Examination of Income Cont.

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Examination of Income Cont.

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4.10.4  Examination of Income (Cont. 1)

4.10.4.6 
Formal Indirect Methods of Determining Income

4.10.4.6.3  (06-01-2004)
Bank Deposits and Cash Expenditures Method—Introduction

  1. An important feature of any examination is the inspection or analysis of the taxpayer’s bank records. This is particularly so in the examination of inadequate, nonexistent or possibly falsified books and records. The depth of the bank account analysis (see IRM 4.10.4.3.3.6 and IRM 4.10.4.3.4.7(2)) will depend upon the facts and circumstances of the individual case. When the bank account analysis indicates a reasonable likelihood of unreported income, the examination of income may be expanded to include the use of the formal Bank Deposits and Cash Expenditures Method to make the actual determination of tax liability.
  2. In summary, income is proven through a detailed, in-depth analysis of all bank deposits, cancelled checks, currency transactions, and electronic debits, transfers, and credits to the bank accounts AND identification of the taxpayer's cash expenditures. The Bank Deposits and Cash Expenditures Method is distinguished from the Bank Account Analysis by:
    1. the depth and analysis of all the individual bank account transactions, and
    2. the accounting for cash expenditures, and
    3. determination of actual personal living expenses.

     

  3. The Bank Deposits and Cash Expenditures Method computes income by showing what happened to a taxpayer’s funds. It is based on the theory that if a taxpayer receives money, only two things can happen: it can either be deposited or it can be spent.
  4. This method is based on the assumptions that:
    1. Proof of deposits into bank accounts, after certain adjustments have been made for nontaxable receipts, constitutes evidence of taxable receipts.
    2. Outlays, as disclosed on the return, were actually made. These outlays could only have been paid for by credit card, check, or cash. If outlays were paid by cash, then the source of that cash must be from a taxable source unless otherwise accounted for. It is the burden of the taxpayer to demonstrate a nontaxable source for this cash.

     

  5. The Bank Deposits and Cash Expenditures Method can be used in the examination of both business and nonbusiness returns.
  6. The Bank Deposits and Cash Expenditures Method may supply leads to additional unreported income, not only from the amounts and frequency of deposits, but also by identifying the sources of such deposits. Determining how deposited funds are dispersed or accumulated (to whom and for what purpose) might also provide leads to other sources of income.
  7. If the Bank Deposits and Cash Expenditures Method indicates an understatement of income, it may be due to either unreporting of gross receipts or overstating expenses, or a combination of both.

4.10.4.6.3.1  (06-01-2004)
Case Law (Bank Deposits and Cash Expenditures Method)

  1. The classic bank deposits case is Gleckman v. United States, 80 F.2d 394 (8th Cir. 1935). The court held that standing alone bank deposits and large items of receipts do not prove additional tax due. On the other hand, if it is shown that these amounts can be associated with a business or income-producing activity, then the income is taxable. Since the Gleckman case, the Bank Deposits Method has received consistent judicial approval.
  2. The Gleckman case, and the cases that followed, taught that in order to use the Bank Deposits and Cash Expenditures Method in determining income, it must be shown that:
    1. The taxpayer was engaged in a business or income-producing activity,
    2. The taxpayer made periodic deposits of funds into a bank account or accounts,
    3. An adequate investigation of deposits was made by the examiner in order to negate or eliminate the likelihood that the deposits arose from nontaxable sources of income, and
    4. Unidentified bank deposits have the inherent appearance of income; i.e., the size of the deposits, odd or even amounts, source of checks deposited, dates of deposits, etc.

     

4.10.4.6.3.2  (06-01-2004)
When to Use the Bank Deposits and Cash Expenditures Method

  1. The Bank Deposits and Cash Expenditures Method should not be the automatic choice when selecting a formal indirect method to make the actual determination of tax liability. For example, cash intensive businesses, where significant amounts of gross receipts are not deposited and numerous cash outlays occur, do not lend themselves to this method.
  2. If the Bank Deposits and Cash Expenditures Method is the method of choice, the entire analysis must be completed; shortened versions that do not account for business and personal cash expenditures are insufficient.
  3. The Bank Deposits and Cash Expenditures Method is recommended when:
    1. The taxpayer’s books and records are unreliable, unavailable, withheld, or incomplete.
    2. The taxpayer makes periodic deposits of funds into bank account(s) which appear to be generated from an income-producing activity.
    3. The taxpayer pays most business expenses by check.
    4. The taxpayer previously used bank account deposits to determine and report taxable income.

     

  4. The advantages of the Bank Deposits and Cash Expenditures Method include:
    1. Provides a complete picture of the taxpayer's activities; it clearly reflects the size and scope of the taxpayer's financial activities.
    2. Avoids necessity of documenting business expenses, with the exception of technical adjustments such as depreciation.
    3. When the taxpayer overstates business expenses, Gross Receipts is automatically adjusted in the mechanics of the calculation.

     

4.10.4.6.3.3  (06-01-2004)
Bank Deposit Defined

  1. Total deposits include amounts deposited from both taxable and nontaxable sources to all bank accounts (both business and personal) maintained or controlled by the taxpayer, as well as deposits made to accounts in savings and loan companies, investment trusts, brokerage houses, credit unions, and other financial institutions.

4.10.4.6.3.4  (06-01-2004)
Gross Receipts Defined

  1. Gross Receipts represents the total or gross taxable receipts of the taxpayer during the year from all sources, not reduced by returned sales and allowances, cost of goods sold, basis, or expenses. Gross Receipts, or Gross Business Receipts, can be determined by computing the sum of the three items listed below and deducting nontaxable and/or nonbusiness receipts, duplicated deposits, etc.
    1. Funds received by a taxpayer during the year, which were deposited in financial institutions, such as banks, savings and loan associations, etc.
    2. Funds expended that were not deposited.
    3. Funds accumulated and not deposited.

     

  2. 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
    7. Gross farm income

     

  3. Gross Receipts does not include nontaxable income, such as, but not limited to, gifts, inheritances, loan proceeds, transfers between accounts, checks to cash redeposited, tax exempt interest, insurance proceeds, and Federal tax refunds.

4.10.4.6.3.5  (06-01-2004)
Factors to Consider

  1. Are there any unusual or extraneous deposits which appear unlikely to have resulted from reported sources of income?
    1. Size of Deposit—Due to the need for expediency, the examiner may limit the examination to large deposits or deposits over a certain amount. However, the identification of smaller regular deposits may be indicative of dividend income, interest, rent, or other income, leading to a source of investment income.
    2. Kind of Deposit—An item of deposit may be unusual due to the kind of deposit, check or cash, in its relationship to the taxpayer’s business or source of income. An explanation may be required if a large cash deposit is made by a taxpayer whose deposits normally consist of checks. Also, a bank statement noting only one or two large even dollar deposits, in lieu of the normal odd dollar and cents deposits, would be unusual and require an explanation.
    3. Pattern and Frequency of Deposits —Many taxpayers, due to the nature of their business or the convenience of the depository used, will follow a set pattern in making deposits. Deviation from this pattern may bear questioning.
    4. Frequency of Deposits- Bank statements or deposit slips which indicate repeat deposits of the same amount on a monthly basis, quarterly or semi-annual basis may indicate rental, dividend, interest or other income accruing to the taxpayer.
    5. Location of Bank On Which the Check Was Drawn—The examination of deposit slips may indicate items of deposit which appear questionable due to the location of the bank on which the deposited check was drawn. It is common practice when preparing a deposit slip to list either the name of the bank, city of the bank or identification number of the bank upon which the deposited check was drawn. If an identification number is used, the name and location of the bank can be determined by reference to the banker’s guide. In all cases, if the location of the bank on which the check for deposit was drawn bears little relation to the taxpayer’s business location or source of income, it may indicate the need for further investigation.

     

  2. Are there any loan proceeds, collection of loans, or extraneous items reflected in deposits? In the analysis of bank deposits, the examiner should identify all items of this nature. This is a necessary step before comparing receipts to deposits.
    1. If loan proceeds are identified, request the loan application documents to verify the source and amount of the nontaxable funds. Review the loan application information for consistency with other information; i.e., cash flows, assets, anticipated gross receipts, etc. Discrepancies should be resolved with the taxpayer's assistance.
    2. If repayments of loans are identified, request the debt instruments to establish that a loan was made, the terms of the debt, and the repayment schedule. Ask the taxpayer to document the flow of funds to the borrower (e.g., a cancelled check) and to explain where the money came from (e.g., Accumulated Funds). Ask how much money has been collected to date and whether the taxpayer reported interest earned. Contact the party receiving the loan and ask for a notarized statement outlining the terms of the loan, when it was received, and the amount of money repaid.

     

  3. Are there transfers between bank accounts or redeposits?
    1. Before an examiner can reach any conclusion about the relationship between deposits and reported receipts, transfers and redeposits must be eliminated.
    2. For example, if a taxpayer draws a check to cash for the purpose of cashing payroll checks and then redeposits these payroll checks, the examiner would be incorrect if total deposits were compared to receipts reported without adjusting for this amount. The taxpayer has done nothing more than redeposit the same funds in the form of someone else’s checks.

     

  4. Are there personal or nonbusiness bank accounts?
    1. Unreported income may be found in personal accounts. If the analysis is limited to an inspection of the business bank accounts only, omitted taxable income in personal accounts may not be discovered.
    2. The examiner should ascertain whether the deposits, as reflected in these accounts, can be accounted for by withdrawals or transfers from business accounts or from other known sources of funds.
    3. The examiner should not overlook the possibility of more than one personal or business bank account.

     

  5. Are the deposits in personal and business accounts, as adjusted, during short periods of time, accounted for by the records?
    1. It is not unusual to find that total deposits will reconcile on a yearly basis with the total receipts for the year reported on the tax return.
    2. A closer examination of deposits on a weekly or monthly basis may indicate that these deposits do not reconcile with the receipts reported during the same periods.
    3. Reported receipts may not be deposited in the closing months of the year to balance out the excess of deposits and the understatement of receipts in the earlier months.

     

4.10.4.6.3.6  (06-01-2004)
Gross Receipts Formula

  1. The Bank Deposits and Cash Expenditures Method is used to determine Gross Receipts from all sources; i.e., it is not limited to consideration of business receipts. The formula for computing Gross Receipts is:
    1. Total bank deposits $151,500
    Less:    
    2. Nontaxable receipts deposited (35,000)
    3. Net deposits resulting from taxable receipts $116,500
    Add:    
    4. Business expenses paid by cash $50,700
    5. Capital items paid by cash (personal and business) $20,300
    6. Personal expenses paid by cash $ 7,034
    7. Cash accumulated during the year  
      from receipts $ 5,000
      $83,034
    Subtotal: $199,534
    8. Less: Nontaxable cash used for  
      (4) through (7) (15,000)
    9. Add: Acct. Rec. Ending Balance 0
    10. Subtract: Acct. Rec. Beg. Bal. 0
    11. Gross Receipts as corrected: $184,534

     

4.10.4.6.3.6.1  (06-01-2004)
Explanation of Formula for Bank Deposits and Cash Expenditures Method

  1. The following is an explanation of the specific items used in the above computations. The items are identified by the line number.
  2. Line 1: Total bank deposits means total deposits in all of the taxpayer’s bank accounts. This includes the taxpayer’s business and personal accounts, the spouse’s accounts, and dependent children’s accounts. (Note: This could vary if the spouse files a separate return.) The deposits should be reconciled, if possible, so that only the receipts during the current year are included. This is accomplished by totaling deposits as shown on the bank statements, and adding to this amount any current year’s receipts, which were deposited in the subsequent year, and deducting any prior year’s receipts, which were deposited in the current year.
  3. Example :
    Deposits during 2000, per bank statements $150,000
    Add: 2000 Receipts deposited in 2001 13,000
    Less: 1999 Receipts deposited in 2000 (11,500)
    Reconciled Bank Deposits $151,500

     

    Note:

    Analyze the deposits to identify those that appear unlikely to have resulted from the taxpayer's known business activity. Determining the source of the funds may result in the identification of additional sources of income. Look for amounts that are unusually large (or small) or in even amounts, received on a regular basis, or currency when deposits normally consist of checks.

     

  4. Line 2: Eliminate nontaxable deposits representing duplicated and nontaxable items. Duplicated items include checks to cash where the proceeds are redeposited. An example is when the taxpayer writes a check payable to cash and obtains currency and/or coins from the bank in exchange for the check. This currency is then used to cash customers' checks, which are deposited into the taxpayer’s bank account; in effect, redepositing the funds withdrawn. This deposit must be eliminated in determining deposits from taxable receipts. Transfers between accounts are another example of nontaxable receipts. Transfers can occur between different checking accounts, different savings accounts, and between savings accounts and checking accounts. Such transfers do not represent additional receipts since they are merely a shifting of funds from one account to another. Deposits from transfers must be eliminated in determining deposits from taxable receipts. Other common types of nontaxable receipts that are often deposited and must be eliminated in determining deposits from taxable receipts include loan proceeds, gifts, inheritances, nontaxable Social Security benefits, nontaxable Veterans Administration benefits, tax refunds, etc.

    Example:



     

    Reconciled Bank Deposits—2000   $151,500
    Less: Nontaxable receipts deposited:  
    Loan proceeds $12,000  
    Checks to cash redeposited 3,500  
    Transfers between checking accounts 6,000  
    Nontaxable Veterans Admin. pension 14,000 ($35,500)
    Net deposits from taxable receipts   $116,000

     

     

    Note:

    Loan proceeds should be documented with loan applications and records of disbursement. The documents should be reviewed to confirm the amount and terms of the loan and determine if the information supplied by the taxpayer on the loan application is consistent with information on the return. Differences should be reconciled and may result in the identification of additional sources of income.

     

  5. Line 3: This line represents the total amount of net receipts deposited in bank accounts. At this point, the examiner has completed a detailed reconciliation of the bank deposits.
  6. The next step in the Bank Deposits and Cash Expenditures Method is determining the amount of gross receipts never deposited in the bank accounts. The Bank Deposits and Cash Expenditures Method is incomplete and ineffective unless the cash expenditures are accounted for.
  7. Line 4: Business expenses paid by cash are computed by determining the business expenses paid by check and subtracting this amount from the total business expenses reported on the tax return. Examiners should be satisfied that all checks have been presented. Should the taxpayer remove any portion of the nondeductible checks, the analysis would result in an understatement of unreported income.
    1. First determine total disbursements by adding the total deposits to the opening account balance, and then subtracting the ending balance. The resulting figure must then be adjusted for checks written during the year, which have not cleared the bank and checks written in the prior year, which cleared during the current year. This is merely a reconciliation of the checks so that only the current year’s checks are taken into account.
    2. Then identify all the checks for personal expenses and purchases of assets (business and personal) that would not be deductible as a business expense on the tax return, and subtract from the total disbursements. The result will be the business expenses paid by check.
    3. Analyze the business expenses claimed on the tax return to eliminate expenses which are not cash outlays; i.e., depreciation, depletion, bad debts, etc.,
    4. Subtract the business expenses paid by check from the expenses requiring cash outlays claimed on the tax return. The result is the amount of business expenses paid by cash rather than check.

     

    Note:

    Generally, the number of nonbusiness checks written is less than the number of business checks. Nonbusiness checks include checks for personal living expenses, capital purchases (personal and business), checks to cash redeposited, check transfers between accounts, and payments on liabilities. Checks for these items would be included even if the taxpayer deducted them on the return.

     

    Note:

    This step is based on the assumption that outlays as disclosed on the return were actually made and could only have been paid for by either check or cash. The result could represent unsubstantiated business expenses. Effectively, the taxpayer is either underreporting Gross Receipts or overstating expenses. Either way, the adjustment amount is the same.

     

    Example:



     

    Total business expenses per return:   $200,000
    Noncash business expenses:   $60,000
    Total business expenses requiring cash outlay per return:   $140,000
    Computation of business checks for year:  
    Balance @ 1–1–2000: $10,000  
     Add: Deposits: 150,000  
    Sub-Total: $160,000  
     Less: Balance @ 12–31–2000: (8,000)  
    Sub-Total $152,000  
     Add: Checks written in 2000 but cleared in 2001:    
    3,000  
    Sub-Total:   $155,000  
     Less: Checks written in 1999    
      but cleared in 2000: (6,000)  
    Total checks written in 2000: $149,000  
     Less: Nonbusiness checks    
            
    Checks to cash: $3,500    
    Check transfers: 6,000    
    Personal expenses: 34,500    
    Capital items: 15,700 $59,700  
    Total business checks: $89,300
    Total business expenses paid by cash $50,700

     

     

  8. Line 5: Capital items paid by cash include cash purchases of capital assets, cash deposited in savings accounts, and cash used to make payments on liabilities or debt. For each item, determine how much the taxpayer paid during the year and subtract any payments made by check to arrive at the amount paid with cash.
    1. Review information in the file included with the case building data.
    2. Personal assets may be identified by reviewing state registrations and licenses, property records and building permits.
    3. Review the depreciation schedules to identify business assets for which the taxpayer is making payments; i.e., the taxpayer does not have clear title.

     

  9. Line 6: Personal expenses paid by cash include living expenses, income taxes, etc. Personal items paid for by cash can be determined in the same manner as the business expenses paid by cash. Add up all the actual personal living expense identified as part of the Financial Status Analysis and by completing Form 4822 with the taxpayer's assistance, and then subtract the personal living expenses paid by check. The remainder will be the personal living expenses paid with cash. Personal living expenses purchased with credit cards must also be considered.
  10. Line 7: Cash accumulated during the year is the cash (undeposited currency and coins) received by the taxpayer during the year which is on hand at the end of the year (it was neither expended nor deposited). There are two considerations:
    1. Increases in cash-on-hand at the end of the year that is associated with normal business practices and the need to complete cash transactions with customers.
    2. Increases in accumulations of funds that are not generally associated with normal business practices. Taxpayers may accumulate significant amounts of funds for personal use.

     

  11. Examiners should establish the amount and verify the taxpayer's statements of cash on hand and cash accumulations early in the examination, before the likelihood of unreported income is established. This information is needed to complete the Financial Status Analysis. Asking taxpayer's about cash on hand and cash accumulations does not violate IRC section 7602(e), which requires the IRS to establish a likelihood of unreported income before using a financial status audit technique (formal indirect method) to make the actual determination of tax liability. For additional information see:
    1. IRM 4.10.4.2.5 and IRM 4.10.4.2.6
    2. IRM 4.10.4.3.3.2(3) and (4)
    3. IRM 4.10.4.3.4.4(3)
    4. Exhibit 4.10.4-1`

     

  12. Line 8: Nontaxable cash used for (4) through (7) is nontaxable cash used to pay expenses, purchase capital assets, deposit into savings accounts, make payments on liabilities, and to accumulate. Nontaxable cash includes: loans not deposited, withdrawals from savings accounts not redeposited, gifts, inheritances, collection of loans receivable, nontaxable income, etc. It is important to get complete information about nontaxable income as efforts may be wasted if the taxpayer later provides information regarding the availability of nontaxable sources of funds to explain an understatement. See IRM 4.10.4.6.8.3 for possible defenses the taxpayer might raise regarding nontaxable sources of funds.
  13. Lines 9 and 10: To account for changes in Account Receivable for accrual basis taxpayers, subtract the beginning balance from the ending balance to determine the change. A net increase represents additional taxable Gross Receipts, a net decrease represents payments already included in prior year Gross Receipts. See IRM 4.10.4.6.3.6.2 for complete discussion of adjustments for accrual basis taxpayers.
  14. Line 11: Gross Receipts as corrected should be compared to the Gross Receipts reported on the tax return to compute the adjustment amount.

4.10.4.6.3.6.2  (06-01-2004)
Adjustments for Accrual Basis Taxpayers

  1. If the taxpayer is on the accrual basis, the differences between the beginning and ending balances of Accounts Receivable and Accounts Payable should be added to or subtracted from the corrected Gross Receipts to convert the computation to the accrual basis accounting method. In some cases, it will not be practical to determine the amount of Accounts Receivable and Accounts Payable due to the inadequacy of the records. In such cases, these adjustments may be ignored unless the amount appears to be material. Changes in the balances of Accounts Receivable and Accounts Payable should be handled as follows:
  2. An increase in Accounts Receivable is added to Gross Receipts. An increase in receivables results from sales on accounts during the year being in excess of collections on account during the year. Therefore, the taxpayer has income from sales that is not reflected in deposits or cash expended because the cash has not yet been received. This increase is added to Gross Receipts, as determined, so that the taxpayer’s current income is properly reflected.
  3. A decrease in Accounts Receivable is subtracted from Gross Receipts. A decrease in receivables results from collections on account during the year. Therefore, the taxpayer has received cash during the year which is attributable to sales made in a previous year. This decrease is subtracted from Gross Receipts so that the taxpayer’s current income is properly reflected.
  4. An increase in Accounts Payable is subtracted from Gross Receipts. An increase in payables results from purchases on account during the year. This affects the bank deposit computation in the following manner:
    1. The total outlays per return includes all purchases and expenses deducted on the return regardless of whether or not they were all paid (except depreciation, amortization, etc.). Thus, the amount of Accounts Payable at the end of the year is included in total outlays per return.
    2. The taxpayer presumably paid for all purchases and expenses incurred during the year, except for the Accounts Payable balance at the end of the year, and also paid off the Accounts Payable amount owing at the beginning of the year. Business expenses paid by check include all such payments, i.e., payments on Accounts Payable and payments of current expenses.
    3. The amount of business expenses paid by cash, which is added to deposits and other cash expenditures in arriving at Gross Receipts, is determined by subtracting business checks from total outlays per return.
    4. If the balance of Accounts Payable at the end of the year is greater than the balance at the beginning of the year, the total outlays per return will be greater than the actual amount paid by check and cash. Therefore, if an increase in Accounts Payable is NOT subtracted from Gross Receipts, the amount of business expenses paid by cash will be overstated in the amount of the increase in Accounts Payable, and the Gross Receipts as determined will be overstated in the same amount.

     

  5. A decrease in Accounts Payable is added to Gross Receipts. A decrease in Accounts Payable results from payments on account during the year being in excess of purchases on account during the year. This has the direct opposite effect on the bank deposit computation as an increase in Accounts Payable discussed in IRM 4.10.4.6.3(4) above. In other words, the total outlays per return will be less than the actual amount paid by check and cash. This will result in an understatement of business expenses paid by cash in the amount of the decrease in Accounts Payable, and an understatement of the Gross Receipts as determined in the same amount.

4.10.4.6.3.6.3  (06-01-2004)
Bank Service Charges

  1. Bank service charges are charged to a depositor’s account for various reasons. They appear on bank statements in the same manner as checks except that they are identified by code letters which are keyed to explanations. If all of these charges are allowable business expenses, no adjustment is necessary in the computation. The charges will automatically be reflected in the total checks written (beginning bank balance plus deposits less ending bank balance) and business expenses paid by check (total checks written less nonbusiness checks) . Any charges which are not allowable business expenses should be included with the nonbusiness checks.

4.10.4.6.3.6.4  (06-01-2004)
Returned Checks

  1. Checks deposited by the taxpayer but returned by the bank are charged to the taxpayer’s account. This situation arises when the taxpayer deposits a check which is not paid by the bank on which it is drawn for some reason. For example, the maker of the check did not have sufficient funds in the account to pay the check, the maker did not have an account, etc. Since these items are reflected in the closing bank balances, no adjustments in the bank deposit computations are required. However, the transaction should be categorized as a nontaxable deposit.

4.10.4.6.3.6.5  (06-01-2004)
Overdrawn Accounts

  1. A bank account is overdrawn when the amount of the depositor’s outstanding checks is greater than the balance on deposit in the account. Normally, this situation will have no effect on the bank deposit computation. It will merely entail the use of negative bank balances in the computation of total checks written.
  2. An example of such a computation follows:
    Bank balance @ 1/1/2000 per bank statement $11,500
    Less: 1999 Outstanding checks (13,000)
    Balance @ 1/1/2000 as reconciled (1,500)
    Add: Deposits—2000 125,000
    Total available $123,500
    Bank balance @ 12/31/2000 per  
     bank statement  $5,000