Examination of Income Cont.

4.10.4 Examination of Income (Cont. 1)

4.10.4.6 Formal Indirect Methods of Determining Income
Exhibit 4.10.4-1 Interview Questions Addressing Accumulated Funds
Exhibit 4.10.4-2 Internal Sources of Information
Exhibit 4.10.4-3 External Sources of Information
Exhibit 4.10.4-4 Example of Net Worth Method
Exhibit 4.10.4-5 Bypassing Powers of Attorney
Exhibit 4.10.4-6 Auditing Net Operating Loss Deductions (NOLD)

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

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.
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.
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.
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.
The Bank Deposits and Cash Expenditures Method can be used in the examination of both business and nonbusiness returns.
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.
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)

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.
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

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.
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.
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.
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

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

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.
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
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

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.
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.
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.
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.
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

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

The following is an explanation of the specific items used in the above computations. The items are identified by the line number.
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.

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.

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.

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.
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.

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.

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.
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.
Analyze the business expenses claimed on the tax return to eliminate expenses which are not cash outlays; i.e., depreciation, depletion, bad debts, etc.,
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:
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

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.
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.
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.
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`
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.
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.
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

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:
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.
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.
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.
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

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

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

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.

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
Less: 2000 Outstanding checks	($7,200)
Balance @ 12/31/2000	(2,200)
Total checks written in 2000	$125,700

After the corrected Gross Receipts is determined, a comparison must be made with the amount reported on the return to arrive at the adjustment to income.
The understatement of Gross Receipts and/or overstatement of expenses is added to the taxable income reported on the return.

4.10.4.6.3.7 (06-01-2004)
Adjustments to Noncash Expenses

The Bank Deposits and Cash Expenditures Method does not account for noncash expenses claimed on the tax return that do not represent a current outlay of funds. Examples include depreciation, depletion, bad debts and inventory. Therefore, these expenses should be separately considered and specific item adjustments made if necessary. For example, if the bank deposit computation revealed an adjustment of $5,000 and depreciation claimed was found to be overstated in the amount of $1,000, there would be two adjustments:
1. Unreported income in the amount of $5,000
2. Adjustment to depreciation in the amount of $1,000

4.10.4.6.4 (06-01-2004)
Source and Application of Funds Method

The Source and Application of Funds Method of reconstructing income to determine the actual tax liability is an analysis of a taxpayer’s cash flows and comparison of all known expenditures with all known receipts for the period. Net increases and decreases in assets and liabilities are taken into account along with nondeductible expenditures and nontaxable receipts. The excess of expenditures over the sum of reported and nontaxable income is unreported taxable income.

4.10.4.6.4.1 (06-01-2004)
Case Law (Source and Application of Funds Method)

The use of the Source and Application of Funds Method of proof in establishing unreported income received the Supreme Court’s approval in United States v. Johnson, 319 U.S. 503 (1943) . In addition to proving the taxpayer owned gambling establishments whose winnings were unreported, it was proven that in three of the years involved, the taxpayer’s personal expenditures exceeded his current income plus his declared accumulated funds.

4.10.4.6.4.2 (06-01-2004)
When to Use the Source and Application of Funds Method

This method is based on the theory that any excess expense items (applications) over income items (sources) represent an understatement of taxable income. Only the net increase or decrease in assets and liabilities are considered along with other expenditures and receipts.
The Source and Application of Funds Method is recommended in the following situations:
1. The review of a taxpayer’s return indicates that the taxpayer’s deductions and other expenditures appear out of proportion to the income reported.
2. The taxpayer’s cash does not all flow from a bank account which can be analyzed to determine its source and subsequent disposition.
3. The taxpayer makes it a common business practice to use cash receipts to pay business expenses.

4.10.4.6.4.3 (06-01-2004)
Example of Source and Application of Funds Method

In the Source and Application of Funds Method, rather than show the beginning and ending balances of assets and liabilities and determine the overall difference, the amount of change for each asset and liability is determined separately. This can be illustrated as follows:

Example :

Application of Funds
Increase in bank balance	$200
Personal expenses	$40,000
Total Funds Applied		$40,200

Sources of Funds
Schedule C	$18,000
Net Funds Available		$18,000

Excess Application over Sources
Understatement of Income		$22,200

Sources of funds are the various ways the taxpayer acquires money during the year. Decreases in assets and increases in liabilities generate funds. Funds also come from taxable and nontaxable sources of income. Unreported sources of income even though known, are not listed in this computation since the purpose is to determine the amount of any unreported income. Specific omissions of income are denoted separately and do not become a component of this formal indirect method. Examples of sources of funds include:
1. Decreases in assets; i.e., decrease in cash on hand, decrease in bank account balances (including personal and business checking and savings accounts), decreases in inventory, and decreases in Accounts Receivable.
2. Increases in liabilities; i.e., increase in Accounts Payable and increase in loan principal.
3. Taxable and nontaxable income.
4. Deductions which do not require funds such as depreciation, carryovers and carrybacks, and adjusted basis of assets sold.
Application of funds are ways the taxpayer used (or expended) money during the year. Increases in assets, decreases in liabilities, and expenditures for personal living all require the use of money and, therefore, are applications of funds. Examples of applications of funds include:
1. Increases in assets, i.e., increase in cash on hand, increase in bank account balances (including personal and business checking and savings accounts), increases in inventory, increases in Accounts Receivable, business equipment purchased, real estate purchased, and personal assets acquired.
2. Decreases in liabilities; i.e., decrease in accounts payable, and decrease in loan principal.
3. Personal living expenses.

4.10.4.6.4.4 (06-01-2004)
Accrual Basis Taxpayers

Since the results of this method are on a cash basis, adjustments must be made for an accrual basis taxpayer. Accounts Receivable at the beginning of the period examined are shown on the debit side, as they are presumed to be collected during the period. Ending Accounts Receivables are a credit adjustment, required to effect a noncash increase in income.
Accounts Payable are shown as adjustments in the reverse order of Accounts Receivables. Beginning Accounts Payable are a credit adjustment having the result of increasing income and transferring a current period cash expenditure to the prior period in which it was incurred and deductible under the accrual method. Conversely, ending Accounts Payable balances are a debit adjustment having the effect of reducing income to result in a noncash reduction of income.

4.10.4.6.4.4.1 (06-01-2004)
Opening Cash on Hand

It should be noted that the establishment of the beginning amount of Cash on Hand and Accumulated Fund for the year is as important in this method as it is in the Net Worth Method. See subsection 4.10.4.6.8.3 below for possible defenses the taxpayer might raise regarding the availability of nontaxable funds.

4.10.4.6.4.4.2 (06-01-2004)
Example of Source and Application of Funds Method for Accrual Taxpayers

Funds Applied:

Increase in cash on hand	$ 4,000
Increase in cash in banks	5,000
Increase in accounts receivable	21,400
Increase in loans receivable	13,000
Increase in inventory	19,000
Increase in stocks and bonds	12,500
Increase in furniture and fixtures	11,100
Increase in real estate	135,000
Increase in personal automobile	24,000
Decrease in accounts payable	11,500
Decrease in mortgage payable	23,000
Personal living expenses	29,700
Federal income tax paid	6,500
Nondeductible personal loss	3,500
Gifts made	10,000
Total Funds Applied	$ 329,200

Sources of Funds:

Decrease in cash on hand	$3,100
Decrease in bank balance	2,000
Decrease in securities	13,500
Increase in accounts payable	11,800
Increase in notes payable	22,100
Increase in mortgage payable	121,500
Increase in accumulated depreciation	23,300
Tax exempt interest	1,700
Inheritance	42,000
Total Sources of Funds	$241,000

Understatement of Income:

Total Application of Funds	$329,200
Total Sources of Funds	241,000
Adjusted Gross Income as corrected:	88,200
Less: Adjusted Gross Income as reported	51,600
Understatement of Adjusted Gross Income:	36,600

4.10.4.6.5 (06-01-2004)
Markup Method

The Markup Method produces a reconstruction of income based on the use of percentages or ratios considered typical for the business under examination in order to make the actual determination of tax liability. It consists of an analysis of sales and/or cost of sales and the application of an appropriate percentage of markup to arrive at the taxpayer’s Gross Receipts. By reference to similar businesses, percentage computations determine sales, cost of sales, gross profit or even net profit. By using some known base and the typical applicable percentage, individual items of income or expenses may be determined. These percentages can be obtained from analysis of Bureau of Labor Statistics data or industry publications. However, it is preferable to use the taxpayer’s actual markups if possible.
The Markup Method is a formal indirect method that can overcome the weaknesses of the Bank Deposits and Cash Expenditures Method, Source and Application of Funds Method, and Net Worth Method, which do not effectively reconstruct income when cash is not deposited and the total cash outlays cannot be determined unless volunteered by the taxpayer. If personal enrichment occurs that cannot be identified, the effectiveness of these methods is diminished. For example, the possibility exists that significant personal acquisitions or expenditures are paid with cash and are not evident. The Markup Method is similar to how state sales tax agencies conduct audits. The cost of goods sold is verified and the resulting Gross Receipts are determined based on actual markup.
This method is most effective when applied to businesses whose inventory is regulated or purchases can be readily broken down in groups with the same percentage of markup.
An effective initial interview with the taxpayer is the key to determining the pertinent facts specific to the business being examined.

4.10.4.6.5.1 (06-01-2004)
Case Law (Markup Method)

In United States v. Fior D'Italia, Inc., 536 U.S. 238 (2002), the majority held that IRC section 446(b) does not limit authority to use aggregate estimation of income taxes (unreported tip income).
In Barragan v. Commissioner, TC Memo 1993-92, the Service properly determined gross receipts from a gas station based on the supplier's delivery records and the retail prices per an independent market survey. Similarly, in Staddord v. Commissioner, TC Memo 1992-637, the Service properly determined gross receipts from gas stations based on Bureau of Labor Statistics data.
In Nicols v. Commissioner, TC Memo 1983-242, the Service was upheld in applying an established tip rate to the taxpayer's gross receipts to determine unreported tip income.
In Webb v. Commissioner, 394 F.2d 366, 371-372 (5th Cir. 1968), aff'g T.C. Memo. 1968-81, the Government determined Webb's income from liquor sales using the Markup Method.
It was held in the Estate of Bertein v. Commissioner , TC Memo 1956-260, that the inability to use other [formal] indirect methods is not prerequisite for using a percentage method.
In the case of Yorkville Live Poultry Co. v. Commissioner , 18 BTA 47 (1929), the Board of Tax Appeals approved a net income computation based upon 4 percent of the net sales where no books were available.

4.10.4.6.5.2 (06-01-2004)
When to Use the Markup Method

The Markup Method is recommended in the following situations:
1. When inventories are a principal income producing factor and the taxpayer has nonexistent or unreliable records.
2. Where a taxpayer’s cost of goods sold or merchandise purchased is from a limited number of sources, these sources can be ascertained with reasonable certainty, and there is a reasonable degree of consistency as to sales prices.
This method is effective for industries such as liquor stores, taverns, gasoline retailers, restaurants, and jewelry stores.
Examiners should address the following issues when applying the Markup Method:
1. Use the taxpayer's own records and oral testimony to establish the markup percentages based on known costs and sales prices. This should be the best source of information. Plausible explanations for why the taxpayer's markup percentages differ from national averages should be accepted.
2. If it appears that the cost of goods sold and/or purchases are also understated, issue a summons to the taxpayer's suppliers for sales records.
3. Judgment should be exercised by examiners when using industry standards or surveys to make sure the comparisons are valid and are for similar situations. Consider the availability of valid sources of information containing the necessary percentages and ratios. Adjust percentages and ratios to reflect those during the time of the return under audit. IRC section 7491(b) places the burden of proof on the Service with respect to any item of income that was reconstructed solely through the use of statistical information or unrelated taxpayers.

4.10.4.6.5.3 (06-01-2004)
Gross Profit Margin to Sales

The gross profit to sales ratio indicates the average markup on products. The calculation divides the gross profit margin (sales less cost of goods sold) by total sales

Sales - Cost of Sales

Sales

Example: A taxpayer sells two products, A and B, and reports $140,000 in gross sales. The costs for product A are $50,000 and the costs for product B are $80,000. The costs are verified with the third party supplier and adjusted for opening and closing inventory.

Sales per return:	$140,000
Cost of Goods Sold (Product A)	$50,000
Cost of Goods Sold (Product B)	$80,000

The examiner determines the gross profit margins for products A and B by interviewing the taxpayer, analyzing the taxpayer's records, and reviewing industry standards.
Product A:	10%
Product B:	20%

Step 1: Determine the COGS%
	Product A	Product B
Gross Receipts:	100%	100%
Less: Gross Profit %	10%	20%
COGS%	90%	80%

Step 2: Determine the correct Gross Receipts: (COGS/COGS% = Gross Receipts)
	Product A	Product B
$50,000/.90	$55,555
$80,000/.80		$100,000

Step 3: Determine the Adjustment to Gross Receipts
Sales of Product A:	$ 55,555
Sales of Product B:	+ $100,000
Sales as Recomputed:	$155,000
Sales per Tax Return:	- $140,000
Adjustment to Gross Receipts:	$15,555

4.10.4.6.5.4 (06-01-2004)
Cost of Sales to Gross Receipts Ratio

Using the Cost of Sales to Gross Receipts ratio is a variation of the Gross Profit Margin to Sales ratio. It also is a comparison of costs to sales.

Example: a taxpayer sells two products, A and B, and reports $70,000 in gross receipts. The costs for product A are $20,000 and the costs for product B are $30,000. The costs are verified with the third party supplier and adjusted for opening and closing inventory.

Sales per return:	$ 70,000
Cost of Sales (Product A)	$ 20,000
Cost of Sales (Product B)	$ 30,000
The examiner determines that cost of sales is 75% of sales for product A and 50% of B by interviewing the taxpayer, analyzing the taxpayer's records, and reviewing industry standards.

Step 1: Determine the COGS%
	Product A	Product B
Cost of Sales %	75%	50%

Step 2: Determine the correct Gross Receipts: (COS/COS% = Gross Receipts)
	Product A	Product B
$20,000/.75	$26,666
$30,000/.50		$60,000

Step 3: Determine the Adjustment to Gross Receipts
Sales of Product A:	$ 26,666
Sales of Product B:	+ $ 60,000
Sales as Recomputed:	$ 86,666
Sales per Tax Return:	- $ 70,000
Income Adjustment:	$16,666

4.10.4.6.6 (06-01-2004)
Unit and Volume Method

In many instances Gross Receipts may be determined or verified by applying the sales price to the volume of business done by the taxpayer. The number of units or volume of business done by the taxpayer might be determined from the taxpayer’s books as the records under examination may be adequate as to cost of goods sold or expenses. In other cases, the determination of units or volume handled may come from third party sources.
This method for determining the actual tax liability has been effectively applied in carryout pizza businesses, coin operated laundry mats, and mortuaries.

4.10.4.6.6.1 (06-01-2004)
Case Law (Unit and Volume Method)

In Salami v. Commissioner, TC Memo 1997-347, the court held that a cab driver's gross income could be determined using claimed gas expenses, price per gallon, miles per gallon, occupancy rates, etc. Same for the cab driver in Irby v. Commissioner, TC Memo 1981-399.
In Maltese v. Commissioner, TC Memo 1988-322, the Service was upheld in determining gross income by determining the number of pizza crusts per 100 pounds of flour times the average price per pizza.
In Stanoch v. Commissioner, TC Memo 1959-132, the Service established Gross Receipts for a tavern by allowing a specific measurement of liquor per drink and a percentage for spillage.

4.10.4.6.6.2 (06-01-2004)
When to Use the Unit and Volume Method

The Unit and Volume Method is recommended for making the actual determination of tax liability when:
1. The examiner can determine the number of units handled by the taxpayer and also know the price charged per unit.
2. The business has only a few types of products which are sold or there is little variation in the types of services performed, and the charges made by the taxpayer (sales price) for merchandise or services are relatively the same throughout the tax period.

4.10.4.6.6.3 (06-01-2004)
Other Considerations

Examiners should be aware of the following when considering the Unit and Volume Method:
1. Is there a common denominator for the business that drives gross receipts?
2. Can the number of units handled or consumed by the taxpayer be ascertained?
3. Is the price per unit or profit per unit obtainable?
4. Is there a third party from whom the taxpayer's consumption, units of production, or sales are available?

4.10.4.6.6.4 (06-01-2004)
Example of Computation

This example is for a coin operated laundry, where the known unit is the amount of water needed for each unit of sale (load of laundry). Per the utility bills, the taxpayer consumed 3,000,000 gallons of water.

Gallons of water consumed:	3,000,000
Non washing machine consumption (spillage):	- 50,000
Net water available for paid loads (gallons):	2,950,000

Gallons of water per load of wash, determined from manufacturer or credible oral testimony, is 27 gallons.

The reconstructed number of loads of wash is 2,950,000/27 = 109,259.

The price per washing machine load is $2.50. The gross receipts from washing machines is 109,259 loads x $2.50/load = $273,148.

The price per dryer load is $1.50. Based on observations on different days of the week, the examiner determines that customers' use of dryers is 75% of their wash loads. The price per dryer load is $1.50. Therefore, the gross receipts for dryer use is .75(109,259) x $1.50 = $122,916.

Summarize the Gross Receipts for all the services and compare to the Gross Receipts reported on the tax return.

Gross Receipts from washers:	$ 273,148
Gross Receipts from dryers:	+ $122,916
Other Receipts (vending, arcade):	$ 25,000
Sales as Recomputed:	$ 421,064
Sales per Tax Return:	- $ 376,745
Income Adjustment:	$44,319

4.10.4.6.7 (06-01-2004)
Net Worth Method

The Net Worth Method for determining the actual tax liability is based upon the theory that increases in a taxpayer’s net worth during a taxable year, adjusted for nondeductible expenditures and nontaxable income, must result from taxable income. This method requires a complete reconstruction of the taxpayer’s financial history, since the Government must account for all assets, liabilities, nondeductible expenditures, and nontaxable sources of funds during the relevant period.
The theory of the Net Worth Method is based upon the fact that for any given year, a taxpayer’s income is applied or expended on items which are either deductible or nondeductible, including increases to the taxpayer’s net worth through the purchase of assets and/or reduction of liabilities.
The taxpayer’s net worth (total assets less total liabilities) is determined at the beginning and at the end of the taxable year. The difference between these two amounts will be the increase or decrease in net worth. The taxable portion of the income can be reconstructed by calculating the increase in net worth during the year, adding back the nondeductible items, and subtracting that portion of the income which is partially or wholly nontaxable.
The purpose of the Net Worth Method is to determine, through a change in net worth, whether the taxpayer is purchasing assets, reducing liabilities, or making expenditures with funds not reported as taxable income.

4.10.4.6.7.1 (06-01-2004)
Case Law (Net Worth Method)

The Net Worth Method is a very old method of determining income. See United States v. Frost, 25 F.Cas. 1221 (N.D. Ill. 1869). The first criminal case involving the Net Worth Method was United States v. Beard, 222 F.2d 84 (4th Cir. 1955), which involved delinquent returns.
The use of the Net Worth Method of proof has been approved by the Supreme Court in: Holland v. United States, 348 U.S. 121 (1954). Holland set forth the following requirements that the Government must meet when using the Net Worth Method:
1. Establish an opening net worth, also known as the base year, with reasonable certainty.
2. Negate reasonable explanations by the taxpayer inconsistent with guilt; i.e., reasons for the increased net worth other than the receipt of taxable funds. Failure to address the taxpayer's explanations might result in serious injustice.
3. Establish that the net worth increases are attributable to currently taxable income.
4. Where there are no books and records, willfulness may be inferred from that fact coupled with proof of an understatement of income. But where the books and records appear correct on their face, an inference of willfulness from net worth increases alone might not be justified.
5. The Government must prove every element beyond a reasonable doubt, though not to a mathematical certainty.

4.10.4.6.7.2 (06-01-2004)
When to Use the Net Worth Method

The Net Worth Method is generally recommended in the following situations:
1. Two or more years are under examination.
2. Numerous changes to assets and liabilities are made during the period.
3. No books and records are maintained.
4. The books and records are inadequate or not available.
5. The books and records are withheld by the taxpayer.
The fact that the taxpayer’s books and records accurately reflect the figures on a return does not prevent the use of the Net Worth Method of proof. The Government can still look beyond the "self-serving declarations" in a taxpayer’s books and records and use any evidence available to determine whether the books accurately reflect the taxpayer's financial history.
While the Net Worth Method was originally used against taxpayers whose principal source of income was from an illegal activity, it is now regularly recommended in fraud cases, especially where significant changes in net worth have occurred and other methods of proof are insufficient.
In addition to being used as a primary means of proving taxable income so that an actual determination of tax liability can be made, the Net Worth Method is relied upon to corroborate other methods of proof and test the accuracy of reported taxable income.

4.10.4.6.7.3 (06-01-2004)
Formula for the Net Worth Method

The formula for computing income using the Net Worth Method is as follows:

Total Assets	$XXX
Less: Total Liabilities	(XXX)
Net Worth, end of year	$XXX
Less: Net Worth, beginning of year	(XXX)
Increase or decrease in net worth	$XXX
Add: Nondeductible expenditures	XXX
Sub-Total	XXX
Less: Nontaxable income	(XXX)
Adjusted gross income (this figure would be net or taxable income in the case of partnerships and corporations)	$XXX

The same accounting method used by the taxpayer on the tax return must be used in computing net worth, unless the examination discloses that the accounting method should be changed. If the taxpayer reports on the cash basis, such items as business Accounts Receivable and Accounts Payable would not be included in the analysis. However, if the taxpayer is on the accrual basis, all accrued business assets and business liabilities would be included in the analysis.

4.10.4.6.7.3.1 (06-01-2004)
Adjustments to Arrive at Adjusted Gross Income

These adjustments are commonly referred to as "below-the-line adjustments." These adjustments are necessary to convert the change in net worth to Adjusted Gross Income. Adjustments are made to increase or decrease net worth to account for expenditures not included in the assets or liabilities, as well as nondeductible and nontaxable items.
Nondeductible items are funds spent which do not increase an asset or decrease a liability. These items are added to the change in net worth.
Nontaxable income items reduce or decrease changes in net worth and must be removed to arrive at adjusted gross income.
Tax deductible items are funds spent which do not increase an asset or decrease a liability, but are deductible for purposes of determining the correct taxable income. These items are subtracted from the corrected adjusted gross income.
The following information must be determined in order to compute income by the Net Worth Method:
1. The taxpayer’s assets and liabilities, both business and personal, at the beginning and end of the taxable year.
2. The nondeductible expenditures which consist of items such as personal living expenses, income tax payments, the nondeductible portion of capital losses, losses on the sale of personal assets (if included in assets in the balance sheet), hobby losses, and gifts made.
3. The nontaxable income, which consists of items such as tax-exempt interest, nontaxable pensions, nontaxable portions of proceeds from life insurance policies, Veterans Administration benefits, nonrecognized gain on the sale of personal residence, Federal income tax refunds, inheritances, and gifts received.
4. Loan proceeds are not included in the adjustment for nontaxable income because loans are accounted for as both an increase in assets (cash) and increase in liabilities (debt). The effect on net worth is zero.

4.10.4.6.7.3.2 (06-01-2004)
Adjustments to Arrive at Taxable Income

After the correct Adjusted Gross Income has been determined, it is necessary to recompute the deductions allowable for determining taxable income. Changes in Adjusted Gross Income may affect the medical, contribution, and certain miscellaneous deductions.

4.10.4.6.7.4 (06-01-2004)
Determining Opening and Closing Net Worth

It may be difficult or even impossible to accurately determine the exact amount of the taxpayer’s personal assets at the beginning or end of a year. This is particularly true in the case of personal property, residence, etc. The balances of such items can be estimated. The workpapers should clearly reflect which items are estimates and also how the other amounts were determined.
Asset values should be listed at cost or at the taxpayer’s basis if it is different from cost. In computing the net worth, the examiner should use the same accounting period the taxpayer used in filing the tax return and should also use the same accounting method that the taxpayer is required to use. For example, business Accounts Receivable and Accounts Payable would appear on the net worth statement for an accrual basis taxpayer, but not for a cash basis taxpayer. Liabilities such as mortgages, notes payable, etc. should be included even for the cash basis taxpayer so that the equity in those assets will be reflected.
To establish the cost of assets or liabilities, examiners should use:
1. Prior income tax returns,
2. Financial statements filed with lending institutions,
3. The books and records of the taxpayer, including source documents, such as invoices and cancelled checks, and
4. Insurance policy coverage indicating the existence of assets or liabilities and the value placed on them.
Any asset or liability which does not change during the year could be omitted from the beginning and ending net worth computation without affecting the increase or decrease in net worth; i.e., taxpayer’s personal residence, or furniture. The question may arise; however, as to why items that do not change should be included in the net worth statement in the first place, particularly since they have no bearing on the final result. These items should be included for the following reasons:
1. The net worth statement should be as complete as possible so that the taxpayer will not have grounds to successfully contest its credibility due to omitted items.
2. The net worth statements are frequently used as a starting point in future examinations of the same taxpayer and a complete net worth would be valuable to the next examiner.
Examiners should use the following procedures to determine opening and closing net worth:
1. Prepare a balance sheet for the beginning and end of each year involved, including reserves for depreciation and amortization.
2. Establish the opening net worth with reasonable certainty, including the verification of taxpayer’s admissions. An inaccurate opening net worth will discredit the computation of taxable income.
3. Investigate any leads the taxpayer may offer which would establish the incorrectness of the Government’s computation.
The opening net worth must be reasonably certain.
1. The opening net worth will be overstated if the calculation includes assets not actually held by the taxpayer, includes assets with inflated values, or omits or understates liabilities.
2. Opening net worth will be understated if the calculation omits or understates assets, includes nonexistent liabilities, or overstates liabilities.
The accuracy of the ending net worth is just as important as the opening net worth. However, it is usually more easily obtained and verified. When taxpayers are confronted with a net worth computation, they may allege that their ending inventories were taken at retail value instead of at cost. Thus, the taxpayer will contend ending inventory is overstated, which caused an increase in net worth. To verify this allegation, obtain and verify the inventory records.

4.10.4.6.7.5 (06-01-2004)
Likely Source of Income

The courts require the Government to show that there is a likely source of income from which the increase in net worth resulted. Since the rationale of the Net Worth Method is that increases in net worth result from taxable income, there must be a taxable source. It is not essential to pinpoint the specific source but only to indicate the "possibility" or "opportunity" of likely sources to support the inference that the unreported income came from a taxable source. It is also important to attempt to verify or refute the taxpayer’s contention that the increase in net worth resulted from nontaxable sources. If all possible nontaxable sources are negated, then an inference can be made that the increase in net worth came from taxable sources.

4.10.4.6.7.6 (06-01-2004)
Opening Cash on Hand

Circumstantial evidence of excess income is often met with the defense that the extra funds came from accumulated cash or other legitimate sources, such as gifts or loans from relatives. To address these potential defenses, the examiner must ascertain the amount of cash on hand and the accumulated funds at the beginning of the audit period. See IRM 4.10.4.6.8.3 below for possible defenses the taxpayer might raise regarding nontaxable sources of cash.

4.10.4.6.7.7 (06-01-2004)
Verification of Items

The examiner must reconstruct the taxpayer’s net worth through records and other evidence. Every item on a statement of net worth or a financial statement should be verified if possible. Large nontaxable sources derived from related parties should be carefully scrutinized. A statement by the taxpayer or third party serves only as a lead to the examiner. Sworn statements should be secured where possible. Examination of related parties’ books and records may be necessary to verify questionable transactions.

4.10.4.6.7.8 (06-01-2004)
Personal Living Expenses

The taxpayer’s personal living expenses are also indicative of a taxpayer’s income. Since personal living costs are assumed to represent taxable income unless shown otherwise, the Net Worth Method should include a computation of the taxpayer’s actual personal living expenses.
The determination of the taxpayer’s actual personal living expenses is essential in the reconstruction of income by the Net Worth Method. The schedule of personal living expenses is incorporated into the net worth schedule. When the net worth is negligible it may be more feasible to reconstruct income using the Source and Application of Funds Method.

4.10.4.6.7.9 (06-01-2004)
Advantages of Net Worth Method

Avoids having to document day to day activities and considers the year as a whole.
Does not depend on individual transactions but only on positions at certain points in time.
Avoids having to document business expenses, since net worth increases are reflected of dispositions of net business profits.

4.10.4.6.7.10 (06-01-2004)
Example of Net Worth Computation

An example of the Net Worth Method is included as Exhibit 4.10.4-4.

4.10.4.6.8 (06-01-2004)
Potential Taxpayer Defenses Against Formal Indirect Methods of Computing Income

If the use of a formal indirect method results in an apparent understatement of taxable income, it is important that the examiner be prepared to address the taxpayer's potential defenses.
The defenses can be grouped into three categories:
1. Showing that the computation is inaccurate or flawed,
2. Showing that the unexplained difference is due to a nontaxable source, or
3. Showing that the unexplained difference is from expenditures of available cash accumulated in prior years.

4.10.4.6.8.1 (06-01-2004)
Computation is Inaccurate or Flawed

Bank Deposits and Cash Expenditures Method—Most challenges to the accuracy of this method focus on the nature of the individual deposits in the account(s). The taxpayer may claim that the deposits consist of taxable and nontaxable items that were not correctly classified by the examiner. Deposits of loan proceeds, gifts and inheritances, as well as transfers from other accounts are some of the most common claims. Redeposits of items, such as insufficient funds checks, may also cause inaccuracy if counted twice. The examiner should carefully review the analysis and attempt to identify the source and character of each deposit before presenting results as an understatement of taxable income.
Source and Application of Funds Method—Most common errors are in the areas of adjustments for the accrual method of accounting and the handling of loan transactions. Examiners should insure these areas, as well as the entire computation, are correct and fundamentally sound.
Markup Method—The main challenges to this method are to show that the computation relies upon improper percentages, improper cost of sales, or that the examiner’s computation fails to give adequate consideration to significant items such as spillage, breakage or theft losses. These issues should be addressed and quantified during the initial interview. Since the method relies on a comparison of a situation similar to that under examination, defenses could be formulated based on dissimilarities in several areas such as type of merchandise handled, size of the operation, locality, time period covered, or general merchandising policy.
Net Worth Method—Challenges to the accuracy of this formal indirect method are generally aimed at the correctness of the opening net worth figure and the failure to prove "cash on hand " in the understatement years. An accurate opening net worth figure is essential and should be computed based on solid evidence. The amount of "Cash on Hand," and/or "Accumulated Funds" if any, must be established early in the examination to refute this defense. The concepts of "Cash on Hand" and "Accumulated Funds" is an important concept in formal indirect methods and is discussed in subsection 4.10.4.6.8.3 below.

4.10.4.6.8.2 (06-01-2004)
Unexplained Difference is Due to a Nontaxable Source

The taxpayer may attempt to refute the findings of the examiner’s formal indirect method by claiming the unexplained difference is actually caused by the receipt of nontaxable sources of funds.
If it can be shown that all nontaxable sources of income have been considered, then it can be concluded that the only likely source remaining is a taxable one. Examiners need to show that increases in taxable income arose from a likely taxable source. This can be demonstrated by specific omissions, showing the taxpayer’s business had the capacity to generate more sales, or comparisons over time. To the extent that the possible source can be identified, the more acceptable the computation will be.

4.10.4.6.8.3 (06-01-2004)
Unexplained Difference is Due to Cash on Hand or Accumulated Funds

The taxpayer may attempt to refute the findings of the examiner’s formal indirect method by claiming the unexplained difference is actually caused by the use of nontaxable funds accumulated in prior years.
Since Cash on Hand and Accumulated Funds are important fundamental aspects of the examination of income and the formal indirect methods, examiners should establish the amount and verify the taxpayer’s statements of cash accumulations during the initial interview. This is necessary because:
1. Cash on Hand and Accumulated Funds can explain Financial Status Analyses that appear to identify a potentially significant imbalance. The issue can be resolved quickly and with the least amount of burden to the taxpayer if it is addressed early in the examination.
2. The information is needed to determine whether a formal indirect method should be used, and which method is most appropriate.
3. An adjustment for unreported income can be challenged if the availability of Cash on Hand and Accumulated Funds is not addressed at the beginning of the audit. The after-the-fact "cash in the mattress" defense cannot be used if the actual Cash on Hand and Accumulated Funds have already been established.
In order to avoid any misunderstanding by the taxpayer, it is important that the meaning of "cash on hand" and " accumulated funds" be explained prior to answering any inquiry. Taxpayers must understand the term, "cash on hand" means any undeposited currency and coins used for normal business transactions. Accumulated funds refers to cash accumulated by the taxpayer and is not associated with normal 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. Once the terms are understood, the examiner should inquire as to the existence of any cash on hand and accumulated funds. See Exhibit 4.10.4-1, Interview Questions Addressing Accumulated Funds.
If a taxpayer attempts to avoid answering questions concerning cash, examiners should try to pinpoint amounts by starting with an estimate such as "over or under $10,000" and narrowing the range until the taxpayer agrees with a general amount.
A commitment should be sought concerning whether an individual had any large accumulations of cash during the tax period under audit. Examiners should ask the taxpayer to make an affirmative statement regarding the existence or nonexistence of Cash on Hand and Accumulated Funds.
If taxpayers allege that they have what appears to be an inordinate amount of cash, the examiner should further inquire to establish:
1. The amount of cash on hand at the end of each year under examination to the present (at the time of the interview).
2. How it was accumulated.
3. Where it was kept and in what denominations.
4. Who had knowledge of it.
5. Who counted it.
6. When and where any of it was spent.
7. Why did the taxpayer accumulate the cash on hand
Information regarding cash is necessary to establish the consistency and reliability of the taxpayer’s statement. Usually no direct corroborating evidence is available but statements made about the source and use of the funds can be verified. Look for inconsistencies. For example:
1. The taxpayer may not have had sufficient taxable or nontaxable income in prior years to accumulate cash.
2. Claims of substantial cash on hand might be discredited by showing that the taxpayer lived frugally, borrowed money, made installment purchases, incurred large debts, was delinquent on accounts, had a poor credit rating or filed for bankruptcy.
3. Financial statements filed by the taxpayer at banks and other places could be reviewed to see if the taxpayer disclosed the Cash on Hand on these statements.
A taxpayer’s explanation for Cash on Hand or Accumulated Funds may change during an examination. The examiner should document the information as it is received. The documentation should include when and where the information was received, who was present, what was said, and when the documentation was prepared; i.e., contemporaneously to the event.

Exhibit 4.10.4-1 (06-01-2004)
Interview Questions Addressing Accumulated Funds

The following template can be used as part of the initial interview with a taxpayer.

Do you keep more than $1,000 on your person, at your home, at your business, or in any other location?
What do the accumulated funds consist of? (For example, paper money, coin, money orders, cashier checks, etc.)
In what denominations were the funds accumulated?
Where do you keep the accumulated funds? (Provide exact location.)
Were the accumulated funds always kept in the location identified in question 4? If not, provide the exact locations and dates that the accumulated funds were kept there.
What kind of container were the accumulated funds kept in? (Shape and dimensions of the container.)
How much accumulated funds did you have at the beginning of the year under audit? At the end of the year under audit?
How much accumulated funds do you have right now (today's date)?
Over what period of time were the funds accumulated?
Are the accumulated funds yours alone, or does it belong to more than one person? Identify each person (name and relationship to taxpayer) having ownership of these accumulated funds.
Do any of the other owners have access to these accumulated funds? If yes, provide the following information.
1. Name of person with access.
2. Date of each access.
3. Identify the increase or decrease in accumulated funds for each access.
4. Determine whether each person obtaining access was accompanied by another person. If so, provide the name and relationship of such person(s).
5. Identify the type of records kept to identify the name(s), date(s) and effect on the accumulated funds each time there was an access.
Why are you accumulating funds? (Ask each person having ownership.)
What is the original source of the money included in the accumulated funds? (Ask each person having ownership.)
How often do you access the accumulated funds?
What is the effect of each access? Do you add or withdraw from the accumulated funds?
Are you accompanied by another individual when you access the accumulated funds? If yes, provide the name and address of the persons involved.
Do you count the accumulated funds every time you access them? If not, provide the dates and purpose for when the funds were counted.
Does anyone else know about the accumulated funds? If yes, provide the name, relationship, address and phone number for the person. Also determine whether these persons have access to the accumulated funds and if so, the manner and circumstances under which their access was made.

Exhibit 4.10.4-2 (06-01-2004)
Internal Sources of Information

Information Data Retrieval System (IDRS) Commands
AMDIS	provides a summary of all years open for examination
AMDISA	provides the exam records for a specific year under audit

Business Master File On-Line (BMFOL) - IRM 2.3.59
BRTVUE	Provides business entity return information
BMFOLI	Provides a list of all tax periods on Master File. Indicates whether a return was filed for those tax periods. Returns covered include income tax, employment tax, and excise tax.
BMFOLR	return information
BMFOLT	Provides a return transcript for a specific tax period on Master File.
BMFOLU	Provides total wages for a calendar year per the Form(s) 941, W-3, and the W-2's filed by the taxpayer. It also provides the number of W-2's listed on the W-3 and the number of W-2's actually filed. This information is available if an MFT 88 appears on BMFOLI for the calendar year.
BMFOLZ	audit history screen

The Dependent Database On-Line - IRM 2.3.54
DDBOL (def 0,1,2)	access to dependent database for specific years

The Duplicate Direct Deposit On-Line Research - IRM 2.3.74
DUPOL (def 0,1,2)	Displays both IMF and BMF taxpayer information to help aid in fraud detection (use of SSN) by monitoring duplicate direct deposits made to taxpayers' bank accounts.

Individual Master File On-Line (IMFOL)
(Provides read-only access to IMF - See IRM 2.3.51)
RTVUE	Provides tax return information, including all schedules filed with the return.
IMFOLR	Provides account postings and basic nonbusiness tax return information such as AGI, wages, interest income, and itemized deductions.
IMFOLT	tax module screen
IMFOLI	Provides a list of all tax periods on Master File. Indicates whether a return was filed for those tax periods and if the return filed was a substitute for return (SFR) or the taxpayer's return (POSTED). Also indicates subsequent assessments after the return was filed.
IMFOLZ	audit history record

National Account Profile (NAP)
INOLE	Provides access to the National Account Profile, which contains selected entity information for all Master File (MF) accounts such as name, address and date EIN established (or date of birth) - IRM 2.3.47
INOLET	TIN type known
INOLES	specific account

Information Returns Master File Transcript Request (IRPTR)
IRPTR	Allows IDRS users to request either on-line or hardcopy IRP transcripts from IRMF - IRM 2.3.35
IRPTRL	payee IRPOL request (summary)
IRPTRO	itemized payee listing of Forms 1099 and W-2 for the taxpayer
IRPTRR	payer hardcopy request

The Transcript Research System (TRS)
MFTRA	allows for hard copy transcripts or real-time displays for transcript data - IRM 2.3.32. Provides dates of assessment, date tax return was filed, date tax return was due, date of prior audit, dates liens filed.

Payer Master File (PMF)
PMFOLS	provides information from the Payer Master File. The summary screen shows all sources of income and amounts - IRM 2.3.53
Delinquent Return Investigations
TDINQ	displays entity and module data pertinent to delinquent return investigations (if present), including the Revenue Officer assigned to the taxpayer account - IRM 2.3.26

Currency and Banking Retrieval System (CBRS)
Overview	The Bank Secrecy Act and money laundering statutes were passed by Congress to help facilitate the identification and prosecution of individuals involved in illegal activities for profit.
	The CBRS database is accessible to authorized personnel within the Treasury Department. The system can be used to identify bank accounts, secreted cash, leads to assets and foreign bank accounts, nominees and other useful information for Compliance and other law enforcement personnel.
Form 4789	Currency Transaction Reports (CTR) - domestic financial institutions, including banks, credit unions, check cashing establishments, and currency exchanges are required to file a CTR on each deposit, withdrawal, exchange of currency, or other payment or transfer involving a transaction in currency in an amount greater than $10,000. Either cash-in or cash-out can generate the reporting requirements.
Form 8362	Currency Transaction Report by Casino (CTRC) - Casinos are required to file a CTRC on each deposit, withdrawal, exchange of currency, gambling token or chips, or other payment or transfer which involves a transaction in currency of more than $10,000.
	Currency Transaction Report for Nevada Casino- same requirements as Form 8362, except is filed only by Nevada casinos.
Form 4790 (Customs)	Report of International Transportation of Currency or Monetary Instruments (CMIR) - each person who transports, or has transported, currency of the United States, any other country's traveler checks, money orders, or investment securities, or any other negotiable instruments, is required to file this form.
Form 90-22.1 (Treasury)	Report of Foreign Bank and Financial Accounts (FBAR)- United States persons must both file the form and answer yes to the question on Schedule B, Form 1040, if they have a financial interest in, or signature authority for a bank, securities, or other financial account, in a foreign country which exceeds $10,000 in total value at any time during the calendar year.
Form 8300	Report of Cash Payments Over $10,000 Received in a Trade or Business - required to be filed by any person who, in the course of carrying on a trade or business, receives more than $10,000 in cash in one transaction or related transactions.
	Criminal Referral Form (CRF)- These forms are filed voluntarily by banks on unusual, suspicious, structured transactions and cancelled transactions.
Form 7501 (Customs)	Entry Summary (EXC) - Filed by importers or licensed customs brokers whenever commodities are imported into the United States. CBRS reflects only those commodities that are subject to excise tax.

Exhibit 4.10.4-3 (06-01-2004)
External Sources of Information

Contacts made with government officials to obtain information that is available to the public are not considered third party contacts under IRC section 7602(c). Such contacts are routinely made and there is no expectation of privacy with respect to the information that is provided to, or maintained by, government officials and which is available to the general public. Some examples are:

Contact with Postal officials to obtain a taxpayer's current address,
Contact with a county clerk to obtain lien information on a taxpayer's property,
Contact with a clerk of the Court to obtain publicly available court records,
Contacts with state officials to obtain corporate charters or other publicly available information regarding corporate taxpayers or exempt organizations.

Treas. Reg. section 301.7602-2(f)(5) states that IRC section 7602(c) does not apply to any contact with any office of any local, state, Federal or foreign governmental entity except for contacts concerning the taxpayer's business with the government office contacted, such as the taxpayer's contracts with, or employment by, the government office. The term "office" includes any agent or contractor of the governmental office acting in such capacity.

Government Agencies
- Bureau of Labor Statistics
- Social Security Administration
- U.S. Post Office
- Department of Motor Vehicles
- Law Enforcement agencies
- Occupational Safety and Health Administration (OSHA)
- Department of Social Services
- Department of Agriculture
- Small Business Administration
- Department of Transportation
- Fictitious Name Register
- Better Business Bureau
Court Records
- Divorce
- Liens
- Probate
- Property records
- Mortgages (amount/holder)
- Bankruptcy
State Information
- Permits
- Licenses
- Sales Tax
- Employment/Unemployment data
Trade Associations
Corporations (Charters, etc.)
City Directory
Subscriber Information Sources (Dun & Bradstreet, Robert Morris & Associates, LEXIS)
News Media (newspapers, internet, magazines, etc.)

Exhibit 4.10.4-4 (06-01-2004)
Example of Net Worth Method

	12/31/1999	12/31/2000	12/31/2001
Assets
Cash on Hand	$ 1,000	$ 2,500	$ 2,000
Cash in Banks	15,000	20,000	22,500
Securities	22,000	19,000	18,500
Inventory	31,000	42,000	55,000
Loans/Acct. Rec.	28,000	35,000	38,000
Furniture and Fixtures	57,000	59,500	69,000
Real Estate	145,000	145,000	170,000
Personal Auto	26,000	26,000	37,000
Total Assets	$ 325,000	$ 349,000	$ 412,000
Liabilities
Accounts Payable	$ 24,000	$ 13,500	$ 18,500
Notes Payable	10,000	20,000	17,000
Mortgage Payable	135,000	122,000	140,000
Accumulated Depreciation	24,000	34,500	41,500
Total Liabilities	$ 193,000	$ 190,000	$ 217,000
Net Worth	$132,000	$159,000	$195,000
Less Prior Year's Net Worth		132,000	159,000
Increase in Net Worth		$ 27,000	$ 36,000
Adjustments to arrive at Adjusted Gross Income
Adjustments to Increase Net Worth*		51,400	41,600
Subtotal		$ 78,400	$ 77,600
Adjustments to Decrease Net Worth**		16,700	9,400
Corrected AGI		$ 61,700	$ 68,200
Adjustments to arrive at Corrected Taxable Income
Adjustments to arrive at Taxable Income***		21,400	22,800
Corrected Taxable Income		$ 40,300	$ 45,400
Taxable Income per Return		21,300	22,980
Taxable Income not Reported		$ 19,000	$ 22,420
Footnotes:
*Adjustments to Increase Net Worth (nondeductible items)
		12/31/2000	12/31/2001
Personal Living Expenses (below)		$39,300	$32,700
Federal Income Tax		6,100	4,000
Nondeductible Capital Loss		-0-	-0-
Nondeductible Personal Loss		-0-	-0-
Nondeductible Hobby Loss		1,800	2,900
Gifts Made		4,200	2,000
Total Adjustments		$ 51,400	$ 41,600

Personal Living Expenses
Food & Outside Meals		$ 5,100	$ 5,300
Home Repairs		1,900	-0-
Utilities		2,200	2,550
Auto Expense		2,700	2,850
Department Store Purchases		3,200	1,100
Recreation & Entertainment		2,100	1,800
Vacation		3,300	-0-
Charitable Contributions		1,500	1,000
Interest Paid		10,800	12,300
Taxes		3,500	3,700
Medical		3,000	2,100
Total Personal Living Expenses		$ 39,300	$ 32,700

Adjustments to Decrease Net Worth** (nontaxable items)
		12/31/2000	12/31/2001
Tax Exempt Interest		$1,700	$ 1,400
Social Security		-0-	-0-
Life Insurance Proceeds		15,000	-0-
Inheritance		-0-	8,000
Total Adjustments		$ 16,700	$ 9,400

* Adjustments to Arrive at Taxable Income**
		12/31/2000	12/31/2001
Itemized or Standard Deduction:
Medical (net of limitation)		$ -0-	$ -0-
Taxes		3,500	3,700
Interest		10,800	12,300
Casualty Loss		-0-	-0-
Contributions		1,500	1,000
Total Itemized Deductions		$ 15,800	$ 17,000
Standard Deduction (joint)		7,350	7,600
Greater of Itemized or Standard Deduction		$ 15,800	$17,000
Add Personal Exemptions (2)		5,600	5,800
Total Adjustments		$ 21,400	$ 22,800

Exhibit 4.10.4-5 (06-01-2004)
Bypassing Powers of Attorney

Authority granted under IRC section 7521(c) permits the bypassing of a power of attorney responsible for unreasonable delays or hindrance of an Internal Revenue Service examination. Circular 230, titled " Regulations Governing the Practice of Attorneys, Certified Public Accountants, Enrolled Agents, Enrolled Actuaries, and Appraisers before the Internal Revenue Service," provides the regulations governing the practice of tax professionals before the Internal Revenue Service. The key provisions are contained in Subpart B, titled "Duties and restrictions relating to Practice Before the Internal Revenue Service."

Section 10.20(a), Information to be furnished to the Internal Revenue Service

No attorney, certified public accountant, enrolled agent or enrolled actuary shall neglect or refuse promptly to submit records or information in any matter before the Internal Revenue Service, or shall interfere, or attempt to interfere, with any proper and lawful effort by the Internal Revenue Service or its officers or employees to obtain any such record or information, unless he believes in good faith and on reasonable grounds that such record or information is privileged or that the request for, or effort to obtain, such record or information is of doubtful legality.

Section 10.21, Knowledge of Client's Omission

Each attorney, certified public accountant, enrolled agent or enrolled actuary who, having been retained by a client with respect to a matter administered by the Internal Revenue Service, knows that the client has not complied with the revenue laws of the United States or has made an error in or omission from any return, document, affidavit, or other paper, which the taxpayer is required by the revenue laws of the United States to execute, shall advise the client promptly of the fact of such noncompliance, error, or omission.

Section 10.22, Diligence as to Accuracy

Each attorney, certified public accountant, enrolled agent or enrolled actuary shall exercise due diligence:

(a) In preparing or assisting in the preparation of, approving, and filing returns, documents, affidavits, and other papers relating to Internal Revenue Service matters;

(b) In determining the correctness of oral or written representations made by him to the Department of the Treasury; and

(c) In determining the correctness or oral or written representations made by him to any matter administered by the Internal Revenue Code.

Section 10.23, Prompt Disposition of Pending Matters

No attorney, certified public accountant, enrolled agent, or enrolled actuary shall unreasonably delay the prompt disposition of any matter before the Internal Revenue Service.

Exhibit 4.10.4-6 (06-01-2004)
Auditing Net Operating Loss Deductions (NOLD)

The Net Operating Loss (NOLD)

A NOLD is reported as a negative amount on the "Other Income" line of Form 1040. Deductions are allowable under IRC section 172. Examiners may require taxpayers to produce the records necessary to prove they are entitled to the NOLD.

Proof

The taxpayer is required to maintain such records as will allow an examiner to verify the accuracy of the deduction. Copies of tax returns are not proof, nor are accountants' workpapers. In Owens v. Commissioner, T.C. Memo 2001-143, the Court concluded that "although each of the returns for 1990, 1991, and 1992 shows a loss attributable to the petitioners' Schedule C business, petitioners failed to introduce any evidence establishing the loss claimed in each of those returns. The returns for 1990 through 1992 constitute nothing more than the position of petitioners that they had the respective losses claimed on those returns."

Records are Made Available

Faced with the examination of a NOLD, a taxpayer should make records from the source years available to the examiner. Examiners must audit the records to determine the accuracy of the NOLD.

Alternatively, when the source of the NOLD is the same business (or there are other similarities), it is probable that, if the records were examined, the result would be similar to the current year adjustments. If the taxpayer agrees, the examiner may propose a full or partial disallowance of the NOLD based on this premise in the interest of reducing burden for both the Service and the taxpayer. If the taxpayer does not agree, the examiner must audit the records provided by the taxpayer.

If the taxpayer declines to produce the records, or the records are unavailable, the examiner should disallow the entire NOLD for lack of substantiation.

Statutes of Limitation

The statute of limitation for the year of the net operation loss is not an impediment when making an adjustment for the purpose of determining how much net operating loss may be carried forward and deducted in a subsequent year. Under IRC section 7602(a), the Secretary is authorized to examine any books, papers, records, or other data which may be relevant or material to such inquiry.

Example 1:

The taxpayer's 2001 return includes the following:

1. Schedule C Loss: -$45,000

2. NOLD: -$90,000

3. Taxable Income: -$150,000 (including the NOLD)

The NOLD is a carryforward of accumulated losses from the Schedule C business in the prior three years:

Year 1998 NOL: -$15,000

Year 1999 NOL: -$35,000

Year 2000 NOL: -$40,000

The examiner determines that the taxpayer did not report $100,000 in gross receipts from the Schedule C business. Without considering the NOLD, the adjustment of $100,000 to taxable income will have no impact on the taxpayer's income tax liability; i.e., taxable income will be -$50,000. However, given that the source of the unreported income in the current year is the same business that is generating the NOLD, it is likely that taxable income was similarly unreported in the prior years. The examiner audits the NOLD issue and determines that the entire NOLD should be disallowed. The corrected taxable income for 2001 is +$40,000, reflecting adjustments for both the $100,000 additional income and the disallowed $90,000 NOLD.

Example 2:

The taxpayer's 2001 return includes the following:

1. Schedule C Loss: -$46,000

2. NOLD: -$110,000

3. Taxable Income: -$30,000 (including the NOLD and other sources of income reported on the return)

The NOLD is a carryforward of accumulated losses from the Schedule C business in the prior three years:

Year 1998 NOL: -$25,000

Year 1999 NOL: -$45,000

Year 2000 NOL: -$40,000

The examiner determines that the taxpayer did not report $25,000 in gross receipts from the Schedule C business. Without considering the NOLD, the adjustment of $25,000 to taxable income will have no impact on the taxpayer's income tax liability; i.e., taxable income will be -$5,000.

Examiners have the authority to make factual determinations to arrive at the substantially correct tax liability. In this case, the amount of unreported income in the current year is less than the amount of the NOLD; i.e., the taxpayer underreported $25,000 in the current year and the NOLD was in excess of $75,000 (3 x $25,000). Assuming that there is a consistent pattern over the four year period, such as the same business practices, the examiner could reasonably conclude that the taxpayer underreported income in the prior years. With the taxpayer's agreement, the examiner could propose an adjustment to the NOLD based on an analysis of business ratios without actually auditing the taxpayer's records. For example, if the Cost of Goods Sold to Gross Receipts ratio for the year under audit is 75% after correcting for the $25,000 underreported income, the same percentage could be used to compute the NOLD adjustment for the prior years if the taxpayer agreed.

Year		Per Return	Corrected	Unreported Income
1998	COGS	$178,000	$178,000
	Gross Receipts	$210,000	$237,333	$27,333*
	COGS/GR Ratio	85%	75%
1999	COGS	$252,000	$252,000
	Gross Receipts	$300,000	$336,000	$36,000
	COGS/GR Ratio	84%	75%
2000	COGS	$192,000	$192,000
	Gross Receipts	$240,000	$256,000	$16,000
	COGS/GR Ratio	80%	75%
* Limited to NOLD of $25,000 per 1998 return

The adjustment to the NOLD carryforward originating in 1998 is limited to $25,000, even though the amount of unreported income is $27,333. The NOLD adjustment for the 2001 return is $25,000 + $36,000 + $16,000 = $77,000.

The corrected taxable income would be $72,000, reflecting adjustments for both the $25,000 in additional income and the $77,000 reduction of the NOLD. The remaining NOLD is $33,000 computed as $9,000 from 1999 and $24,000 from 2000.

If the taxpayer does not agree with the results, the examiner must audit the taxpayer's books and records to make an actual determination of tax liability.

Conclusion:

Examiners will need to apply professional judgment based on all the facts and circumstances when deciding on the proper course of action. The above examples are not intended to direct a like determination on actual cases; only to demonstrate approaches that may be taken in similar circumstances

Examination of Income Cont.

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

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

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

4.10.4.6.3.3 (06-01-2004) Bank Deposit Defined

4.10.4.6.3.4 (06-01-2004) Gross Receipts Defined

4.10.4.6.3.5 (06-01-2004) Factors to Consider

4.10.4.6.3.6 (06-01-2004) Gross Receipts Formula

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

Note:

Example:

Note:

Note:

Note:

Example:

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

4.10.4.6.3.6.3 (06-01-2004) Bank Service Charges

4.10.4.6.3.6.4 (06-01-2004) Returned Checks

4.10.4.6.3.6.5 (06-01-2004) Overdrawn Accounts

4.10.4.6.3.7 (06-01-2004) Adjustments to Noncash Expenses

4.10.4.6.4 (06-01-2004) Source and Application of Funds Method

4.10.4.6.4.1 (06-01-2004) Case Law (Source and Application of Funds Method)

4.10.4.6.4.2 (06-01-2004) When to Use the Source and Application of Funds Method

4.10.4.6.4.3 (06-01-2004) Example of Source and Application of Funds Method

4.10.4.6.4.4 (06-01-2004) Accrual Basis Taxpayers

4.10.4.6.4.4.1 (06-01-2004) Opening Cash on Hand

4.10.4.6.4.4.2 (06-01-2004) Example of Source and Application of Funds Method for Accrual Taxpayers

4.10.4.6.5 (06-01-2004) Markup Method

4.10.4.6.5.1 (06-01-2004) Case Law (Markup Method)

4.10.4.6.5.2 (06-01-2004) When to Use the Markup Method

4.10.4.6.5.3 (06-01-2004) Gross Profit Margin to Sales

4.10.4.6.5.4 (06-01-2004) Cost of Sales to Gross Receipts Ratio

4.10.4.6.6 (06-01-2004) Unit and Volume Method

4.10.4.6.6.1 (06-01-2004) Case Law (Unit and Volume Method)

4.10.4.6.6.2 (06-01-2004) When to Use the Unit and Volume Method

4.10.4.6.6.3 (06-01-2004) Other Considerations

4.10.4.6.6.4 (06-01-2004) Example of Computation

4.10.4.6.7 (06-01-2004) Net Worth Method

4.10.4.6.7.1 (06-01-2004) Case Law (Net Worth Method)

4.10.4.6.7.2 (06-01-2004) When to Use the Net Worth Method

4.10.4.6.7.3 (06-01-2004) Formula for the Net Worth Method

4.10.4.6.7.3.1 (06-01-2004) Adjustments to Arrive at Adjusted Gross Income

4.10.4.6.7.3.2 (06-01-2004) Adjustments to Arrive at Taxable Income

4.10.4.6.7.4 (06-01-2004) Determining Opening and Closing Net Worth

4.10.4.6.7.5 (06-01-2004) Likely Source of Income

4.10.4.6.7.6 (06-01-2004) Opening Cash on Hand

4.10.4.6.7.7 (06-01-2004) Verification of Items

4.10.4.6.7.8 (06-01-2004) Personal Living Expenses

4.10.4.6.7.9 (06-01-2004) Advantages of Net Worth Method

4.10.4.6.7.10 (06-01-2004) Example of Net Worth Computation

4.10.4.6.8 (06-01-2004) Potential Taxpayer Defenses Against Formal Indirect Methods of Computing Income

4.10.4.6.8.1 (06-01-2004) Computation is Inaccurate or Flawed

4.10.4.6.8.2 (06-01-2004) Unexplained Difference is Due to a Nontaxable Source

4.10.4.6.8.3 (06-01-2004) Unexplained Difference is Due to Cash on Hand or Accumulated Funds

Exhibit 4.10.4-1 (06-01-2004) Interview Questions Addressing Accumulated Funds

Exhibit 4.10.4-2 (06-01-2004) Internal Sources of Information

Exhibit 4.10.4-3 (06-01-2004) External Sources of Information

Exhibit 4.10.4-4 (06-01-2004) Example of Net Worth Method

Exhibit 4.10.4-5 (06-01-2004) Bypassing Powers of Attorney

Exhibit 4.10.4-6 (06-01-2004) Auditing Net Operating Loss Deductions (NOLD)

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

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

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

4.10.4.6.3.3 (06-01-2004)
Bank Deposit Defined

4.10.4.6.3.4 (06-01-2004)
Gross Receipts Defined

4.10.4.6.3.5 (06-01-2004)
Factors to Consider

4.10.4.6.3.6 (06-01-2004)
Gross Receipts Formula

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

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

4.10.4.6.3.6.3 (06-01-2004)
Bank Service Charges

4.10.4.6.3.6.4 (06-01-2004)
Returned Checks

4.10.4.6.3.6.5 (06-01-2004)
Overdrawn Accounts

4.10.4.6.3.7 (06-01-2004)
Adjustments to Noncash Expenses

4.10.4.6.4 (06-01-2004)
Source and Application of Funds Method

4.10.4.6.4.1 (06-01-2004)
Case Law (Source and Application of Funds Method)

4.10.4.6.4.2 (06-01-2004)
When to Use the Source and Application of Funds Method

4.10.4.6.4.3 (06-01-2004)
Example of Source and Application of Funds Method

4.10.4.6.4.4 (06-01-2004)
Accrual Basis Taxpayers

4.10.4.6.4.4.1 (06-01-2004)
Opening Cash on Hand

4.10.4.6.4.4.2 (06-01-2004)
Example of Source and Application of Funds Method for Accrual Taxpayers

4.10.4.6.5 (06-01-2004)
Markup Method

4.10.4.6.5.1 (06-01-2004)
Case Law (Markup Method)

4.10.4.6.5.2 (06-01-2004)
When to Use the Markup Method

4.10.4.6.5.3 (06-01-2004)
Gross Profit Margin to Sales

4.10.4.6.5.4 (06-01-2004)
Cost of Sales to Gross Receipts Ratio

4.10.4.6.6 (06-01-2004)
Unit and Volume Method

4.10.4.6.6.1 (06-01-2004)
Case Law (Unit and Volume Method)

4.10.4.6.6.2 (06-01-2004)
When to Use the Unit and Volume Method

4.10.4.6.6.3 (06-01-2004)
Other Considerations

4.10.4.6.6.4 (06-01-2004)
Example of Computation

4.10.4.6.7 (06-01-2004)
Net Worth Method

4.10.4.6.7.1 (06-01-2004)
Case Law (Net Worth Method)

4.10.4.6.7.2 (06-01-2004)
When to Use the Net Worth Method

4.10.4.6.7.3 (06-01-2004)
Formula for the Net Worth Method

4.10.4.6.7.3.1 (06-01-2004)
Adjustments to Arrive at Adjusted Gross Income

4.10.4.6.7.3.2 (06-01-2004)
Adjustments to Arrive at Taxable Income

4.10.4.6.7.4 (06-01-2004)
Determining Opening and Closing Net Worth

4.10.4.6.7.5 (06-01-2004)
Likely Source of Income

4.10.4.6.7.6 (06-01-2004)
Opening Cash on Hand

4.10.4.6.7.7 (06-01-2004)
Verification of Items

4.10.4.6.7.8 (06-01-2004)
Personal Living Expenses

4.10.4.6.7.9 (06-01-2004)
Advantages of Net Worth Method

4.10.4.6.7.10 (06-01-2004)
Example of Net Worth Computation

4.10.4.6.8 (06-01-2004)
Potential Taxpayer Defenses Against Formal Indirect Methods of Computing Income

4.10.4.6.8.1 (06-01-2004)
Computation is Inaccurate or Flawed

4.10.4.6.8.2 (06-01-2004)
Unexplained Difference is Due to a Nontaxable Source

4.10.4.6.8.3 (06-01-2004)
Unexplained Difference is Due to Cash on Hand or Accumulated Funds

Exhibit 4.10.4-1 (06-01-2004)
Interview Questions Addressing Accumulated Funds

Exhibit 4.10.4-2 (06-01-2004)
Internal Sources of Information

Exhibit 4.10.4-3 (06-01-2004)
External Sources of Information

Exhibit 4.10.4-4 (06-01-2004)
Example of Net Worth Method

Exhibit 4.10.4-5 (06-01-2004)
Bypassing Powers of Attorney

Exhibit 4.10.4-6 (06-01-2004)
Auditing Net Operating Loss Deductions (NOLD)