IRS Income Examination Process
How does Uncle Sam know that you haven’t reported income if you don’t receive W-2s or 1099s? And you’re also clever enough not to deposit your unreported income in your bank account, so there is no “paper trail.” What then? The IRS uses what are called “indirect methods” of uncovering this income during IRS income examinations. Don’t worry, the IRS won’t come after you for the $100 winnings you didn’t report from your office fantasy football league challenge. The materiality threshhold is generally $10,000 for most taxpayers.
Direct vs. Indirect Methods
A direct method for the IRS to look for potentially unreported income would involve looking for direct evidence of omitted income such as cancelled customer checks, public records, deeds, etc. An indirect method would involve the IRS reconstructing your financial records. Indirect methods are used when there is no “paper trail.”
Why Would the IRS Use an Indirect Method?
When you are audited by the IRS, it almost always includes a “minimum income probe”, which is required under Internal Revenue Manual (IRM) 22.214.171.124.2. This applies to both business and non-business returns. Non-business includes individuals, self-employed/sole proprietors, and disregarded LLCs. A large majority of taxpayers fall into this section. When the IRS suspects a large amount of unreported income during the minimum income probe, then the scope of the income probe is expanded.
A minimum income probe of an individual return consists of:
- Matching income reporting documents (W-2s, 1099s, etc) with the tax return
- Asking a standard list of income questions during your initial interview. The examiner will note your responses on the “initial interview questionnaire.” You will be asked about sources of income and your record-keeping practices. A taxpayer who intentionally lies on the questionnaire would be a prime candidate for a civil fraud penalty.
- Financial status analysis: This is a spreadsheet in which the examiner enters sources of funds on the left side of the T-Account and expenditures of funds on the right side. Total sources are compared with total expenditures. It’s common practice before an audit for the IRS to complete a public records check to determine what assets you own and when they were purchased. If you purchased 3 brand new BMWs in 2014 and you’re being audited for that year, the purchase price of those vehicles (or a close approximation) would be entered into the expenditure side.
If the T-Account does not show a material imbalance, then the examiner should stop here. And if he doesn’t, get a tax attorney! The examiner is not allowed to continue examining your income under the minimum income probe section of the IRM.
If the T-Account shows a material imbalance, additional questions will be asked of you to reconcile the difference. For example, you received a $100,000 nontaxable inheritance from your “nana”, which would explain the 3 BMWs you purchased. The examiner will likely ask you for proof such as probate records. A lie here also makes you a candidate for the civil fraud penalty.
If the T-Account is not reconciled during the audit of a non-business return, the examiner will request bank statements for all your accounts and conduct a bank deposit analysis. Here, the examiner is looking for unexplained cash deposits. If additional income is found here that resolves the T-Account, then your financial status audit should end. However, if the income still is not reconciled, then the IRS will use an indirect method. See further below, “Results of Minimum Income Probes.”
A minimum income probe of an individual “business” return includes the following:
- Financial Status Analysis – Prepare a financial status analysis to estimate whether reported income is sufficient to support the taxpayer’s financial activities. See IRM 126.96.36.199.3.1.
- Interview – Conduct an interview with the taxpayer (or representative) to gain an understanding of the taxpayer’s financial history, identify sources of nontaxable funds, and establish the amount of currency the taxpayer has on hand. Consider possible bartering income as part of the minimum income probes. See IRM 188.8.131.52.3.2.
- Tour of Business – Tour the business site and review of the Internet website to gain familiarity with the taxpayer’s operations and internal controls, and identify potential sources of unreported income. However, a tour of the physical business site is not required for office audit cases but may be conducted if appropriate and with manager approval. See IRM 184.108.40.206.3.3.
- Internal Control – Evaluate internal controls to determine the reliability of the books and records (including electronic books and records), identify high risk issues, and determine the depth of the examination of income. See IRM 220.127.116.11.3.4.
- Reconciliation of Income – Reconcile the income reported on the tax return to the taxpayer’s books and records. An analysis of the IRP information in the file should also be completed to ensure all business and/or investment activities reflected on the IRP document are properly accounted for on the tax return. See IRM 18.104.22.168.3.5.
- Testing Gross Receipts – Test the gross receipts by tying the original source documents to the books. See IRM 22.214.171.124.3.6.
- Bank Analysis – Prepare an analysis of the taxpayer’s personal and business bank and financial accounts (including investment accounts) to evaluate the accuracy of gross receipts reported on the tax return. See IRM 126.96.36.199.3.7.
- Business Ratios – Prepare an analysis of business ratios to evaluate the reasonableness of the taxpayer’s business operations and identify issues needing a more thorough examination. See IRM 188.8.131.52.3.8.
- E-Commerce and/or Internet Use – Determine if there is Internet use and e-commerce income activity. See IRM 184.108.40.206.7.1.
Results of the minimum income probes
After completion of the minimum income probes for both business and non-business returns, the examiner must evaluate the information collected to this point and determine the scope of the examination of income, using the following criteria:
|The results show that the taxpayer reported all taxable income from known sources, the books and records can be reconciled to the tax return, all financial activities are in balance, and the bank deposits do not exceed reported income.||The examination of income may be limited to the Minimum Income Probes. The results and conclusions reached should be documented in the examination workpapers.|
|The results indicate the potential of unreported income due to inaccurate reporting of taxable income from known sources, the books and records cannot be reconciled to the tax return, a material imbalance in the financial status analysis that cannot be reconciled, excess unexplained bank deposits, or inadequate internal control.||A more in-depth examination of income is warranted. See IRM 220.127.116.11 for suggested guidelines for an in-depth examination of income.|
A “more in-depth examination of income” would depend on the taxpayer and the type of business being conducted. A preliminary step might be to contact 3rd parties (for example, business associates) to obtain information or evidence to reconcile income issues. It may also involve reviewing your books and records.
A formal indirect method to make the actual determination of tax liability may be pursued when the taxpayer’s books and records are missing, incomplete, or irregularities are identified; or the financial status analysis indicates a material imbalance after consideration of specific adjustments identified during the examination.
Results of the in-depth examination of income
After completion of the in-depth examination of income, the examiner will decide the next step using the following decision criteria:
|The taxpayer or third parties have successfully explained the reason for the understatement.||Document the results in the workpapers and conclude the examination of income without adjustment.|
|The adjustments to income and understatement meet the criteria for referral to Criminal Investigation.||A referral should be made to Criminal Investigation.|
|The taxpayer agrees to the proposed adjustments to income. There is no indication of additional unreported income.||Document the results in the workpapers and make the adjustment, resolve other issues, and close the case agreed.|
|The taxpayer does not agree to the proposed adjustments to income and the adjustments are not based on estimated personal living expenses derived from BLS data or comparable statistics.||Document the results in the workpapers and close the case unagreed.|
|The taxpayer does not agree to the proposed adjustments to income and the adjustments are based on estimatedpersonal living expenses derived from BLS data or comparable statistics.||Consider using one of the formal indirect methods to determine the actual amount of unreported income. NOTE: A case should not be closed unagreed if adjustments to income are based on estimated Personal Living Expenses.|
Formal Indirect Methods of Determining Income
- Internal Revenue Code. IRC 446(b) provides that if no method of accounting has been regularly used by the taxpayer, or if the method used does not clearly reflect income, the computation of taxable income shall be made under such method as, in the opinion of the Secretary, does clearly reflect income.
- Case law. If the examiner has a reasonable indication that unreported income exists, the Service has been granted the authority, through the development of case law, to use a formal indirect method of reconstructing income to determine whether or not the taxpayer has accurately reported total taxable income received. The “formal” indirect method need not be exact, but must be reasonable in light of the surrounding facts and circumstances. Holland v. United States, 348 U.S. 121, 134 (1954).
When the IRS will use an indirect method?
The use of a formal indirect method to make the actual determination of tax liability should be considered when the factual development of the case leads the examiner to the conclusion that the taxpayer’s tax return and supporting books and records do not accurately reflect the total taxable income received and the examiner has established a reasonable likelihood of unreported income.
The following list, which is not intended to be all inclusive, identifies circumstances that, individually or in combination, would support the use of a formal indirect method.
- MOST COMMON for non-business taxpayers. A financial status analysis that cannot be balanced; i.e., the taxpayer’s known business and personal expenses exceed the reported income per the return and nontaxable sources of funds have not been identified to explain the difference. This was discussed above under “minimum income probes.”
- Irregularities in the taxpayer’s books and weak internal controls.
- Gross profit percentages change significantly from one year to another, or are unusually high or low for that market segment or industry.
- The taxpayer’s bank accounts have unexplained items of deposit.
- The taxpayer does not make regular deposits of income, but uses cash instead.
- A review of the taxpayer’s prior and subsequent year returns show a significant increase in net worth not supported by reported income.
- There are no books and records. Examiners should determine whether books and/or records ever existed, and whether books and records exist for the prior or subsequent years. If books and records have been destroyed, determine who destroyed them, why, and when.
- No method of accounting has been regularly used by the taxpayer or the method used does not clearly reflect income. See IRC 446(b).
There are 5 types of indirect methods
- Source and Application of Funds Method: The Source and Application of Funds Method 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 the adjustment to income.
- MOST COMMON for non-business taxpayers. Bank Deposits and Cash Expenditures Method: 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 items of income are denoted separately.
- 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. If known, use of the taxpayer’s actual markup is required.
- 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.
- 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 IRS is thorough when it comes to examinations of income, and examiners are expected to document their findings in detail. The reason is that the IRS has the burden of proof when it comes to income (as apposed to deductions, for which taxpayers carry the burden of proof). This is why it is important to be represented by a tax professional for an IRS audit. For complex income issues, it’s even more important to hire a tax attorney who understands the IRS process. Even after the audit has ended and adjustments have been made, it’s not too late to hire an attorney. There’s a good chance the examiner did not properly document the income examination, made procedural errors, or made substantive errors. The first thing a knowledgeable attorney should do after a contested audit is request a copy of the examiner’s workpapers under the Freedom of Information Act (aka FOIA request).