Examination of Income

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Examination of Income

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4.10.4  Examination of Income

4.10.4.1  (06-01-2004)
Overview

  1. The purpose of this section is to provide guidance for the examination of income. It includes the minimum income probe requirements for all types of returns, in-depth examination techniques, and formal indirect methods. See IRM 4.10.4.3.5 for instructions regarding income probes for nonfilers and delinquently filed returns.
  2. An examination of income is conducted to determine whether taxable income has been accurately reported on the tax return. The steps taken in an examination are dependent on the facts and circumstances, and therefore, the audit strategy for completing the examination of income must remain dynamic. Consideration should be given to tax return information, responses to interview questions, the taxpayer’s books and records, and other financial information when completing an examination of income. As new information becomes available, the audit plan should be adjusted accordingly; examiners should use their judgment when determining the depth of the examination of income.
  3. It is advisable to include a statement on the initial IDR indicating that the examiner may request additional records as the examination progresses. This will help prevent any potential misunderstanding about the scope and depth of the examination of income.
  4. Examinations of income for all business tax returns should incorporate industry-based audit techniques. Audit technique guides are included on the CCH disk provided to examiners. The audit technique guides and other industry-based information are available at the following sites.
    1. SBSE's Technical Guidance at http://sbse.web.irs.gov/TG/TGIndustryIssues.htm
    2. LMSB's Pre-filing & Technical Guidance - Industry Guides at http://lmsb.irs.gov/hq/pftg/guides.asp
    3. IRS's web site at http://www.irs.gov. Use the menu to select " Businesses" , and then "More Topics" , under Related Topics. The first heading on the list is "Audit Technique Guides " , which will provide a listing of guides in alphabetical order.

     

4.10.4.1.1  (06-01-2004)
Scope of Section

  1. IRM 4.10.4 applies to all examinations conducted by interview.
  2. IRM 4.10.4 does not apply to correspondence examinations.

4.10.4.2  (06-01-2004)
Definitions

  1. The following definitions are provided to clarify terms used within this IRM section. An understanding of these definitions is helpful to complete the Examination of Income.

4.10.4.2.1  (06-01-2004)
"Nonbusiness" Returns

  1. Individual returns with activity codes 530–534, with no attached business schedule(s); i.e., no Schedule C or Schedule F.
  2. For Office Audit, individual returns which have an attached business schedule(s) Schedule C or Schedule F) and Gross Receipts is NOT a classified issue.

4.10.4.2.2  (06-01-2004)
"Business" Returns

  1. All types of returns other than nonbusiness returns described in 4.10.4.2.1, above.
  2. For Office Audit, individual returns which have an attached business schedule(s) Schedule C or Schedule F and Gross Receipts is a classified issue.

4.10.4.2.3  (06-01-2004)
Gross Receipts or Gross Income

  1. The term "Gross Receipts" or "Gross Income" means the taxpayer's total or gross taxable receipts during the year from all sources. Gross Receipts is not reduced by returned sales, allowances, cost of goods sold, basis, or expenses. Gross Receipts includes, but is not limited to the following:
    1. gross sales of a trade or business;
    2. gross fees and commissions;
    3. gross wages, salaries, tips, and gratuities;
    4. gross dividends, interest, rents, royalties, pensions, and annuities;
    5. gross income from estates, trusts, and partnerships;
    6. gross proceeds from the sale of assets; and
    7. gross farm income.

     

  2. Gross receipts does not include nontaxable income; e.g., gifts, loans, etc.

4.10.4.2.4  (06-01-2004)
Gross Business Receipts

  1. The term Gross Business Receipts means the gross receipts derived from a trade, business, farm, or profession. The distinction between " Gross Receipts" and "Gross Business Receipts" is important when examining nonbusiness returns or business returns which also include nonbusiness income.

4.10.4.2.5  (06-01-2004)
Cash-on-Hand

  1. Generally, Cash-on-Hand is currency (not balances in bank accounts) associated with routine business practices and/or the need to complete cash transactions with customers.

4.10.4.2.6  (06-01-2004)
Accumulated Funds

  1. Accumulated Funds is currency accumulated by the taxpayer, but not associated with routine business practices and/or transactions with customers. The funds may have been taxed in prior years, originate from nontaxable sources, or may represent taxable income in the year under audit.

4.10.4.2.7  (06-01-2004)
Specific Item Method

  1. The specific item method involves the use of direct evidence to determine the tax liability based on omitted income, overstated expenses, or both. Direct evidence is evidence from which only one logical conclusion can be reached.
  2. Direct documentary evidence is generally regarded as having the greatest value and, when possible, examiners should ask to see the original documents when there is reason to believe they exist. Documentary evidence should not be solely relied upon to the exclusion of facts established through oral testimony or other techniques, such as a tour of the business site.
  3. The specific item method is appropriate when the taxpayer maintains books and records, adjustments are due to technical issues (such as timing or character of funds), or the potential sources of unreported income are limited (such as an insurance agent who underwrites for several companies).
  4. The specific item method is not useful if the taxpayer's gross receipts are generated from numerous sources or in small amounts, such as a grocery store.
  5. See IRM 4.10.7.3 for complete discussion.

4.10.4.2.8  (06-01-2004)
Indirect Method

  1. The indirect method involves the use of circumstantial evidence to prove omitted income, overstated expenses, or both. Circumstantial evidence is evidence from which more than one logical conclusion can be reached. To support adjustments for additional taxable income, both the credibility of the evidence and the reasonableness of the conclusion must be evaluated before the determination of tax liability is made.
  2. Analytical reviews and testing of the taxpayer's books and records conducted during the minimum income probes may result in the identification of additional taxable income. The Financial Status Analysis and Bank Account Analysis are not prohibited by IRC section 7602(e), Limitation on the Use of Financial Status Audit Techniques, simply because an adjustment to taxable income supported by indirect (circumstantial) evidence may be the result. Ultimately, the completion of the minimum income probes may result in the determination of additional tax liability using a formal indirect method.
  3. Example : The minimum income probes for an individual business return includes a Bank Account Analysis (see IRM 4.10.4.3.3.6). There is an identifiable potential source of additional taxable income. The records used for the analysis are the bank account statements, which are prepared by a third party, and are credible evidence. The characterization of excess funds as additional taxable income is reasonable because deposits of nontaxable funds are identified and eliminated.
  4. See IRM 4.10.7.3 for complete discussion.

4.10.4.2.9  (06-01-2004)
Formal Indirect Method

  1. The formal indirect methods are audit techniques used to determine the amount of unreported income.
    1. Bank Deposit and Cash Expenditures Method (IRM 4.10.4.6.3)
    2. Source and Application of Funds Method (IRM 4.10.4.6.4)
    3. Percentage of Markup Method (IRM 4.10.4.6.5)
    4. Unit and Volume Method (IRM 4.10.4.6.6)
    5. Net Worth Method (IRM 4.10.4.6.7)

     

  2. The formal indirect methods are also known as Financial Status Audit Techniques. See IRM 4.10.4.6.1 for additional discussion. They are distinguishable from other audit techniques by the following characteristics:
    1. reliance on indirect evidence of income,
    2. in-depth analysis of actual costs that requires the extensive collection of detailed information using intrusive techniques, and
    3. subject to 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."

     

  3. Formal indirect methods are appropriate when the taxpayer's books and records are missing, incomplete, or irregularities are identified; or the Financial Status Analysis (see IRM 4.10.4.3.3.1) indicates a material imbalance of cash flows after consideration of other adjustments identified during the examination. See IRM 4.10.4.6.2.

4.10.4.3  (06-01-2004)
Minimum Requirements For Examination of Income

  1. Examiners will consider Gross Income during the examination of all income tax returns. Certain minimum probes will be made regardless of the type of return filed by the taxpayer. The minimum income probes are fundamentally designed as a set of analytical tests intended to determine whether the taxpayer accurately reported income. If the taxpayer is underreporting income, the probes should result in the identification of at least some of the understatement.
    1. The minimum income probes vary depending upon the type of return (nonbusiness or business) and the method of the examination (Office Audit or Field Examination).
    2. The minimum income probes are not subject to IRC section 7602(e) governing the use of Financial Status Audit Techniques.

     

  2. Reported Gross Income will be considered regardless of whether the taxpayer maintains a double-entry set of books.
  3. When the amount of a Net Operating Loss deduction (NOLD) is material, it constitutes a large, unusual, or questionable item (LUQ) that should be addressed as part of the examination of income. See IRM 4.10.2.3.1 for complete LUQ discussion. Refer to Exhibit 4.10.4-6, Auditing Net Operating Loss Deductions (NOLD), for additional audit guidance. Additional factors specific to NOLDs, which should be considered, include:
    1. The NOLD was generated from the same business that gave rise to an adjustment for unreported income in the current year under examination.
    2. Materiality of the current year adjustment to income,
    3. Likelihood of erroneous reporting in prior years,
    4. Materiality of NOLD, and
    5. Prior audit activity.

     

4.10.4.3.1  (06-01-2004)
Exception to the Minimum Requirements

  1. Minimum income probes will be conducted during every examination unless the examination is a "limited scope" examination. See IRM 4.10.2.6.1.1, Limiting the Scope of an Examination, for detailed discussion. The scope of an examination of a return may be limited to one or two issues if the return does not appear to be worthy of examination for any other issues.
  2. Before limiting the scope of an audit of an individual business return, a preliminary Financial Status Analysis based on the tax return data and available data will be prepared as outlined in IRM 4.10.4.3.3.1(6)(a). If the analysis indicates a material imbalance, the excess expenditures are considered to be a potential understatement of taxable income which requires further development during the audit; i.e., the minimum income probes must be completed.
    1. Example 1 : a claim will be examined for a highly technical issue requiring factual development. The preliminary Financial Status Analysis indicated the taxpayer had sufficient funds for the expenditures identified on the return. The scope of the audit can be limited to the technical issue.
    2. Example 2 : A taxpayer filed a 1040X reflecting a significant increase in Schedule C expenses. The statute was open for the claim issue only. The taxpayer verified all the additional expenses during the audit. However, when the additional expenses were included in the preliminary Financial Status Analysis, there was a material imbalance. The scope of the audit should not be limited; the material imbalance should be resolved.

     

  3. Before limiting the scope of an audit of a related return, 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 related return as filed and internal sources of information (see Exhibit 4.10.4-2), and review the return for other potential issues. See IRM 4.10.5.4, Related Returns.
  4. The examination workpapers should state that the scope of the audit was limited and cite the reasons.

4.10.4.3.2  (06-01-2004)
Minimum Income Probes: "Nonbusiness" Returns

  1. The taxpayer should be interviewed. 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. Question the taxpayer concerning possible sources of income, other than those reported, and Accumulated Funds. This questioning and completion of Form 4700–A, Form 4700 Supplement, or comments on Form 4318, Examination Workpapers, will fulfill the minimum income probe requirement if there is no other information in the file indicating potential unreported income. See IRM 4.10.4.3.3.2, IRM 4.10.4.6.8.3 and Exhibit 4.10.4-1 for additional guidance on interviewing taxpayers.
  2. Internal Revenue Code section 7521(c) states that an examiner 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 as a means to expedite the examination process. Should an examiner find that a representative is shielding a taxpayer, an examiner can bypass the representative and deal directly with the taxpayer. See Exhibit 4.10.4-5, Bypassing Powers of Attorney.
  3. An analysis of all IRP information in the file should also be done to ensure there are no other business or investment activities not included on the tax return.
  4. Possible bartering income should be considered as part of the minimum income probes.
  5. A preliminary Financial Status Analysis will be completed for all nonbusiness returns which include a Schedule C, E, or F, regardless of whether Gross Receipts was classified as an audit issue. The analysis will be based on the tax return as filed, information included as part of the case building, and information available through internal sources. See IRM 4.10.4.3.3.1 for detailed explanation and instructions.
  6. With regards to IRC section 7602(e), which addresses the use of Financial Status Audit Techniques, examiners should not routinely ask for bank statements, cancelled checks or deposit slips to complete the examination of income on nonbusiness returns. Requests for documentation supporting specific issues can be made and may include cancelled checks. There may be situations in which there is a reasonable indication of unreported income in the pre-contact stage of the examination; i.e., a grossly imbalanced Financial Status Analysis or Forms 1099 for business income not included on the tax return. In such situations, the initial information document request (IDR) may include a request for personal banking records, including bank statements, cancelled checks, and deposit slips.
  7. Deviations from the minimum income probes must be approved by the Group Manager and documented in the case file.

4.10.4.3.3  (06-01-2004)
Minimum Income Probes: Individual "Business" Returns

  1. An examination of gross income on an individual business return will include the following audit techniques:
    1. A Financial Status Analysis to estimate whether reported income is sufficient to support the taxpayer's financial activities.
    2. An interview with the taxpayer (or representative) to gain an understanding of the taxpayer's financial history, identify sources of nontaxable funds, and establish the amount of currency the taxpayer has on hand. See Exhibit 4.10.4-1, Interview Questions Addressing Accumulated Funds.
    3. A tour of the business site to gain familiarity with the taxpayer's operations and internal controls, and identify potential sources of unreported income.
    4. An evaluation of internal controls to determine the reliability of the books and records, identify high risk issues, and determine the depth of the examination of income.
    5. Reconciliation of the income reported on the tax return to the taxpayer's books and records.
    6. An analysis of the taxpayer's personal and business bank accounts to evaluate the accuracy of gross receipts reported on the tax return.
    7. An analysis of business ratios to evaluate the reasonableness of the taxpayer's business operations and identify issues needing a more thorough examination.

     

  2. Deviations from the minimum income probes must be approved by the Group Manager and documented in the case file.

4.10.4.3.3.1  (06-01-2004)
Financial Status Analysis (Individual Business Return)

  1. A Financial Status Analysis is an analysis of the taxpayer's cash flows to estimate whether there are sufficient funds to cover the taxpayer's expenses. The analysis serves two purposes:
    1. determining the depth of the examination of income, and
    2. establishing that there is a reasonable likelihood of unreported income that justifies the use of a formal indirect method.

     

  2. The intent of the analysis is to determine whether there is a significant risk of a material misstatement of taxable income. Materiality is the significance or importance of an item in determining the correct tax liability and requires the examiner’s judgment regarding the return as a whole and the separate items that comprise the return. Among the factors which must be considered when determining whether the imbalance is material are:
    1. Comparative size of the imbalance;
    2. Absolute size of the imbalance;
    3. Results of multi-year analysis;
    4. Ratios and industry standards;
    5. Relationship between the size of the imbalance and the tax liability.

     

  3. The Financial Status Analysis should include consideration of all sources and expenditures of funds identified on the tax returns, information included as part of the case building and internal sources of information (see Exhibit 4.10.4–2, Internal Sources of Information), and reasonable estimates for other expenses known to exist, but for which the exact costs are not known. Personal living expenses can be estimated using Bureau of Labor Statistics information. The analysis should also be updated during the examination as additional information becomes available; i.e., nontaxable sources of funds or disallowed expenses.
  4. Example : As part of the pre-contact planning process, an examiner may perform internal research of resources such as Choice Point, Currency and Banking Retrieval System (CBRS), Information Document Retrieval System (IDRS), Corporate Files on Line (CFOL), and/or Midwest Automated Compliance System (MACS). Note: some of this information may be automatically included with case building.
  5. The Cash-T provides a quick and easy format for documenting and determining whether there is an indication of a potential understatement of taxable income. Enter sources of cash funds on the left side of the Cash-T and expenditures of cash funds on the right side. Total sources are compared with total expenditures.
  6. The completion of a Financial Status Analysis does not trigger the provisions of 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" . A Financial Status Analysis is an analytical tool used to identify and estimate the materiality of cash flow imbalances. Financial Status Audit Techniques are the formal indirect methods used to make the actual determination of tax liability and are subject to the limitations of IRC section 7602(e). See IRM 4.10.4.6
  7. Steps for completing a Financial Status Analysis:
    1. Prepare a preliminary Cash-T based upon the tax return data and information in the case file; e.g., records of monetary transactions (CBRS). If the Cash-T indicates a material imbalance, the excess expenditures are considered to be a potential understatement of taxable income which requires further development during the audit.
    2. Use subsequent interviews and information gathering during the examination to update the Financial Status Analysis and resolve any imbalance. For example, when the profit margins are consistently low, but the taxpayer is able to continuously service substantial debt (mortgage), the examiner should make further inquiries.
    3. The analysis should be updated as audit adjustments are identified. The adjustment may be the result of unreported gross receipts, overstated expenses, or from a combination of these items.
    4. When completed, the Financial Status Analysis should indicate that either income is sufficient to support the taxpayer's financial activities or there is a significant imbalance indicating the potential for unreported income.

     

  8. An examiner may consider observing a taxpayer's residence when completing a Financial Status Analysis. However, observing a taxpayer's home should not be intrusive and generally should not include talking with the taxpayer's neighbors. Inspections of the inside of a taxpayer's home should be limited due to privacy issues and the intrusive nature. (Note: the purpose of inspecting the interior of a taxpayer's home includes determining the validity of a deduction for an office or business located in the residence.)
  9. Example: An examiner believes, based on the address on the tax return, that the taxpayer's home is located in a recently developed subdivision where the homes are selling for more the $300,000. The preliminary Financial Status Analysis indicates that the taxpayer could not support the purchase or maintenance of such a home based on the reported income. The examiner drives by the home and discovers that the taxpayer lives in a modest 40 year old home across the street from the new subdivision.
  10. The preliminary Financial Status Analysis and subsequent modifications will be made part of the examination workpapers.
  11. Financial Status "Audits" are cases where the Financial Status Analysis indicates that the taxpayer's sources of funds are not sufficient to support the taxpayer's financial activities, and the use of a formal indirect method can be justified. Note: the decision to use a formal indirect method should not be made until after completion of the minimum income probes.

4.10.4.3.3.2  (06-01-2004)
Initial Interview (Individual Business Return)

  1. The taxpayer should be interviewed. 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.
  2. Internal Revenue Code section 7521(c) states that an examiner 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 as a means to expedite the examination process. 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
  3. Question the taxpayer/representative concerning possible nontaxable sources of funds, gifts, loans, known errors/omissions on the return, and unreported sources of income. These questions should be addressed at the initial interview early in the examination. The information will be needed to reconcile the Financial Status Analysis, analyze the bank accounts, and reconcile the income reported on the tax return to the books and records. Also, the information will be critical should it later become necessary to use a formal indirect method to make the actual determination of tax liability.
    1. If loan proceeds are identified, request the loan application documents to verify the source and amount of the nontaxable funds. Bank loans are easily documented; however, loans or gifts from family members or other individuals pose a more difficult verification problem. The examiner should inquire as to why the amount provided was cash, when the amount was given, how it was given (one payment or multiple) and any provisions for repayment. Review the documentation for consistency with other evidence; i.e., cash flows, anticipated gross receipts, etc. Discrepancies should be resolved with the taxpayer's assistance.
    2. Nontaxable sources of funds can be eliminated by showing that the provider of the funds was incapable of generating the amounts stated by the taxpayer; i.e., the absence of any documentation reflecting the source of the funds and/or the absence of sources of funds available to the provider.
    3. Refer to IRM 4.10.7.3, Evaluating Evidence, for additional guidance.

     

  4. Affirmatively obtain the beginning and ending balances for cash-on-hand from the taxpayer or representative for the year(s) under examination. See IRM 4.10.4.6.8.3 for complete discussion and Exhibit 4.10.4-1 for interview questions. Generally, cash-on-hand is currency associated with normal business practices and the need to complete cash transactions with customers. If additional years are examined, be sure to determine and document the beginning and ending cash-on-hand for those years. This information will be needed to complete the reconciliation of income as reported on the tax return to the taxpayer's books and records and will be critical should it later become necessary to use a formal indirect method to make the actual determination of tax liability.
  5. Affirmatively determine the beginning and ending balances of accumulated funds for the year(s) under examination. Generally, accumulated funds is currency not associated with normal business practices. The funds may have been taxed in prior years, originate from nontaxable sources, or may represent taxable income in the year under audit. See IRM 4.10.4.6.8.3 for complete discussion and Exhibit 4.10.4-1 for interview questions.
  6. Ask the taxpayer for assistance to resolve a Financial Status Analysis indicating a material imbalance.
    1. Example : an examiner completes a pre-contact analysis of an individual taxpayer's return with a Schedule C. Based upon an analysis of the taxpayer's cash flows on the face of the return, the examiner believes the reported income is insufficient to support the taxpayer's expenses. The examiner may ask the taxpayer how the financial activities were supported, based on the income reported on the return.

     

  7. Ask the taxpayer to explain the accounting system, including:
    1. the normal flow of each type of transaction from its initiation to its inclusion in the financial statements, and
    2. the flow of funds into and out of the business.

     

  8. Question the taxpayer regarding business policies and practices for:
    1. product pricing and determining profit margins,
    2. accounting for Cost of Goods Sold, and
    3. accounting for spillage, breakage, and theft losses.

     

  9. 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 observed 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.
  10. For Tax Compliance Officers and Tax Auditors: Completion of Forms 4700–A, Form 4700 Supplement, and Form 4700–B, Business Supplement, will assist the auditor in fulfilling the minimum income probe requirements.
  11. Refer to IRM 4.10.7.3.2, Oral Testimony, for complete discussion and documentation requirements.

4.10.4.3.3.3  (06-01-2004)
Tour of Business Sites (Individual Business Return)

  1. 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:
    1. gain familiarity with the taxpayer’s business operation and internal controls,
    2. identify potential sources of unreported income, and
    3. confirm the existence of assets.

     

  2. This requirement applies to Field examinations only.
  3. The results of a tour and any observations and/or comments should be documented in the examination workpapers.
  4. See IRM 4.10.3.3 for complete discussion.

4.10.4.3.3.4  (06-01-2004)
Evaluation of Internal Controls (Individual Business Return)

  1. Evaluate the internal controls to gain an understanding of the taxpayer’s business operations and control features. The evaluation will help examiners set the scope and depth of the examination of income and determine the appropriate audit techniques.
  2. The evaluation should not be limited to a consideration of the segregation of duties. See IRM 4.10.3.4 for complete discussion. Examiners should:
    1. Determine the reliability of the books and records, regardless of the sophistication of the recordkeeping method.
    2. Gain an understanding of the taxpayer's business operations; i.e., how income is generated and recorded.
    3. Determine how business assets are safeguarded; i.e., what steps the taxpayer takes to ensure that the business operates as intended and avoid misstatements of financial information.

     

  3. While there is no exhaustive definition of weak internal accounting controls which will impact the scope and depth of the examination of income, examples include:
    1. books and records that cannot be reconciled to the tax return
    2. transactions that are not properly authorized
    3. recorded transactions are not valid
    4. existing transactions are not recorded
    5. transactions are improperly valued
    6. transactions are improperly classified
    7. transaction are recorded at the improper time
    8. transactions are incorrectly summarized
    9. transactions all made by the same person or related parties
    10. significant co-mingling of business and personal funds

     

  4. Weak internal controls alone do not necessarily establish a reasonable likelihood of unreported income under IRC section 7602(e) that justifies the use of a formal indirect method to make the actual determination of tax liability. Examiners must also demonstrate that there are irregularities in the taxpayer's books and records. See IRM 4.10.4.3.3.5.
  5. Example : The fact that a taxpayer does not maintain separate business and personal bank accounts does not, per se, warrant the use of a formal indirect method to make the actual determination of tax liability. The examiner must first determine whether the books and records are reliable, whether the income per the books and records can be reconciled to the return, and whether the taxpayer segregated or identified the sources of funds to properly account for taxable income. The test of whether an examiner can use a formal indirect method to determine the tax liability is whether there is a reasonable indication that there is a likelihood of unreported income.
  6. The workpapers will document:
    1. the conclusions reached by the analysis of internal controls,
    2. the impact on the scope of the examination, and
    3. the impact on the depth of the examination of income.

     

4.10.4.3.3.5  (06-01-2004)
Reconciliation of Income per Books and Records to Income Reported on Tax Return (Individual Business Return)

  1. Reconcile the income reported on the tax return to the taxpayer’s books and records. Ask the taxpayer how income was computed and duplicate the taxpayer's steps. Refer to IRM 4.10.3.5.6, Step 6: Reconciling the Taxpayer's Books and Records to the Tax Return, for complete discussion.
  2. Test the information obtained in the initial interview and from the evaluation of the internal controls to determine if transactions were properly recorded.
  3. If the income per the books and records cannot be reconciled with the income reported on the tax return, ask the taxpayer to provide an explanation for the difference; i.e., how the accounts per books were accumulated for the tax return.
  4. Irregularities in a taxpayer's books and records, or inconsistencies in reporting transactions may be an indication of unreported income justifying the use of a formal indirect method to make the actual determination of tax liability. Example: a taxpayer's books and records are reconciled to the income tax return. No discrepancy is noted when reconciling income to the bank statements and sales journals, or verifying purchases by inspecting cancelled checks and invoices. The examiner also attempted to tie purchases to specific jobs and the income received from those jobs. For a few purchases, there was no corresponding job or income reported.
  5. The lack of books and records, or the underlying source documents will justify expansion of an income probe beyond the minimum income probes. Example: the taxpayer owns and operates a cash-intensive food service business. The taxpayer's books and records tie to the tax return. As part of the audit, the examiner should test gross receipts by tying the original source documents (cash register receipts and/or invoices) to the books. However, the taxpayer does not have the original documents.
  6. The fact that a taxpayer's books and records were not prepared contemporaneously to the business activity does not, per se, permit an examiner to use a formal indirect method to make the actual determination of tax liability. The test of whether a formal indirect method can be used is whether there is a reasonable indication that there is a likelihood of unreported income. Example: a taxpayer advises an examiner during an audit that the books were prepared after the end of the tax year based on bank statements and cancelled checks.

4.10.4.3.3.6  (06-01-2004)
Bank Account Analysis (Individual Business Return)

  1. Perform an analysis of the taxpayer's business and personal bank accounts; i.e., statements, deposit slips, and canceled checks, etc. The Service is not prohibited from asking for these records, as well as wire transfers, on the initial information document request (IDR) or at any time during the examination for an individual business return.
  2. This analysis is used to
    1. identify deposits which may be taxable income,
    2. determine whether business expenses mayhave been paid from other sources (such as Cash-on-Hand or Accumulated Funds) or are overstated, and
    3. estimate the risk of co-mingled personal and business bank accounts, and
    4. whether cash is deposited.

     

  3. The steps of the Bank Account Analysis are:
    1. Analyze the deposits. Look for unusual deposits (size or source), general 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, co-mingling of personal and business activities, and cash-backs when a deposit is made.
    2. Total the deposits and reconcile deposits of nontaxable funds and transfers between accounts. Particular attention should be paid to 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) should be categorized as a nontaxable transactions. Note: this step is a duplication of the reconciliation of income reported on the tax return to the taxpayer's books and records if the taxpayer reported income based on bank deposits.
    3. Determine disbursements by adding the opening bank balance to the total deposits and then subtracting out the ending balance.
    4. Conduct a cursory review of cancelled checks to determine whether nondeductible expenditures (personal expenses, investments, payments on asset purchases, etc.) are included with business expenses and if so, the dollar amount. Significant co-mingling of accounts warrants a more in-depth analysis.
    5. Subtract the nondeductible expenditures from the total disbursements. The remainder should approximate the deductible business expenses on the tax return (other than noncash expenses such as accruals and depreciation). NOTE: It may be easier to identify the business expenditures in some cases, which can then be subtracted from the total disbursements; the remainder will be personal expenses paid by check.

     

  4. Compare the total deposits with the reported Gross Income. Include all accounts, whether designated as personal or business.
  5. If the analysis results in the identification of excess deposits over reported Gross Income, the excess represents potential unreported income.
    1. If specific transactions or deposits can be identified as the source of the understatement, a specific item adjustment to income supported by direct evidence should be made.
    2. 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. Technically, this is an adjustment due to the use of an indirect method. However, IRC 7602(e) governing the use of Financial Status Audit Techniques, is not triggered because the adjustment stems from an analysis of the taxpayer's books and records and is not intrusive. See IRM 4.10.4.2.9, Indirect Method.

     

  6. 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.
  7. If the analysis indicates significant co-mingling of funds, then the internal controls are weak and the books and records may be unreliable. (See IRM 4.10.4.3.3.4.)
  8. A potentially material misstatement of taxable income identified through a bank account analysis establishes a reasonable likelihood of additional unreported taxable income justifying the use of a formal indirect method to make the actual determination of tax liability.

4.10.4.3.3.7  (06-01-2004)
Business Ratio Analyses (Individual Business Return)

  1. The initial reconciliation of income per the books and records to the tax return provides the examiner with an understanding of how the taxpayer determined gross receipts. The books and records can also be used to evaluate the accuracy and reasonableness of the reported amount of income through the use of ratios.
  2. Horizontal Analysis - This analysis identifies changes over time and may result in the identification of LUQ items not readily identified from a review of a single return alone. The tax return under audit should be compared to the prior and subsequent year returns.
    1. Examiners should consider absolute numeric entries, changes in key ratios, and any other changes indicative of a change in financial activities. The analysis should be based on expenses that vary with changes in production or volume of sales.
    2. The analysis should include all schedules that report financial activity, including Schedules C, D, and E.
    3. The analysis can be documented by notes on the MACS prints, or a prepared schedule.
    4. This analysis should be completed in conjunction with the Required Filing Checks under IRM 4.10.5.3.
    5. Significant variations (5% or more) suggest changes in business or reporting practices that need to be discussed with the taxpayer.

     

  3. Example : In many industries, Cost of Goods Sold bears a direct relationship to Sales. An analysis of the prior and current year business ratios indicates consistency between years. The analysis for the current and subsequent year indicates a change in business practices that should be explained by the taxpayer.
    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