taxpayer must not only overcome that presumption, but also establish the specific amount of the refund claimed [Welch v. Helvering, 54 S.Ct. 8 (1933)]. The taxpayer has the burden of presenting "substantial evidence" to persuade the court to set aside the IRS's findings.

Income Reconstruction Defenses

To prove an error exists in the income reconstruction and contest the deficiency or the amount of a refund, taxpayers have used several tactics. It is important for the taxpayer to focus on errors made by the IRS in applying the income reconstruction method, not the theory behind the method. All of the court-accepted methods are based on sound accounting principles.

While lost or stolen records do not lessen the burden of showing the reconstruction was arbitrary or erroneous, the taxpayer can still be successful. When there are no records because of an innocent loss, the court will accept credible testimony. Testimony as to how the records were lost is important. If testimony can demonstrate the records would have shown the IRS's reconstruction to be arbitrary, capricious, or erroneous, the presumption of correctness may be overcome. The court may reject the income reconstruction, adjust the deficiency, or allow estimates under the Cohan rule.

Net Worth Method. A common defense against the net worth method is that the opening net worth is too low. Taxpayers often claim the existence of a cash hoard that was not taken into account by the IRS. To be successful, the taxpayer must demonstrate a credible source for the cash hoard. Circumstantial evidence such as regularly conducting business in cash, need for cash on a regular basis, documented distrust of banks, and a large cash expenditure before the examination period, can all lend credence to a cash hoard defense. In addition, the taxpayer may be able to show there are other assets not included in the beginning net worth, e.g., inventory on consignment, receivables, or assets owned by the taxpayer but held by a third party.

The difference between beginning and ending net worth represents income. This income is reduced by the amount of any reported taxable and nontaxable income received by the taxpayer. The alleged unreported income can be reduced by the amount of any gifts, inheritances, tax exempt interest, capital loss carryovers, and loans not taken into account by the IRS. The taxpayer may also assert the IRS has overestimated personal living expenses or other nondeductible expenses, thereby reducing the amount of income to be explained.

Sources and Applications of Funds. The IRS must establish what funds were available to the taxpayer at the beginning of the year, funds acquired during the year, and then show the expenditures exceed the sum of those funds. As in the net worth method, the IRS must investigate all reasonable leads provided by the taxpayer as to nontaxable sources of funds and establish a likely source for the unreported income.

Again, the taxpayer may attempt to prove the beginning funds balance was understated because of a cash hoard or the existence of assets later sold for cash but not included in the analysis by the IRS.

Percentage Markup. This method has several weaknesses because the basis for comparison is an industry average. The taxpayer may claim IRS calculations do not take into account actual breakage, shoplifting, or employee theft. Also, asset size often explains differences in financial ratios. Location, the age of assets, new competition entering the market, experience of the operator, liberal discount policy, and product mix, can all account for a taxpayer failing to achieve industry profit margins.

Bank Deposits. As with the net worth method, the IRS must determine the taxpayer's beginning position and investigate leads offered by the taxpayer to explain nontaxable sources of cash. The best defense against this method is an alternative nontaxable source of the deposits. Sources such as loans, gifts, inheritances, transfers from other accounts, life insurance proceeds, sale of assets at a loss, tax exempt bond interest, or reimbursement for past expenditures can all explain deposits. However, testimony without corroborating evidence will not usually overcome the presumption of correctness attached to the reconstruction. Another defense is that the deposits are misclassified and actually belong to another tax year. Alternatively, the taxpayer may attempt to show that income related to the deposits was included on the return.

Unit Volume Computation. To contest this method, the taxpayer may show that volume assumptions used are not true for the taxpayer's business. The taxpayer may dispute the number of pizzas per bag of flour or drinks per quart of liquor as arbitrary and not realistic given the conditions of the taxpayer's business. The taxpayer may be able to document two-for-one marketing plans or losses due to poor employee training and high turnover to dispute the calculation of units sold. Sale of inventory in bulk for catering or to other businesses or abnormal employee theft or breakage can explain lower than average unit volume sales. *

Charles E. Price, PhD, CPA, is an associate professor at Auburn University. Leonard G. Weld, PhD, CPA, is chair, Department of Accounting and Finance, at the University of Texas at Tyler.