31.08 NET WORTH ASSETS

31.08[1] Reflected at Cost -- Generally

      As a general rule, when establishing the net worth of a taxpayer, 

assets are reflected at cost and not at fair market value.  Thus, if a 

taxpayer buys a house for $50,000, the house is reflected as a net worth 

asset at $50,000, even though the house may be worth $100,000 in the year 

for which the taxpayer's net worth is being determined.

      Assets are generally reflected in a net worth statement at cost 

because the net worth method is concerned not with value (which may result 

from appreciation rather than the receipt of taxable income) but only with 

actual costs and expenditures.  

United States

 v. O'Connor, 237 F.2d 

466, 473 n.6 (2d Cir. 1956).  See 

United States

 v. Terrell, 

754 F.2d 1139, 1145 (5th Cir. 1985) (using a cost basis to determine net 

worth means that assets preexisting the indictment period are a source of 

nontaxable funds only to the extent of  basis); Hayes v. United 

States, 407 F.2d 189 (5th Cir. 1969) (cost of partially constructed 

apartments taken from defendant's income tax return, and cost of land based 

on information furnished by the defendant's accountant).

      As an exception to this general rule, cost is not used when the 

Internal Revenue Code dictates that a basis other than cost be used in 

determining tax consequences.  For example, if services are paid for in 

property, then the fair market value of the property is included as 

compensation in gross income.  Treas. Reg. § 1.61-2(d) (26 C.F.R.).  In 

this situation, property received in exchange for services would be 

reflected at its fair market value in the net worth computation.  For other 

examples of situations where an asset would be reflected at a figure other 

than cost, see 26 U.S.C. § 1014(a) (basis of property acquired 

from a decedent is the fair market value of the property at the date of the 

decedent's death); 26 U.S.C. § 1015 (basis of property acquired by 

gifts and transfers in trust).

31.08[2] Across the Board Assets

      An across the board asset is an asset which the taxpayer owned in the 

opening year and  continued to own throughout the prosecution years, with no 

increase or decrease in the cost of the asset.  Since a net worth 

computation measures changes, an across the board asset does not affect a 

taxpayer's net worth.  For example, assume that the prosecution years are 

1995 through 1998, and the defendant purchased stock for $10,000.00 in 1994 

and still owned the same stock at the end of 1998.  There would be no change 

in the basis of the stock, and the effect on the defendant's net worth would 

be zero.  Because an across the board asset does not affect the net worth 

computation, it has been held that it is not error to leave such an asset 

out of the net worth computation. 

United States

 v. Mackey, 345 F.2d 

499, 505 (7th Cir. 1965).

       It is not necessary for the government to establish the basis for 

every asset the taxpayer owns.  

United States

 v. Schafer, 580 F.2d 

774, 778 (5th Cir. 1978).  It is sufficient for the government to identify 

with reasonable specificity the basis in every asset, including cash, in 

which a purchase or sales transaction occurred in the tax years in question. 

Schafer, 580 F.2d at 778.  Note, however, that in Schafer, the 

court assumed that possible omitted assets were across the board assets.

      In 

United States

 v. Tolbert, 406 F.2d 81, 84 (7th Cir. 1969), 

the government's net worth computation reflected the defendant's accounts 

receivable as an across the board asset for all of the years in question.  

The government figure was based on a statement the defendant had given the 

agents. There was testimony at the trial that the accounts receivable had 

increased during the prosecution years.  The court rejected the defendant's 

argument that it was reversible error not to reflect the alleged increase,  

observing that if the accounts receivable did increase during the 

prosecution years, the error in failing to reflect the increase was in the 

defendant's favor and did not prejudice him.  The court found that there 

would be prejudice only if the evidence showed that the accounts receivable 

had decreased during the prosecution years.  Tolbert, 406 F.2d at 84.  

See also United States v. Scrima, 819 F.2d 996, 999 

(11th Cir. 1987) ("government employed the floating cash or dash formula 

where cash is an unknown but constant factor throughout the net worth 

period"); United States v. Terrell, 754 F.2d 1139, 1145 (5th Cir. 

1985); 

United States

 v. Dwoskin, 644 F.2d 418, 421 (5th Cir. 1981).

31.08[3] Bank Accounts and Nominee Accounts

      Money in the bank represents an asset in a net worth computation.  In 

the usual situation, it is a relatively simple matter to determine how much 

money the defendant had in the bank at the end of each year, with the 

balance being reflected in the net worth statement.  However, all 

outstanding checks should be subtracted from the end of the year bank 

statement balance otherwise the  balance would be inflated.  United 

States v. Vardine, 305 F.2d 60, 65 (2d Cir. 1962).  Similarly, deposits 

in transit are added to the end of the year statement balance.

      In a number of instances, the taxpayer will have maintained bank 

accounts in the names of family members or in the names of third-party 

nominees.  It must then be determined whether the money in the account was 

supplied by the defendant.  If so, the bank balances are included in the 

defendant's net worth. This was the case in 

United States

 v. 

Balistrieri, 403 F.2d 472, 479 (7th Cir. 1968), vacated and remanded 

on other grounds, 395 U.S. 710 (1969), aff'd after remand, 436 

F.2d 1212 (7th Cir. 1971).  There, the defendant attacked the propriety of 

including cash that had been deposited in the bank in his name and the name 

of his nineteen-year old son in the defendant's net worth computation.  

Rejecting the defendant's argument, the court found that the jury had ample 

grounds to believe that the money was in fact the defendant's, since the 

government proved that the defendant controlled the account and withdrew a 

substantial amount from it.  Balistrieri, 403 F.2d at 479.  

See also Talik v. United States, 340 F.2d 138, 141 (9th 

Cir. 1965) (attributing entire balance in account to defendant was justified 

because either the account belonged to defendant or any money belonging to 

the daughter was a gift from her parents).

31.08[4] Assets and Liabilities of Husband and Wife or Children

      In determining a defendant's opening net worth, consideration must be 

given to assets and liabilities of a non-defendant spouse and children.  

Such assets and liabilities need not be included in the government's 

computation where the net effect of inclusion would be de minimis.  The 

government, however, must have investigated  a spouse's and/or child's 

assets and liabilities before deciding not to include  them in the 

computation.  

United States

 v. Goichman, 407 F. Supp. 980, 995-96 

(E.D. Pa.), aff'd, 547 F.2d 778 (3d Cir. 1976).

      A failure to conduct such an investigation of the defendant's spouse 

resulted in a reversal in United States v. Meriwether, 440 F.2d 753 

(5th Cir. 1971).  The court held that the government failed to establish 

with reasonable certainty a definite opening net worth of the joint income 

of Meriwether and his wife, saying that the government "came near ignoring 

Mrs. Meriwether."  Meriwether, 440 F.2d at 755.

      The Ninth Circuit appears to disagree with the Fifth Circuit, however, 

holding that the government is not required to establish the net worth of 

the defendant's spouse as part of its prima facie case.  

United States

 v. 

Hallman, 594 F.2d 198, 200 (9th Cir. 1979).  Instead, the government's 

duty to investigate spousal assets only arises under its obligation to 

negate reasonable explanations or leads furnished by the defendant. 

Hallman, 594 F.2d at 200.  However, unless merited by the particular 

circumstances of a given case, consideration always should be given to the 

assets and liabilities of a spouse.

      A somewhat different issue is whether the government can use a joint 

net worth statement for both husband and wife.  The Fifth and Sixth Circuits 

have answered in the affirmative.  In 

United States

 v. Brown, 667 

F.2d 566 (6th Cir. 1982), both husband and wife were tried and convicted of 

income tax evasion.  The court concluded that the government's use of a 

joint net worth statement was "justified," even though the wife was the 

nominal owner of the business that was the source of the unreported income, 

because "the financial affairs of the two defendants were so intertwined as 

to justify a joint reconstruction of their income."  Brown, 667 F.2d 

at 568.

      In a non-defendant spouse case, United States v. Giacalone, 574 

F.2d 328 (6th Cir.1978), the government's evidence showed that the 

defendant's wife earned no income prior to and during the prosecution years, 

that she made some nondeductible expenditures with funds furnished by her 

husband, and that she and her husband filed joint returns.  Because the 

defendant was charged with attempting to evade taxes owed by both him and 

his wife, and "her financial transactions were intertwined with those of her 

husband," the court approved the government's use of a joint net worth 

statement.  Giacalone, 574 F.2d at 333.

      In 

United States

 v. Smith, 890 F.2d 711, 714 (5th Cir. 1989), 

the Fifth Circuit relied on Brown and Giacalone in rejecting a 

defendant's claim that the government was required to exclude assets of the 

defendant's spouse and child to ensure the accuracy of the net worth 

analysis.  In Smith, the government excluded both the income of the 

defendant's daughter and gifts to the defendant's wife and daughter before 

arriving at a final net worth determination of the defendant and his spouse.  

The court stated that the "fabric of the financial blanket is so closely 

woven that a computation of net worth on the joint income of the spouses is 

clearly permissible."  Smith, 890 F.2d at 714.

31.08[5] Real Property

      Real property is reflected in the net worth computation at cost, 

unless the realty falls within one of the exceptions, such as realty 

received as an inheritance.  Where cost cannot be established by direct 

evidence, a determination should be made whether the realty was purchased or 

sold at a time when revenue stamps were affixed to deeds pursuant to a 

federal statute which imposed a tax on deeds.  26 U.S.C. § 4361, 

repealed.  If the realty was purchased or sold at a time when the tax on 

deeds was in effect, the revenue stamps can be used to compute the sales 

price of the realty.  

United States

 v. 18.46 Acres Of Land, Etc., 312 

F.2d 287, 289 (2d Cir. 1963); 
Dickinson
 v. 

United States

, 154 F.2d 

642, 643 (4th Cir. 1946); Ramming Real Estate Co. v. 

United States

, 

122 F.2d 892, 895 (8th Cir. 1941).  On occasion, state stamps can also be 

used to compute the sales price.

      Jointly owned property is especially common in the case of a husband 

and wife.  For an example of a jointly owned asset properly included in full 

in the defendant's net worth, see O'Connor v. 

United States

, 

203 F.2d 301, 303 (4th Cir. 1953).  See also 

United States

 

v. Costello, 221 F.2d 668, 672 (2d Cir. 1955), aff'd, 350 

U.S.

 

359 (1956); United States v. Johnson, 319 

U.S.

 503, 516 (1943) (jury 

could find that a string of gambling houses ostensibly conducted as separate 

enterprises by co-defendants was in fact a single, unified gambling 

enterprise owned by one defendant).

      Finally, note that records of documents affecting an interest in 

property and statements in documents  affecting an interest in property may 

be admissible as exceptions to the hearsay rule.  Fed. R. Evid. Rules 

803(14) and (15).

31.08[6] Partnership Interest

      When the taxpayer has invested money in a partnership, the taxpayer's 

share of the partnership capital is reflected as an asset.  

United States

 

v. Mancuso, 378 F.2d 612, 614-15 (4th Cir.), amended, 387 F.2d 

376 (4th Cir. 1967).  In Mancuso, the government had little direct 

evidence to establish the percentage interest the defendant had in the 

partnership.  Therefore, the government allocated an equal share of the 

partnership capital to all the partners, including the defendant, which 

corresponded to the distribution of profits as reported on the partnership 

tax returns.  The government agent testified that this "conformed to the 

ordinary legal presumption that in absence of evidence of an agreement to 

the contrary the partners' interests are equal."  Mancuso, 378 F.2d 

at 616.

31.08[7] Errors in Net Worth Computation

      If there is an error in the net worth computation for one of the 

prosecution years, the error will not necessarily affect other prosecution 

years. 

United States

 v. Keller, 523 F.2d 1009, 1012 (9th Cir. 1975) 

(error did not carry over to a subsequent year since the asset was disposed 

of in the prior prosecution year).  Moreover, even if an error does affect 

all of the prosecution years, the government is not required to prove its 

case to a mathematical certainty.  If a substantial understatement remains 

after accounting for the error, then a guilty verdict will be upheld.  

Keller, 523 F.2d at 1012.

---

                        31.09 LIABILITIES

      The government must present evidence of a defendant's liabilities.  

These liabilities are subtracted from assets in arriving at a taxpayer's net 

worth. As with assets, the defendant's liabilities must be established with 

reasonable certainty. 

      For examples of evidence establishing liabilities, see 

United States

 v. Schafer, 580 F.2d 774, 780 (5th Cir. 1978); Beard 

v. 

United States

, 222 F.2d 84, 89 (4th Cir. 1955)..  Testimony by the 

investigating agent as to the amount of a liability, without independent 

documentation or third-party testimony, is inadmissible hearsay.  See 

United States v. Morse, 491 F.2d 149, 153-55 (1st Cir. 1974) (a bank 

deposits case, but the principle is applicable to a net worth case).  

      On the other hand, when the agent's investigation reveals that there 

were no liabilities, the agent can testify to the negative finding.  It is 

not hearsay.  

United States

 v. Dwoskin, 644 F.2d 418, 423 (5th Cir. 

1981); Morse, 491 F.2d at 154 n.8;.  Otherwise stated, a witness may 

testify as to his or her failure to find records after a search. United 

States v. Lanier, 578 F.2d 1246, 1255 (8th Cir. 1978); 

United States

 

v. Robinson, 544 F.2d 110, 114-15 (2d Cir. 1976); 

United States

 v. 

Jewett, 438 F.2d 495, 497-98 (8th Cir. 1971); 

United States

 v. 

DeGeorgia, 420 F.2d 889, 891-92 (9th Cir. 1969); Charron v. United 

States, 412 F.2d 657, 660 (9th Cir. 1969); McClanahan v. United 

States, 292 F.2d 630, 637 (5th Cir. 1961) ("[t]his, in fact, is 

frequently the only way in which a negative fact can be proved").See 

also Fed. R. Evid. Rules 803(7) and 803 (10).

      As a general rule, when the defendant is a cash basis taxpayer, the 

net worth computation does not include accrued liabilities.  United 

States v. Balistrieri, 403 F.2d 472, 479 (7th Cir. 1968), vacated and 

remanded, 395 U.S. 710 (1969), aff'd after remand, 436 F.2d 1212 

(7th Cir. 1971).  On the other hand, if the defendant has received cash or 

property in exchange for a liability, then the asset and liability are both 

included in the net worth computation whether the defendant is on a cash or 

accrual basis.  For example, if the defendant buys a house in exchange for a 

mortgage, the house would be shown as an asset and the mortgage as a 

liability.

---

                31.10 NONDEDUCTIBLE EXPENDITURES

31.10[1] Added to Net Worth Increase

      After subtracting the ending net worth from the starting point, the 

resulting net worth increase is further adjusted by adding to the increase 

the taxpayer's nondeductible expenditures during the year, including living 

expenses, for items which are not reflected as assets on the net worth 

statement. 
Holland
 v. 
United States
, 348 

U.S.

 121, 125 (1954); 

United States

 v. Terrell, 754 F.2d 1139, 1144 (5th Cir.1985); 

United States v. Hamilton, 620 F.2d 712, 714 n.1 (9th Cir. 

1980);

United States

 v. Skalicky, 615 F.2d 1117, 1119 (5th Cir. 1980); 

United States v. Hiett, 581 F.2d 1199, 1200 n.1 (5th Cir. 1978); 

United States v. O'Connor, 237 F.2d 466, 473 n.7 (2d Cir. 1956).  "The 

taxpayer's nondeductible expenditures are added to the adjusted net values 

of the defendant's assets at the end of the subject year and, consequently, 

increase the figure to be compared with the opening net worth."  

Hamilton

, 620 F.2d at 716.  See also, 

United States

 

v. Scrima, 819 F.2d 996, 999 (11th Cir. 1987).

31.10[2] Burden on Government

      The government has the burden of establishing that the expenditures 

added to the net worth increase are nondeductible expenditures, as opposed 

to deductible expenses such as business expenses. Any addition to the net 

worth increase must be limited to nondeductible expenditures.  Fowler v. 

United States

, 352 F.2d 100, 103 (8th Cir. 1965).  The government must 

establish the nature of an expenditure by independent documentary or 

testimonial evidence. Greenberg v. 

United States

, 280 F.2d 472 (1st 

Cir. 1960) (agent's testimony regarding expenses insufficient to establish 

nature of expenditure). 

      It is improper to designate an expenditure as personal based solely on 

a review of the taxpayer's checks by the investigating agent and the agent's 

testimony that a check is either for a personal or business purpose.  The 

agent's testimony is hearsay.  See Siravo v. 

United States

, 

377 F.2d 469, 474 (1st Cir. 1967) (third parties testified and the court 

"was careful to exclude testimony by the special agent as to conversations 

with others"); Johnson v. United States, 325 F.2d 709, 711 (1st Cir. 

1963).

      Admissions by the defendant may establish whether expenditures are 

personal or business.  Checks with a notation of "personal" written on them 

constitute a pre-offense admission.   Fowler, 352 F.2d at 103.   

See also United States v. Altruda, 224 F.2d 935, 939 

(2d Cir. 1955) (admitted personal living expenses were added to the net 

worth increases).

      Finally, a nondeductible expenditure made by or on behalf of a spouse, 

children, or any third party can be added to the defendant's net worth 

increase where it can be shown that the defendant furnished the funds for 

the expenditure. 

United States

 v. Giacalone, 574 F.2d 328, 333 (6th 

Cir. 1978) (government proof traced a number of nondeductible expenditures 

by the wife to funds furnished by the defendant); Ford v. United 

States, 210 F.2d 313, 317 (5th Cir. 1954); .  Cf. United 

States v. Lawhon, 499 F.2d 352, 355-56 (5th Cir. 1974) (citrus groves 

and certificates of deposit in the names of children); 

United States

 v. 

Balistrieri, 403 F.2d 472, 479 (7th Cir. 1968), vacated and remanded 

on other grounds, 395 U.S. 710 (1969), aff'd after remand, 436 

F.2d 1212 (7th Cir. 1971) (bank account in name of defendant and his minor 

son).

31.10[3] Nondeductible Expenditures -- Examples

      Proof of  non-deductible expenditures -- such as food, clothing, 

      shelter and gifts -- is one factor in the net worth and expenditures 

      method of proof. . . . Government tax experts routinely add living 

      expenses to their net worth schedules.

United States

 v. Scott, 660 F.2d 1145, 1173 (7th Cir. 1981). 

See 
United States
 v. 

Hamilton

, 620 F.2d 712, 716 (9th Cir. 

1980).

      In Scott, the only daily living expense the government included 

in its net worth calculation was food.  As Attorney General of the State of 

Illinois

, Scott traveled on state business and his travel vouchers were used 

as a basis for arriving at his unreimbursed food expenditures. Scott, 

660 F.2d at 1151.  In addition to food expenses, the government's net worth 

computation included cash travel expenses for personal trips that the 

government was able to document and the purchase of a stamp collection and a 

diamond ring.  Scott, 660 F.2d at 1150-51.

      Living expenses can be based on estimates provided by the taxpayer.  

In United States v. Burdick, 214 F.2d 768, 770 n.6 (3d Cir. 1954), 

vacated, 348 U.S. 905 (1955), aff'd on remand, 221 F.2d 932 

(3d Cir. 1955), the government estimated the defendant's living expenses at 

$2,000 a year on the basis of the defendant's admission that he spent $20 to 

$25 a week for  household expenses alone.  See also United 

States v. Doyle, 234 F.2d 788, 794 (7th Cir. 1956) (expenditures for 

living expenses arrived at largely from defendant's own statements).

      Another method of establishing living expenses is to rely on  

"independent estimates from the Bureau of Labor on what a person with (the 

taxpayer's) reported income and family and financial obligations would be 

expected to spend on non-deductible items."  

Hamilton

, 620 F.2d at 

716.  Caution must be exercised, however, in using Bureau of Labor 

statistics estimates.  The estimates are broken down into categories, such 

as food, clothing, household operations, alcohol, tobacco, gifts, and 

contributions, etc.  The items selected for net worth purposes should be 

limited to necessities such as food, household operations, and clothing.  

Estimates of expenditures subject to greater variation, such as for 

recreation, transportation, and similar items, should not be used. Personal 

insurance premiums and federal income taxes paid by a taxpayer may also  be 

added to the net worth increase.  Dawley v. 

United States

, 186 F.2d 

978, 980 (4th Cir. 1951).  In Armstrong v. 

United States

, 327 F.2d 

189, 192 (9th Cir. 1964), nondeductible expenditures included living 

expenses, payment of insurance premiums, fees paid to an attorney, bond 

premiums, and other nondeductible expenditures.  Automobiles, antiques, and 

travel were added to the net worth increase as nondeductible expenditures in 

United States

 v. Sorrentino, 726 F.2d 876, 880 (1st Cir. 1984).  

Gifts, vacation trips, payments for a maid, and gifts for a spouse and third 

parties are further examples of nondeductible expenditures. 

United States

 

v. Goichman, 407 F. Supp. 980, 989 (E.D. Pa.), aff'd, 547 F.2d 

778 (3d Cir. 1976).

      Where the government is unable to trace expenditures for household 

goods or services, personal entertainment, or personal care items, the jury 

can properly conclude that the defendant must have incurred some expenses 

for these items and that these expenses would have added to the defendant's 

net worth increase and expenditures, beyond what the government proved. 

Scott, 660 F.2d at 1151.  Omitting personal expenditures for food and 

clothing does not permit the jury to improperly speculate as to the 

defendant's personal expenses.  

United States

 v. Notch, 939 F.2d 895, 

900 (10th Cir. 1991).  In Notch, the Tenth Circuit recognized that 

"[t]his conservative approach to the net worth computation made the analysis 

appear more credible" and can be viewed "as showing that the jury need not 

consider personal expenses in order to conclude that defendant understated 

his income."  Notch, 939 F.2d at 900.

      Note that there is a difference in the net worth treatment when living 

expenses are to be used in determining cash on hand in the opening net worth 

as opposed to expenditures for living expenses made in a prosecution year.  

When the purpose is to determine the opening cash on hand of the taxpayer, 

living expenses and other expenditures are subtracted from the available 

resources of the taxpayer in determining whether the taxpayer expended all 

or part of what might otherwise constitute cash on hand.  When the purpose 

is to reflect the increase in wealth of the taxpayer, living expenses and 

other nondeductible expenditures in a prosecution year are added to the net 

worth increase,. 

---

                  31.11 REDUCTIONS IN NET WORTH

      The purpose of the net worth computation is to arrive at taxable 

income, and the computation therefore must reflect taxable consequences.  

Therefore, nontaxable items received by the taxpayer during the prosecution 

period must be eliminated or accounted for in the net worth computation.  

The following types of nontaxable items must be subtracted from the total 

reflecting the net worth increase and nondeductible expenditures:  gifts 

received, inheritances, nontaxable pensions, the nontaxable portion of 

capital gains, veterans benefits, dividend exclusions, tax-exempt interest, 

proceeds from life insurance, and any other nontaxable items.  

      An example of the treatment of such an item is found in United 

States v. Holovachka, 314 F.2d 345, 355 (7th Cir. 1963).  In that case, 

the defendant had purchased bonds for investment purposes and received 

monies during the prosecution year representing the repayment of principal 

and nontaxable interest:

      Government treated the principal repayments as a tax free return of 

      capital which correspondingly decreased defendant's investments in 

      such bonds for those years.  The yearly interest payments received on 

      these bonds were considered to be tax free and were accordingly 

      deducted from defendant's net worth.  The trial court properly 

      instructed the jury that the repayments of principal and the earned 

      interest constituted non-taxable income.

Holovachka, 314 F.2d at 355.  

      Technical items and items that are clearly not fraudulent are also 

deducted from the taxpayer's computed net worth.  Thus, the underreporting 

of an income item as the result of an inadvertent error of the defendant or 

his accountant should not be charged to the defendant.  Any such item is 

subtracted, or otherwise accounted for, in arriving at taxable income.  

      In 

United States

 v. Altruda, 224 F.2d 935, 940 (2d Cir. 1955), 

the defendant's accountant explained to the examining agent prior to trial 

that the defendant had made "errors" in underreporting income from realty 

holdings, and the defendant was given credit for these amounts in the 

government's net worth computation.  In 

United States

 v. Allen, 522 

F.2d 1229, 1231 (6th Cir. 1976), a technical adjustment was made, reducing 

the net worth computation to allow for an error discovered in one of the 

adding machine tapes used in preparing the defendant's return.  The net 

effect was that the adjustment allowed the entire deduction claimed by the 

defendant on his return, and the defendant was not charged with the error in 

the net worth computation.

---

     31.12 ATTRIBUTING NET WORTH INCREASES TO TAXABLE INCOME

31.12[1] Generally

       The net worth method of proof requires evidence supporting "the 

inference that the defendant's net worth increases are attributable to 

currently taxable income."  
Holland
 v. 
United States
, 348 

U.S.

 121, 

137 (1954); 

United States

 v. Dwoskin, 644 F.2d 418, 422 (5th Cir. 

1981); 

United States

 v. Hom Ming Dong, 436 F.2d 1237, 1241 (9th Cir. 

1971); 

United States

 v. Mackey, 345 F.2d 499, 506 (7th Cir. 

1965); . Increases in net worth, standing alone, cannot be assumed to be 

attributable to currently taxable income.

      There are two ways of supporting an inference that net worth  

increases are attributable to currently taxable income:

      1.    Proof of a likely source of taxable income.  

Holland

, 348 

            

U.S.

 at 137-38.

      2.    Negating non-taxable sources of income.  

United States

 

            v. Massei, 355 

U.S.

 595 (1958).

Either method is sufficient.  See also 

United States

 v. 

Sorrentino, 726 F.2d 876, 879-80 (1st Cir. 1984); 

United States

 v. 

Scott, 660 F.2d 1145, 1151 (7th Cir. 1981); Dwoskin, 644 F.2d at 

422; 

United States

 v. Grasso, 629 F.2d 805, 807-08 (2d Cir. 1980); 

United States

 v. Hiett, 581 F.2d 1199, 1201 (5th Cir. 1978).

31.12[2] Proof of Likely Source of Taxable Income

      The government can establish a likely source of taxable income through 

direct or circumstantial evidence.  The applicable rule requires "proof of a 

likely source, from which the jury could reasonably find that the net worth 

increases sprang."  
Holland
 v. 
United States
, 348 

U.S.

 121, 138 

(1954).  It is not necessary for the government to prove by direct evidence 

that the unreported income reflected by the net worth computation, in fact, 

came from the likely source established.  

United States

 v. Mackey, 

345 F.2d 499, 506-07 (7th Cir. 1965).  See also United 

States v. Smith, 890 F.2d 711, 714 (5th Cir. 1989) (likely source of 

income could be indicated by business operations, mineral interests, real 

estate, stocks, bonds, commodities, and gambling); 

United States

 v. 

Greene, 698 F.2d 1364, 1373 (9th Cir. 1983) (the government need not 

prove a  specific source, but only a likely source, and evidence established 

real estate sales, interest income on loans, and unreported securities 

transactions as likely sources of taxable income); 

United States

 v. Hom 

Ming Dong, 436 F.2d 1237, 1241-42 (9th Cir. 1971) (grocery store 

ownership provided likely source); United States v. Costello, 221 

F.2d 668, 671-72 (2d Cir.), aff'd, 350 U.S. 359 (1956) (the evidence 

established that the defendant was a gambler and "gambling is an occupation 

with indeterminate possibilities").

      Likewise, the government does not have to show that the likely source 

was capable of generating the entire amount of unreported income charged in 

the indictment.  

United States

 v. Costanzo, 581 F.2d 28, 33 (2d Cir. 

1978).  The court found that extensive proof supported the inference that 

the defendant's bakery was a likely source of  unreported taxable income 

because the bakery was large enough to generate substantial amounts of 

unreported cash receipts.  Costanzo, 581 F.2d at 33.  Evidence of 

specific items of unreported income is admissible to show a likely source 

from which the net worth increases may have come.  
Holland
, 348 

U.S.

 

at 138; United States v. Schafer, 580 F.2d 774, 777 n.5 (5th Cir. 

1978). See also 
United States
 v. 

Hagen

, 470 F.2d 110, 111 

(10th Cir. 1972), in which the defendant claimed surprise and argued that 

the government introduced evidence as to specific items of unreported income 

to an extent that the specific items proof "changed the theory of the case 

or in any event overshadowed the net worth proof."  The court noted that the 

specific items evidence assumed such a large role at the trial that "at the 

end it became difficult to say whether it still was a net worth case."  

Hagen

, 470 F.2d at 112.  But the court continued:

      In any event the Government followed and met the requirements of 

      
Holland
 v. 

United States

.  The evidence of specific items was 

      proper as indicated to show wilfulness, but it was also proper to show 

      a likely source under Smith v. United States, 348 

U.S.

 147, 75 

      S.Ct. 194, 99 L.Ed. 192 and 
United States
 v. Calderon, 348 

U.S.

 

      160, 75 S.Ct. 186, 99 L.Ed. 202.

470 F.2d at 113.  

      In a situation such as that in 

Hagen

, problems as to the 

government's method of proof can be avoided by clearly designating in a 

response to a motion for a bill of particulars the method of proof to be 

relied upon by the government, such as, net worth method and specific items 

method, or net worth method corroborated by specific items of unreported 

income.

      Once the government has introduced evidence of a likely source of 

taxable income, the government has no burden to negate all possible 

nontaxable sources of the unreported income.  While the government does have 

a duty to check out reasonable leads, when the defendant furnishes no leads, 

"the Government is not required to negate every possible source of 

nontaxable income, a matter peculiarly within the knowledge of the 

defendant."  
Holland
 v. 
United States
, 348 

U.S.

 121, 138 (1954).  

Caution must be exercised in following this principle, however, because the 

government has an obligation in net worth cases to conduct a thorough 

investigation, which would include searching for nontaxable sources of 

income.  

      Once a likely source is established,  the government does not have to 

show that it has investigated "the many possible nontaxable sources of 

income, each of which is as unlikely as it is difficult to disprove."  

Holland
, 348 

U.S.

 at 138.  The government is not limited to showing a 

single likely source of taxable income but can introduce evidence of as many 

possible sources of taxable income as the investigation has developed. 

See, e.g., Feichtmeir v. United States, 389 F.2d 498, 

502 (9th Cir. 1968) (evidence showed the defendant had interests in eight 

operating businesses, investments in real estate, a trust deed, a joint 

venture, stocks and bonds, and an undisclosed Mexican source of income).

31.12[3] Illegal Sources of Income

      There is no requirement that the likely source of income be a legal 

source. James v. 
United States
, 366 

U.S.

 213 (1961).  "[G]ross income 

means all income from whatever source derived . . . ."  26 U.S.C. § 61. 

      Due to the possibility of undue prejudice, courts closely examine 

evidence of an illegal source of income.  See, e.g., United 

States v. Tunnell, 481 F.2d 149, 151 (5th Cir. 1973) (likely source of 

the defendant's net worth increases could have been income from prostitution 

activities at a motel the defendant operated).  When the likely source of 

income is illegal, the evidence must present more than suspicion and 

innuendo. See Ford v. 

United States

, 210 F.2d 313, 317 (5th 

Cir. 1954) (reversing a police chief's tax evasion conviction because 

testimony as to payoffs by prostitutes was not connected to the defendant).  

But see 
United States
 v. 

Windham

, 489 F.2d 1389, 1391 

(5th Cir. 1974) (stating that Ford conviction was reversed because of 

the speculative, hearsay nature of the testimony, not because of its 

content). 

      Likewise, it must be clear that the purpose of introducing evidence of 

illegal activities is to establish a likely source of income, and the 

evidence must not be introduced or alluded to in a manner calculated to 

inflame the jury. In 

United States

 v. Abodeely, 801 F.2d 1020 (8th 

Cir. 1986), the government presented evidence that the defendant derived his 

unreported income from illegal prostitution and from legal gambling 

activities.  After a lengthy discussion of the Rule 403 probative/prejudice 

balancing test, the court concluded that it had:

      [N]o conceptual difficulty with the evidence concerning prostitution. 

      While it is certainly prejudicial, it is highly probative of 

      unreported taxable income.  The gambling evidence, while having less 

      direct probative value, is much less prejudicial, and indeed if its 

      admission was error (which this court does not conclude), the error 

      was harmless beyond a reasonable doubt.  After all, having been shown 

      that Abodeely ran a bar and a brothel, even the most straitlaced 

Iowa

 

      jury would hardly have been adversely affected by a showing of his