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Examination of Income Cont. |
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Examination of Income Cont. | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| 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: 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.
- Review information in the file included with the case building data.
- Personal assets may be identified by reviewing state registrations and licenses, property records and building permits.
- 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:
- 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.
- 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:
- IRM 4.10.4.2.5 and IRM 4.10.4.2.6
- IRM 4.10.4.3.3.2(3) and (4)
- IRM 4.10.4.3.4.4(3)
- 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:
- 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.
- 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.
- 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.
- 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