Handbook 9.5
The Investigative Process
Chapter 9
Method of Proof
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Contents
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The purpose of this chapter is to explain the different methods of proof
to special agents and how to document each method. The following methods
of proof will be discussed in this chapter:
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Specific Items
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Net Worth
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Expenditures
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Bank Deposits
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Percentage Markup
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Unit and Volume
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In order to establish a criminal offense under Internal Revenue Code (IRC)
7201, the special agent must develop evidence to prove a substantial amount
of additional tax due and willful attempt to evade it. To prove the first
element of the offense, it is necessary to establish that the correct taxable
income is in excess of that reported.
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Taxable income may be established by the direct or indirect approach.
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The specific item method involves proof of transactions (sales, expenses,
etc.) affecting taxable income.
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Usually, taxable income can be established with less difficulty by the direct
approach and for this reason it should be used whenever possible.
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Taxpayers, almost without exception, report their income by the specific
item or specific transaction method; that is, the computations which are
reflected in their income tax returns are based upon the sum total of the
transactions they engaged in during the taxable period.
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Most taxpayers maintain books and records in which these various transactions
are recorded as they occur.
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In a specific item case, the government endeavors to prove that the transactions
in which the taxpayer engaged during the year were not completely or accurately
reflected in his or her income tax return, with the result that his or her
income tax liability was understated, and that such result was willful.
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The indirect approach relies upon circumstantial proof of income by use of
such methods as net worth, expenditures, and bank deposits.
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In numerous cases, the courts have approved the use of the following indirect
methods of determining income: net worth, expenditures, and bank deposits.
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Although these methods are considered circumstantial proof of taxable income,
the courts have approved them for use in determining taxable income for criminal
prosecution on the theory that proof of unexpended funds or property in the
hands of a taxpayer may establish a prima facie understatement of income
requiring a taxpayer to overcome the logical inference drawn from the provable
facts.
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In one income tax case the government employed all three methods (net worth,
expenditures, and bank deposits) to show corrected income.
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With respect to the establishment of a prima facie case by such evidence,
the court stated: In these (and other similar) cases, the courts have been
careful to point out that findings of fraud have been sustained if, but only
if, the taxpayer has offered no explanation, or no adequate explanation,
of the discrepancies between (on the one hand) expenditures and bank deposits
and increases in net worth and (on the other hand) the amount of income reported
by the taxpayer.
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Another indirect method of proof is percentage markup. Pending the establishment
of judicial precedents, the percentage markup method of proof should only
be used as a primary method of proof on a limited basis and no longer used
to corroborate other methods used in criminal cases. (See text 427.11.)
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[9.5] 9.3 (07-30-1998)
DISTINGUISHING BETWEEN ACCOUNTING SYSTEMS, ACCOUNTING METHODS, AND METHODS
OF PROVING INCOME
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For many years, there has been much confusion regarding the synonymous use
of the terms "accounting system,""accounting methods," and "methods of proving
or determining income." It is not unusual to hear reference made to the net
worth and expenditures method as a method of accounting when, in fact, it
is a method of proving income by circumstantial or indirect evidence.
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There are two basic accounting systems, the single entry and the double entry
system, but there are various methods of accounting, such as cash, accrual,
hybrid, installment, and long-term or completed contract methods. The usual
methods of determining or proving income are specific item, net worth,
expenditures, bank deposits, and percentage methods.
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Taxable income must be computed, for purposes of criminal prosecution, under
the accounting method by which the taxpayer regularly computes his income.
The reason for this is given in Morrison v. U.S. In this criminal
proceeding, it was necessary to establish not only that the tax liabilities
here were understated, but that the understatement was attributable, at least
in part, to the fact that the taxpayer's returns were not honestly prepared.
Proof of the latter fact could only be accomplished by adopting and consistently
applying the taxpayer's own method of accounting.
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If no method of accounting has been regularly used by the taxpayer or if
the method does not clearly reflect income, special agents may use the method
they believe clearly reflect the taxpayer's income.
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In a specific item case, the government tries to prove that the specific
transactions in which the taxpayer engaged during the year were not completely
or accurately reflected in his or her income tax return, with the result
that his or her income tax liability was understated, and that such
understatement was willfully made.
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The specific item method offers the most direct method of proving unreported
income. It is easier than other methods to present in court and is readily
understood by jurors.
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Omitted income, fictitious deductions, false exemptions, or false tax credits
are means whereby taxes may be evaded.
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Omitted income results from failure to report any of the numerous items of
taxable income expressed and implied in the IRC.
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In the examination of merchant taxpayers, the item of omitted income most
frequently encountered is sales revenue.
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In the case of individuals, omitted income is usually in the form of salaries,
interest, dividends, commissions, gains from the sale of property, and fees.
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Often a deduction which is considered fraudulent takes the guise of a fictitious
purchase of merchandise or a fictitious expense. However, it could be any
fictitious deduction or exemption fraudulently claimed as allowable under
the authority of the IRC.
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There are two types of certificates of deposit. A standard certificate of
deposit and an original issue discount certificate.
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A standard certificate of deposit pays interest at intervals throughout the
term of the note, often quarterly.
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The interest may be withdrawn without penalty although the underlying principal
may not normally be withdrawn without incurring a substantial penalty.
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Financial institutions will issue Forms 1099 INT to the depositor reflecting
the interest earned.
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An original issue discount certificate pays interest only at the note's maturity.
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Pursuant to IRC Section 1232(a)(3), the Service requires holders of this
type of certificate of deposit to report the interest earned on the note
pro rata throughout its term.
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IRC Section 6049 contains specifics as to when Forms 1099-OID will be issued
to holders of the original issue discount (OID) certificates.
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[9.5]
9.4.1.2 (07-30-1998)
Criminal Tax Division's Position on Original Issue Discount Certificates
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The position of the Criminal Tax Division is that Criminal Investigation
(CI) should not recommend prosecution of criminal cases based upon failure
to report interest from original issue discount certificates before the
certificates of deposit mature, unless unusual circumstances warrant prosecution.
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In these cases, a willfulness problem usually arises from the taxpayer's
lack of actual possession, use, and enjoyment of the interest during the
holding period.
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No similar problems should be present in cases involving the standard
certificates of deposit when the interest is made available to the taxpayer.
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In order to properly identify the type of certificates of deposit, the final
report must exhibit copies of the 1099's and copies of the underlying contracts
of the certificates.
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In addition, the report should discuss exhaustively the issue of willfulness.
For example, the investigation should determine whether the principal and
interest on a matured certificate was rolled over into a new certificate
of deposit, whether premature withdrawal of the principal is subject to
penalties, and whether or not there was a premature redemption.
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Next to the specific item method, the net worth method is probably the most
frequently used way of proving taxable income in civil and criminal income
tax cases.
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The net worth method involves a determination of the taxpayer's net worth
(assets less liabilities) at the beginning and end of a taxable year, computing
the increase or decrease in net worth, and then adjusting this amount for
nondeductible and nontaxable items.
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The amount resulting from application of this theory is taxable income.
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By comparing the computed taxable income with income reported on the taxpayer's
return, special agents may determine whether taxable income has been correctly
reported.
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There is no statutory provision defining the net worth method and specifically
authorizing its use by the Commissioner. However, in numerous cases, courts
have approved the use of this method.
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The leading case in this respect is Holland v. U.S. handed down in
1954 by the Supreme Court along with three companion cases, Smith v.
U.S. , Friedberg v. U.S. , U.S. v. Calderon .
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These cases outlined the broad principles governing the trial and review
of cases based on the net worth method of proving income.
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With reference to the use of the net worth method, the court stated that:
To protect the revenue from those who do not render true accounts, the government
must be free to use all legal evidence available to it in determining whether
the story told by the taxpayer's books accurately reflects his financial
history.
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The net worth method is most often used when one or more of the following
conditions prevail:
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Taxpayer maintains no books and records.
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Taxpayers books and records are not available.
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Taxpayer's books and records are inadequate.
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Taxpayer withholds books and records.
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The fact that the taxpayer's books and records accurately reflect the figures
on his or her return does not prevent the use of the net worth theory of
proof. The government can look beyond the self-serving declarations in the
taxpayer's books and records and use any evidence available to contravene
their accuracy.
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In addition to being used as a primary method of proving taxable income in
civil and criminal income tax cases, the net worth method can be used:
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To corroborate other methods of proving income.
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To test-check accuracy of reported taxable income.
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It is essential to establish a starting point from which to calculate future
increases in the taxpayer's net worth. An inaccurate beginning net worth
will affect the accuracy of the determination of income subsequent to the
base point. For instance, if a taxpayer's beginning net worth is understated,
taxable income for the period under consideration will be overstated.
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Proof of visible assets and liabilities comprising beginning net worth is
usually easily established by such means as bank records; county real estate
records; brokerage records; Bureau of Public Debt records; federal and state
income, inheritance, and gift tax returns and records; and books and records
of the taxpayer.
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To establish a firm starting point, it is necessary to show that the defendant
had no large sum of cash for which credit was not given. This is usually
done by offering evidence which negates the existence of a cash hoard, for
example:
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Written or oral admissions from the taxpayer to the investigating agents
concerning net worth. Examples are; signed net worth statement and oral
statements as to cash on hand.
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Failure by defendant to file returns for years prior to indictment period.
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Returns filed by the taxpayer for years prior to prosecution years reflecting
income reported that is inconsistent with existence of a cash hoard. This
would also apply to copies retained by the taxpayer. The taxpayer's filing
record and copies of available income tax returns should be furnished for
at least 5 preceding and all years subsequent to the starting point to furnish
additional support to the starting point.
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Low earnings for years prior to prosecution periods as shown by records of
the Social Security Administration and former employers.
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Net worth as established by books and records of the taxpayer.
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Certificate of Assessments and Payments showing tax assessed for years prior
to the prosecution period. With this information and tables showing tax rates
and the amount allowed for exemptions and dependents, it may be possible
to calculate income reported by a taxpayer for the years in question. The
certificate will not show amount of withholding, capital gains, or nontaxable
income.
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Financial statements presented for credit or other purposes at a time prior
to or during prosecution period. Special agents can obtain these types of
documents from banks, loan companies, bonding companies, and the Internal
Revenue Service (offers in compromise).
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Bankruptcy prior to prosecution periods. Special agents may use the public
record of a bankruptcy as a starting point for net worth purposes. However,
Section 7(a)(10) of the Bankruptcy Act 11, USCA 525(a)(10) as amended by
title 11 of the Organized Crime Control Act of 1970, P.L. 91-452, provides
that no testimony or evidence which is directly or indirectly derived from
testimony given by a bankrupt during bankruptcy proceedings may be offered
in evidence against him or her in any criminal proceedings.
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Prior indebtedness, compromise of overdue debts, avoidance of bankruptcy.
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Installment buying.
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History of prior low earnings and expenditures and checks returned for
insufficient funds.
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Loss of furniture and business because of financial reasons.
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In order for income to be taxable, it must come from a taxable source,
Commissioner v. Glenshaw Glass Co. In the Holland case, the Supreme
Court said: Increase in net worth, standing alone, cannot be assumed to be
attributable to currently taxable income. But proof of a likely source, from
which the jury could reasonably find that the net worth increases sprang,
is sufficient. . ..
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On the basis of the Holland decision, it appeared to many that proof of a
likely source was necessary in every net worth case. This was clarified by
U.S. v. Massei in which the Supreme Court said In Holland we held
that proof of a likely source was sufficient to convict in a net worth case
where the government did not negate all the possible nontaxable sources of
the alleged net worth increases. This was not intended to imply that proof
of a likely source was necessary in every case. On the contrary, should all
possible sources of nontaxable income be negated, there would be no necessity
for proof of a likely source.
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In view of the two decisions cited above, it appears that the government
must either prove a likely source of taxable income, or negate all nontaxable
sources of income. In cases where the government resorts to the latter type
of proof, it is even more important than otherwise to establish a firm starting
point, particularly with reference to cash on hand.
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Proof of a likely taxable source of income has been found sufficient in a
number of criminal income tax cases by:
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Showing that defendant did not report certain income on his tax returns,
U.S. v. Chapman
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Showing that defendant did not report certain income for years prior to
indictment period, U.S. v. Skidmore
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Comparison of business operations and profits of defendant for indictment
years with profits or prior operations for a comparable period. In the Holland
case, the Supreme Court pointed out that the business of the defendant, a
hotel, apparently increased during the years in question, whereas the reported
profits fell to approximately one quarter of the amount declared by the previous
management in a comparable period.
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Effectively contradicting defendant's assertions as to nontaxable sources.
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Opportunities of defendant to receive graft.
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The character of the business has the capacity to produce income in amounts
determined by the net worth method.
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A likely source is established in net worth cases by showing that the source
reported by the taxpayer had the potential to produce income substantially
in excess of that reported.
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Negating nontaxable sources of income may be accomplished by proving non-receipt
of loans, gifts, and inheritances by taxpayer's admissions. Special agents
should also review federal gift tax returns filed by alleged donor, or probate
records of deceased relatives' estates. If the taxpayer advances a specific
explanation of the sources of funds expended, the government does not have
to pursue possible nontaxable sources when the one given is proven false.
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When a taxpayer offers leads or information during a net worth investigation
which, if true, would establish his or her innocence, special agents must
investigate the leads.
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This also applies if a taxpayer offers leads or information after completion
of an investigation, but within a sufficient time before trial.
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If the government fails during the trial of the case to show an investigation
into the validity of the data furnished, the trial judge may consider the
information as true and the government's case insufficient to go to the jury.
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Most leads refer to cash hoards, gifts, inheritances, and loans. These leads
should be checked during normal routine of the investigation.
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The courts have held that the Government does not have to investigate leads
which are not within the category of reasonable verification. This is a question
of judgment and, in the final analysis, is always a matter for the court
to determine.
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During a trial of an income tax case involving use of the net worth method
of proving taxable income, there may be admitted in evidence certain exhibits
referred to as schedules or summaries. These exhibits are not evidence, but
are admitted as summaries of other evidence in the case only for the assistance
and convenience of the jury in considering the evidence which they purport
to summarize. The admissibility and use of summaries are discussed in text
9.6.4.
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The summary which the special agent should become most familiar with is the
one showing the computation of taxable income, an example of which is set
forth in Exhibit 9-1.
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During trials, the net worth computation also has been shown by other means,
such as blackboards and charts.
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Perhaps the most difficult phase of preparing a net worth statement or summary
for use in a criminal case is in making adjustments to the net worth increases
and decreases for the nondeductible and nontaxable items. The most frequently
encountered adjustments involve individual taxpayers and the way of handling
them.
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Add to net worth increases or decreases:
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Personal living expenses.
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Federal income tax payments.
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Nondeductible portion of capital loss.
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Losses on sale of personal assets.
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Gifts made.
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Life insurance premiums.
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Deduct from net worth increases or decreases:
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For capital gain transactions see the appropriate instructions and forms
for statutory inclusions and exclusions.
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Gifts received.
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Inheritances.
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Nontaxable pensions.
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Veteran's benefits.
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Dividend exclusions.
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Tax exempt interest.
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Proceeds from life insurance.
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Errors in taxpayer's records (in his favor). This adjustment relates to honest
mathematical and bookkeeping errors found in books and records of the taxpayer
which tend to account for part of understated income.
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Gains on sale of personal residence (assuming funds are to be invested within
the statutory period. If person is 55 years old or older, deduct the statutory
excludable amount).
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Net operating loss carry-back and carry-forward. In criminal income tax cases,
there is judicial authority to ignore net operating loss carry-backs (See
text 9.1.1)
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Allowed capital loss carry-over.
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Fifty percent of net long-term capital gain when there is both a net long-term
capital gain and a net short-term capital gain.
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Income tax refunds.
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No adjustment is necessary to net worth increase or decrease for:
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Net short-term capital gain.
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Deductible portion of net short-term capital loss.
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Deductible portion of net short-term capital loss.
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Excess of net short-term capital gain over net long-term capital loss.
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The net worth statement may reflect taxable income by whichever method of
accounting (cash, accrual, etc.) is appropriate. Reflecting a certain accounting
method in the net worth computation is accomplished by including certain
accounts in the net worth statement and omitting others. For instance, where
it is desired to compute income of a physician on the cash basis, patient
accounts receivable and business accounts payable at the beginning and end
of each year would be omitted. If the accrual method were used, these accounts
would be included in the net worth computation.
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In preparing a net worth statement or summary for use in a criminal case,
special agents should see that:
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It follows the taxpayer's method of accounting.
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The cost of assets and actual amounts of liabilities are used. The value
(such as market, reproduction, and the like) of these two items is not
considered. Normally, unless the taxpayer agrees to the estimated amount,
estimated nondeductible expenditures are eliminated from the net worth
computation, although, in some cases, it has appeared proper to include some
minimum estimated living expense figures.
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Good accounting principles are followed. For example, bank balances should
be adjusted (reconciled) for outstanding checks and cash (deposits) in transit.
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Technical adjustments that increase income have been eliminated (for example,
unintentional errors or omissions relating to capitalized expenses, depreciation,
revaluation of the basis of property, and changing inventory basis; or doubtful
items such as unidentifiable commingled funds).
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Special agents can overcome the following common defenses in net worth cases
by thoroughly investigating them at the onset of the investigation.
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Defense counsel usually contends that there is no evidence of willfulness.
This contention may be overcome by evidence outlined in text 9.1.1.
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The taxpayer usually alleges that he or she had a large amount of cash on
hand which the government has not considered in the beginning net worth.
The taxpayer also may allege that cash balances are wrong for years subsequent
to the base year.
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In all cases where the net worth method is the primary method of proving
income, the special agent should anticipate this defense and attempt to get
evidence to negate it.
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Admissions of the taxpayer are most effective to pin down the cash amount,
and should be obtained at the initial interview or early in the investigation.
The line of questioning should be directed toward developing:
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The amount of cash on hand (undeposited currency and coin) at the starting
point and at the end of each prosecution year.
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The amount of cash on hand at the date of the interview. (This data is sometimes
useful in computing cash on hand for earlier years.)
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The source of cash referred to in 1 and 2 above.
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Where the cash was kept.
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Who knew about the cash.
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Whether anyone ever counted it.
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When and on what was any cash spent.
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Whether any record is available with respect to the alleged cash on hand.
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The denominations of the cash on hand.
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In most cases the spouse should also be questioned about cash on hand as
well as other matters. In order to avoid any misunderstanding by the taxpayer,
it is suggested that the meaning of cash on hand be explained prior to discussing
the matter.
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The taxpayer (and spouse) also should be questioned regarding financial history
from the time he or she was first gainfully employed, employers, salary,
etc. This information will serve in many cases to check the accuracy of the
taxpayer's statements about cash on hand.
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In addition to admissions, evidence used to establish the starting point
will most often be sufficient to refute the defense of cash on hand.
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The usual sources of nontaxable income claimed by the taxpayer are gifts,
loans, and inheritances. Negating evidence of the type described in text
9.5.4 will most often be sufficient to overcome these claims.
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Special agents should not rely upon inventory figures shown by the taxpayer's
returns as prima facie evidence to establish the values of assets in the
net worth computation. Some taxpayers, either through ignorance or for other
reasons, report inventory at retail value instead of at cost or some other
value. (In a net worth computation where the inventory used exceeds cost
and is larger at the end of the prosecution period than the beginning, income
will be overstated.) To resolve this, the investigating agents should try
to corroborate the inventory figures shown on the taxpayer's returns by
admissions of the taxpayer, statements of employees who took the inventory,
copies of inventory records, etc.
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In certain cases, the taxpayer has falsely claimed that he or she was holding,
as nominee of some individual, funds or other assets which the government
had included in the net worth computation of income. Special agents should
interview the taxpayer about this matter in the early stages of the
investigation.
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This defense is usually predicated on a net worth computation of taxable
income made by the taxpayer's accountant for years prior to the starting
point which will show an operating loss. Defense strategy is to carry the
loss forward to the prosecution years and reduce the alleged tax deficiency
as much as possible.
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To overcome this defense, special agents should make a net worth determination
of income for several years prior to the prosecution period and then on the
basis of this computation either:
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Allow the carry-forward loss, or
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Show the incorrectness of the accountants' determination.
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The objective of this defense is to reduce taxable income by claiming nonexistent
loans, usually from friends or relatives of the taxpayer. Often this defense
may be overcome by showing that the alleged lender was financially unable
to lend the amount claimed.
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The matter of loans should always be covered during the initial interview
with the taxpayer.
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In some cases, the taxpayer and spouse may report income on separate returns,
but assets they acquired are held in joint title. If the jointly held assets
are included in the net worth computation, the claim may be made that they
were acquired with income of the spouse.
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Usually this defense can be overcome by tracing the invested funds to the
taxpayer and by showing the disposition of the spouse's income.
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Cases may be encountered where funds of the taxpayer and spouse are so
intermingled that it is not possible to trace the invested or applied funds
to either party. In such cases, the net worth computation may be made by
including assets, liabilities, and other pertinent items of both and deducting
the taxable income of the spouse to arrive at the taxable income of the one
to be charged.
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The expenditures method is, in theory, closely relate to, if not identical
with, the net worth method of proving income. The method is based on the
theory that if the taxpayer's expenditures during a given year exceed reported
income, and the source of such expenditures is unexplained, it may be inferred
that such expenditures represent unreported income.
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The similarity is further indicated by the fact that the same items or accounts
used in determining taxable income by the net worth method are also considered
when the expenditures method is employed.
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Like the net worth method, there is no statutory provision expressly authorizing
use of the expenditures method by the Commissioner. There are, however, many
cases in which the courts have approved the use of this method.
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The statements made in discussing the net worth method with regard to when
and how that method is used are equally applicable to the expenditures method.
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In cases where the taxpayer has several assets (and liabilities) whose cost
basis remain the same throughout the prosecution period, the expenditures
method may be preferred over the net worth method because a more brief
presentation can be made of the computation of taxable income. This is true
because assets and liabilities which do not change during the prosecution
period may be omitted from the expenditures statement.
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The expenditures method probably is used most often in cases where the taxpayer
spends income on lavish living and has little, if any, net worth.
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In an expenditures case, it is desirable to prepare a complete net worth
statement which may be required to rebut a defense that the funds used came
from the conversion of some asset not considered in the expenditures computation.
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In submitting an expenditures case, special agents should consider the
desirability of also including in the report proof of taxable income by the
net worth method.
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If both methods are shown, the trial attorney can make the final decision
as to which will be the best method to present the case.
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To establish a starting point, the taxpayer's assets at the beginning of
the tax periods should be identified and monitored to determine whether any
assets were converted for use as personal expenditures.
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While establishing a starting point, special agents may prefer to use a net
worth analysis, depending upon the facts and circumstances surrounding the
case.
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For additional information regarding establishing the starting point in net
worth cases, see text 9.5.3.
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[9.5]
9.6.4 (07-30-1998)
Expenditures Summaries Prepared by Special Agents
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Exhibit 9-2 is an expenditures statement which may be used to summarize the
evidence relating to the computation of taxable income.
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The following steps have been found helpful in the preparation of an expenditures
statement:
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Prepare a net worth statement.
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Next, determine the amount of increase or decrease in each asset and liability
appearing on the net worth statement in each taxable year. For instance,
if the beginning and ending bank balances for a taxable year were $4,500
and $150, respectively, it would be determined that this asset has decreased
by $4,350. The amounts so determined and the amounts appearing as adjustments
to net worth increases or decreases are then posted to the expenditures
statement.
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Money spent or applied on nondeductible items (living expenses, income tax
payments, and the like) should be posted to the following sections:
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Increase in assets.
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Decrease in liabilities.
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Nontaxable source items (gifts, inheritances, and the like received by taxpayer)
should be posted to the following sections:
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Decrease in assets.
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Increase in liabilities.
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The defenses discussed in text 9.5.8 regarding the net worth method of
determining income are equally applicable to the expenditures method.
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The bank deposits method is another means of proving income by indirect or
circumstantial evidence.
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By this method, taxable income is proved through analysis of deposits in
all bank accounts, canceled checks, and currency transactions of the taxpayer.
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Very often, it will be found that the taxpayer has made cash payments from
currency receipts not deposited. Such cash receipts or cash expenditures
must be taken into account in computing additional gross income.
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If the taxpayer reported income on the accrual basis, adjustments should
be made in the bank deposits method to reflect accrued income and expenses.
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The usual formula for determining taxable income by the bank deposits method
of a taxpayer, whose only source of income is from a business operation,
is as follows:
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Total deposits $ |
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Add: Payments made in cash, Income Checks Cashed, Cash Withheld from
deposits $ |
| 3. |
Subtotal $ |
| 4. |
Less: Nonincome items and deposits, Transfers, and Redeposits $ |
| 5. |
Subtotal $ |
| 6. |
Less: Cash available for redeposit (Cash withheld from deposits), Check
cashed, Cash withdrawals $ |
| 7. |
Total receipts $ |
| 8. |
Less: Business expenses and costs $ |
| 9. |
Net income from business $ |
| 10. |
Less: Deductions and exemptions $ |
| 11. |
Taxable Income $ |
|
|
|
-
Total deposits of a taxpayer (line 1, formula, text 9.7) consist of not only
amounts deposited to all bank accounts maintained or controlled by him or
her, but also deposits made to accounts in savings and loan companies, investment
trusts, brokerage houses, etc.
-
Since some taxpayers have bank accounts in fictitious names or under special
titles such as Special Account No. 1, Trustee Account, Trading Account, etc.,
special agents should inquire about this during the investigation.
-
If a taxpayer lists checks on a deposit and deducts them from an amount to
be paid to him or her in cash, only the net amount of the deposit should
be used in computing total deposits.
-
Unidentified deposits can also represent omitted income.
|
|
|
-
All provable payments made in cash (line 2, formula, 9.7), including business
expenses, personal expenses, investments, etc., should be added to total
bank deposits. Since adjustments will be made in the section below for non-income
deposits and items, it is immaterial whether the cash used was derived from
a taxable or nontaxable source.
|
|
|
-
Generally all nontaxable income received by a taxpayer will be deducted as
a non-income deposit or item in the bank deposit computation. Examples of
non-income deposits and items are proceeds of loans, redeposits, gifts, and
inheritances. (For other examples see Exhibits 9-3 and 9-5.)
-
Failure to eliminate any non-income deposit or item would result in an
overstatement of income and might be damaging to a criminal case.
|
|
|
-
All business expenses and costs which are found to be deductible must be
allowed, whether paid by check or in cash (line 8, formula, text 9.7(5)).
-
Where an analysis of the checks or other evidence of the disbursements leaves
some doubt about the deductibility of some of the disbursements, it is preferable
for the prosecution case to allow all except those items definitely provable
as being nondeductible, such as personal expenses, investments, and gifts.
-
Whether or not canceled checks are available for analysis and classification,
every effort should be made to arrive at all items constituting allowable
expense that might have been paid from the bank accounts or from undeposited
cash.
-
The allowable depreciation on all known depreciable assets must be deducted
as in any other type of case.
-
Frequently, it will be realized that the taxpayer must have paid out funds
for expenses obviously incurred, but for which no checks or evidences of
specific cash disbursements have been found. In such instances, the amount
claimed, therefore, by the taxpayer (or if not claimed, a reasonable amount)
should be allowed in line 8 (formula, text 9.7(5)), and a corresponding amount
of additional income should be added in line 2.
|
|
|
-
All allowable personal deductions, itemized or standard, and exemptions (line
10, formula, text 9.7(5)) must be deducted from net business income in order
to arrive at taxable income.
|
|
|
-
There is no statutory provision defining the bank deposits method of proving
income and specifically authorizing its use by the Commissioner. There are
numerous reported criminal cases in which the bank deposits method has been
used to determine additional taxable income.
|
|
|
-
The bank deposits method may be used in the following situations:
-
If the taxpayer's books and records are not available.
-
If the taxpayer invokes constitutional privilege and will not allow an
examination of books and records.
-
If the taxpayer's records are not complete and do not adequately reflect
his or her correct taxable income.
-
If the taxpayer uses the bank deposits method in preparing his or her tax
return.
-
The courts have held that there is no necessity to disprove the accuracy
of the taxpayer's books and records as a prerequisite to the use of the bank
deposits method.
|
|
|
-
The bank deposits theory assumes that under certain circumstances proof of
deposits is substantial evidence of taxable receipts.
-
The circumstances are the existence of a business or calling of a lucrative
nature and proof that during the prosecution years, the taxpayer made periodic
deposits to accounts in his or her own name or accounts over which he or
she exercised dominion and control.
-
The government must establish that the deposits reflect income which is current.
This may be accomplished by showing:
-
That the taxpayer was engaged in an income-producing business.
-
That he or she made periodic deposits to his or her bank account.
-
That the deposits have been analyzed to eliminate non-income items such as
loans or gifts, and income items which may be duplications of amounts actually
accounted for and reported, or amounts which have been earned in prior years.
-
The analysis may indicate that certain withdrawals from the bank account
represent business expenditures. If these were not claimed by the taxpayer
as deductions, they will nevertheless be allowed for prosecution purposes.
-
Occasional or irregular deposits are not necessarily ruled out; they may,
if properly analyzed, be considered as income.
-
Bank deposits proof alone will suffice to support a conviction, and it is
not a mere form of corroboration for other kinds of evidence.
|
|
|
-
The schedules and summaries in Exhibits 9-3 through 9-6 are illustrative
of those which may be submitted during trials where the bank deposits method
of proving income is used.
-
Exhibit 9-3 shows the computation of taxable income of John and Mary Roe.
The computation of this same income by the net worth method was previously
shown in Exhibit 9-1.
-
Comparison and study of these two schedules will be beneficial since many
times in criminal tax cases taxable income will be evidenced before the court
by two methods of proof, one tending to corroborate the other.
-
Exhibit 9-4 shows a computation which may be used to determine the amount
of currency disbursements to be added to total deposits. (See line 2, payments
made in cash, text 9.7(5).)
-
Exhibit 9-5 is a summary analysis of disbursements made by check and by currency.
This schedule should be studied together with the net worth statement and
the bank deposits schedule.
-
The analysis of deposits is the vital part of a bank deposits case and too
much importance cannot be placed upon its accuracy. Exhibit 9-6 is illustrative
of a schedule which may be used to show the results of this analysis.
|
|
|
-
The chief defense contentions in bank deposits cases (other than lack of
criminal intent) are:
-
That the spasmodic nature or unconventional amounts of the deposits indicate
that prior accumulated funds, not current receipts, are involved.
-
That the deposits reflect, in whole or in substantial part, non-income items,
income items attributable to other years.
-
The deposits are duplication of current income items already accounted for
by the taxpayer.
-
The proof concerning what cash a taxpayer had on hand at the beginning of
the taxable year in question is relevant to the bank deposits method of proof
of income.
-
If the deposits or expenditures came from funds accumulated in prior years,
obviously they do not represent current income.
-
However, if all the requirements set forth in text 9.7.8 are met, the lack
of proof of the amount of cash on hand would not be fatal to the case.
|
|
|
-
This method is a computation whereby determinations are made by the use of
percentages or ratios considered typical of the business under investigation.
By reference to similar businesses or situations, percentage computations
are secured to determine sales, cost of sales, gross profit, or even net
profit. Likewise, by the use of some known base and the typical percentage
applicable, individual items of income or expense may be determined.
-
The percentage markup method is used on a limited basis.
|
|
|
-
Special agents should resort to the percentage markup method of proof only
when the other traditional methods of proof have proven
unsuccessful.
-
With respect to specific applications of the percentage markup method of
proof, its use should be limited principally to retail establishments rather
than illegal businesses, because more reliable information regarding opening
and closing inventories and the appropriate percentage markup are generally
available for retail establishments.
-
An exception to these preferences may be narcotics trafficking cases assuming
the presence of substantial inside evidence from members of the narcotics
organization to account for the pertinent variables inherent in narcotics
trafficking and this method of proof.
-
Special agents should include in the transmittal memorandum to District Counsel
an explanation of efforts made with respect to the utilization of the traditional
methods of proof and an explanation for the inadequacy or inapplicability
of the traditional methods.
|
|
|
-
The percentages in the percentage markup method may be externally derived
or they may in some instances be internally derived from the taxpayer's accounts
for other periods or from an analysis of subsidiary records.
-
Many percentages may be secured from the examination of the taxpayer's records
even though only part of the records are available.
-
Gross profit percentages may be determined by comparing purchase invoices
with sales invoices, price lists, and other similar data.
-
Also other years not covered by the investigation or portions of years under
investigation may indicate typical percentages applicable to the entire year
or years under current investigation.
-
Substantial internal evidence from which a reliable percentage markup computation
can be obtained is strongly emphasized. Testimony of employees, accountants,
or sales managers, with direct knowledge of sales prices is of great significance
in determining not only the actual percentage markup employed in a given
case, but also opening and closing inventories.
-
Consideration should be given to obtaining internal documents, such as operating
memoranda and subsidiary books and records.
-
The questionable tax returns and the amounts stated thereon for sales and
costs of goods sold should not be used in determining the appropriate percentage
markup, because the use of such returns inherently contradicts the theory
that both sales and cost of goods sold are fraudulently reported on such
tax returns.
|
|
|
-
Although the percentage method may be a useful method of determining or verifying
income, especially when the books and records are inadequate, special agents
should make sure that the comparisons are made with situations that are similar
to those under investigation. Some of the factors to be considered are as
follows:
-
Type of merchandise handled --In order that a proper comparison may
be made, the businesses must be dealing in the same type of merchandise or
service. Comparison of the gross profit of a restaurant with that of a grocery
store would be of little value and should not be used.
-
Size of operation --In many instances, gross profit, cost of doing
business, and net profit percentage on sales will vary according to the size
of a business. This is especially true with respect to expense items and
the net profit as compared with sales. The percentage of net profit to sales
of a large department store might vary considerably from the small
independently-owned general store.
-
Locality --Markups and costs of operations will normally vary with
the size of the city or the location of the businesses in the locality. As
an example, a small business in a community of 5,000 may use newspapers as
a means of advertising, whereas a business doing the same volume in a city
of 500,000 will normally find the cost prohibitive and confine advertising
to some other medium.
-
Period covered --Since gross profit ratios and expense ratios will
tend to vary year by year with economic conditions, the comparison should
normally be made with similar periods covered by the
investigation.
-
General merchandising policy --Comparison should not be made between
businesses having different merchandising policies. Some businesses may work
on large volume with small markup, offering the customer little service;
others may operate on the reverse policy. In situations of this kind, comparisons
should be made only with those businesses having similar merchandising policies.
|
|
|
-
See Exhibit 9-7 for an example of the computation of the percentage markup
method. The percentages used are arbitrary and are not necessarily applicable
to the businesses mentioned.
|
|
|
-
In many instances the determination or verification of gross receipts may
be computed by applying price and profit figures to the known or ascertainable
quantity of business done by the taxpayer. This method is feasible when special
agents can ascertain the number of units handled by the taxpayer and also
when the price or profit charged per unit is known.
-
The number of units sold or quantity of business done by the taxpayer may
be determined in certain instances from the taxpayer's books, since the records
may be adequate with respect to cost of goods sold or expenses, but inadequate
as to sales.
-
There may a regulatory body to which the taxpayer reports units of production
or service. For example:
-
A funeral director is required to report each burial to the city or town
where such burial takes place.
-
A garment manufacturer with union employees buys union labels to be sewed
into the garments manufactured.
-
A taxpayer may also be required to report his production and payroll to a
trade association allied with the labor union.
-
There are also instances where the royalty paid for leased machinery is based
upon the units of production.
-
A piecework system of wages for production workers might also give an accurate
measure of units produced.
-
The use of this method lends itself to those business in which only a few
types of items are handled or there is little variation in the type of service
performed, with the charges made by the taxpayer for the merchandise or services
being relatively the same throughout the taxable period.
-
The following example is illustrative of the unit and volume method of
computation:
|
| Volume of Merchandise (manufacturer): |
| Number of machines manufactured |
92 |
| Average sales price |
$1,100 |
| Computed total sales |
$101,200 |
| Sales reported |
$93,500 |
| Omitted sales |
$7,700 |
|
|
Exhibit [9.5] 9-1 (07/30/98)
Net Worth Statement
| > |
| Handbook Reference: Text 424.8 |
|
| NET WORTH STATEMENT |
| John and Mary Roe |
| Dayton,
Ohio |
|
| ASSETS |
12/31/-- |
12/31/-- |
12/31/-- |
| 1. |
Cash--First National Bank _____ |
$ 4,500.00 |
$ 150.00 |
$ 2,500.00 |
| 2. |
Cash on hand _____ |
25.00 |
25.00 |
25.00 |
| 3. |
Inventory, Liquor Store _____ |
4,800.00 |
13,000.00 |
29,000.00 |
| 4. |
U.S. Savings Bonds _____ |
-0- |
3,750.00 |
-0- |
| 5. |
Note Receivable, Frank Roe _____ |
-0- |
-0- |
300.00 |
| 6. |
Note Receivable, Roger Jones _____ |
-0- |
-0- |
16,000.00 |
| 7. |
Accounts Receivable, Doc's Market _____ |
-0- |
1,600.00 |
-0- |
| 8. |
Lot on Dayton Road _____ |
1,000.00 |
1,000.00 |
1,000.00 |
| 9. |
Ohio Tourist Camp _____ |
12,000.00 |
12,000.00 |
12,000.00 |
| 10. |
Residence, 1100 Vine Street _____ |
2,800.00 |
2,800.00 |
-0- |
| 11. |
30 Acre Farm, East Dayton _____ |
-0- |
7,400.00 |
7,400.00 |
| 12. |
150 Acre Farm, North Dayton _____ |
-0- |
-0- |
7,000.00 |
| 13. |
Equipment--Liquor Store _____ |
800.00 |
800.00 |
800.00 |
| 14. |
Ace Automobile _____ |
2,800.00 |
2,800.00 |
2,800.00 |
| 15. |
Farm Truck _____ |
-0- |
-0- |
800.00 |
| 16. |
Farm Equipment _____ |
-0- |
1,250.00 |
2,250.00 |
| 17. |
Livestock on Farm _____ |
-0- |
900.00 |
1,300.00 |
|
Total
Assets _____ |
$28,725.00 |
$47,475.00 |
$83,175.00 |
|
| LIABILITIES |
| 18. |
First Federal Savings & Loan Assn. _____ |
$ 2,400.00 |
$ 1,800.00 |
$ -0- |
| 19. |
First National Bank _____ |
2,900.00 |
2,700.00 |
-0- |
| 20. |
Depreciation Reserve _____ |
2,500.00 |
3,200.00 |
4,300.00 |
|
Total
Liabilities _____ |
$ 7,800.00 |
$ 7,700.00 |
$ 4,300.00 |
|
|
NET WORTH _____ |
$20,925.00 |
$39,775.00 |
$78,875.00 |
|
|
Less: Net Worth of Prior Year _____ |
|
20,925.00 |
39,775.00 |
|
|
Increase in Net Worth _____ |
|
$18,850.00 |
$39,100.00 |
|
| ADJUSTMENTS |
|
Add: |
| 21. |
Living Expenses _____ |
|
$ 2,500.00 |
$ 2,500.00 |
| 22. |
Life Insurance Premium _____ |
|
300.00 |
500.00 |
| 23. |
Federal Income Taxes Paid _____ |
|
750.00 |
900.00 |
|
Less: |
| 24. |
Long-Term Capital Gain on Sale of Residence (50%) _____ |
|
-0- |
(500.00) |
| 25. |
Inheritance _____ |
|
-0- |
(10,000.00) |
|
|
Adjusted Gross Income _____ |
|
$22,400.00 |
$32,500.00 |
|
|
Less: Standard Deduction _____ |
|
1,000.00 |
1,000.00 |
|
|
Balance _____ |
|
$21,400.00 |
$31,500.00 |
|
|
Less: Exemptions (4) _____ |
|
2,400.00 |
2,400.00 |
|
|
Taxable Income _____ |
|
$19,000.00 |
$29,100.00 |
|
|
Less: Taxable Income Reported _____ |
|
6,100.00 |
6,400.00 |
|
|
Taxable Income Not Reported _____ |
|
$12,900.00 |
$22,700.00 |
|
|
Exhibit [9.5] 9-2 (07/30/98)
Expenditures Statement
| > |
| Handbook Reference: Text 425.6 |
|
|
EXPENDITURES STATEMENT |
|
|
John and Mary Roe |
|
|
Dayton,
Ohio |
|
| Item |
| No. |
Money Spent or Applied on Nondeductible Items |
19-- |
19-- |
| 1. |
Cash--First National Bank (increase) _____ |
-0- |
$ 2,350.00 |
| 3. |
Inventories _____ |
$ 8,200.00 |
16,000.00 |
| 4. |
U. S. Savings Bonds _____ |
3,750.00 |
-0- |
| 5. |
Note Receivable, Frank Roe _____ |
-0- |
300.00 |
| 6. |
Note Receivable, Roger Jones _____ |
-0- |
16,000.00 |
| 7. |
Accounts Receivable, Doc's Market _____ |
1,600.00 |
-0- |
| 11. |
30 Acre Farm, East Dayton _____ |
7,400.00 |
-0- |
| 12. |
150 Acre Farm, North Dayton _____ |
-0- |
7,000.00 |
| 15. |
Farm Truck _____ |
-0- |
800.00 |
| 16. |
Farm Equipment _____ |
1,250.00 |
1,000.00 |
| 17. |
Livestock on Farm _____ |
900.00 |
400.00 |
|
Payments on Loan: |
| 18. |
First Federal Savings & Loan Assn. _____ |
600.00 |
1,800.00 |
| 19. |
First National Bank _____ |
200.00 |
2,700.00 |
| 21. |
Living Expense _____ |
2,500.00 |
2,500.00 |
| 22. |
Life Insurance Premium _____ |
300.00 |
500.00 |
| 23. |
Federal Income Taxes Paid _____ |
750.00 |
900.00 |
|
TOTAL: _____ |
$27,450.00 |
$52,250,000 |
|
Nontaxable Sources of Funds |
| 1. |
Cash--First National Bank (decrease) _____ |
$4,350.00 |
-0- |
| 4. |
U. S. Saving Bonds _____ |
-0- |
$3,750.00 |
| 7. |
Accounts Receivable, Doc's Market _____ |
-0- |
1,600.00 |
| 10. |
Sale of Residence, 1100 Vine Street (cost) _____ |
-0- |
2,800.00 |
| 20. |
Depreciation reserve _____ |
700.00 |
1,100.00 |
| 24. |
Capital Gain on Sale of Residence, |
|
1100 Vine Street (50%) _____ |
-0- |
500.00 |
| 25. |
Inheritance _____ |
-0- |
10,000.00 |
|
TOTAL: _____ |
$5,050.00 |
$19,750.00 |
|
Adjusted Gross Income _____ |
$22,400.00 |
$32,500.00 |
|
Less: Standard Deduction _____ |
1,000.00 |
1,000.00 |
|
Balance _____ |
$21,400.00 |
$31,500.00 |
|
Less: Exemptions (4) _____ |
2,400.00 |
2,400.00 |
|
Taxable Income _____ |
$19,000.00 |
$29,100.00 |
|
Less: Taxable Income Reported _____ |
6,100.00 |
6,400.00 |
|
Taxable Income Not Reported _____ |
$12,900.00 |
$22,700.00 |
|
|
Exhibit [9.5] 9-3 (07/30/98)
Schedule A
| > |
| Handbook Reference: Text 426.6 |
| SCHEDULE--A |
| COMPUTATION OF TAXABLE INCOME BY BANK DEPOSITS
METHOD |
| John and Mary Roe |
| Dayton, Ohio |
|
| For
the Year Ended December 31,
19-- |
|
| Total Deposits--First National Bank _____ |
$163,015.00 |
| Currency Disbursements (see schedule B) _____ |
2,900.00 |
| Subtotal _____ |
$165,915.00 |
| Less: Nonincome Deposits and Items: |
| (1) U.S. Savings Bonds Redeemed
_____ |
$ 3,750.00 |
|
| (2) Notes Receivable, |
| Doc's
Market Collected _____ |
1,600.00 |
| (3) Sale of Residence at 1100
Vine St. _____ |
3,800.00 |
| (4) Inheritance _____ |
10,000.00 |
19,150.00 |
| Gross Receipts from Business _____ |
$146,765.00 |
| Less: Cost of Goods Sold: |
| Inventory 1-1--- _____ |
$ 13,000.00 |
| Purchases -19-- _____ |
124,000.00 |
| Goods Available for Sale _____ |
$137,000.00 |
| Less--Inventory 12-31--- _____ |
29,000.00 |
| Cost
of Goods Sold _____ |
108,000.00 |
| Gross Profit from Business _____ |
$ 38,765.00 |
| Less: Business Expenses |
| Interest _____ |
$ 150.00 |
| Salaries _____ |
4,200.00 |
| Rent _____ |
1,200.00 |
| Material and Supplies _____ |
115.00 |
| Depreciation _____ |
1,100.00 |
| Total
Business Expense _____ |
6,765.00 |
| Net Profit from Business _____ |
$ 32,000.00 |
| Add: Long-Term Capital Gain on Sale of Residence
(50%) _____ |
500.00 |
| Adjusted Gross Income
_____ |
$ 32,500.00 |
| Less: Standard Deduction
_____ |
1,000.00 |
| Balance _____ |
$ 31,500.00 |
| Less: Exemptions (4)
_____ |
2,400.00 |
| Taxable Income _____ |
$ 29,100.00 |
| Less: Taxable Income
Reported _____ |
6,400.00 |
| Taxable Income not Reported
_____ |
$ 22,700.00 |
|
|
Exhibit [9.5] 9-4 (07/30/98)
Schedule B
| > |
| Handbook Reference: Text 426.6 |
|
| SCHEDULE--B |
| COMPUTATION OF CURRENCY DISBURSEMENTS |
| John and Mary Roe |
| Dayton, Ohio |
| For
the Year Ended December 31,
19-- |
|
| Purchases _____ |
$124,000.00 |
| Interest _____ |
150.00 |
| Salaries _____ |
4,200.00 |
| Rent _____ |
1,200.00 |
| Materials & Supplies _____ |
115.00 |
| Loan to Frank Roe _____ |
300.00 |
| Loan to Roger Jones _____ |
16,000.00 |
| Purchase 134 Acre Farm, North Dayton _____ |
7,000.00 |
| Purchase Farm Truck _____ |
800.00 |
| Purchase Farm Equipment _____ |
1,000.00 |
| Purchase of Livestock _____ |
400.00 |
| Payments on Loan--First Federal Savings & Loan _____ |
1,800.00 |
| Payments on Loan--First National Bank _____ |
2,700.00 |
| Living Expense _____ |
2,500.00 |
| Life Insurance Premiums _____ |
500.00 |
| Federal Income Taxes Paid _____ |
900.00 |
| Total Disbursements _____ |
$163,565.00 |
|
| Bank Balance 1-1--- _____ |
$ 150.00 |
| Total Deposits _____ |
163,015.00 |
| Funds Available to Spend _____ |
$163,165.00 |
| Bank Balance 12-31--- _____ |
2,500.00 |
| Bank Disbursements _____ |
160,665.00 |
| Currency Disbursements _____ |
$ 2,900.00 |
|
| Note: This computation may be
made when canceled checks are
incomplete or not available
from which to make an analysis as
shown in Exhibit 300-5.
Data necessary to make such a
computation is usually
obtainable from income tax returns of the
taxpayer and third-party
sources. |
|
|
Internal Revenue Manual
|
Hndbk. 9.5 Chap. 9 Method of Proof
|
(07-30-1998)
|
|
|