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Methods of Proof in a Criminal Tax Investigation

By Joel N. Crouch on April 23, 2018

In a criminal tax investigation, the IRS generally must prove a taxpayer either underreported his income or overstated his deductions. To do so the IRS uses a number of methods of proof that fall under one of two categories: Direct (Specific Items) Method of Proof or Indirect Methods of Proof.

The specific item method offers the most direct method of proving unreported income. The specific item method is the IRS’ preferred method of proving income because it is (i) the easiest to understand and present at trial and (ii) the hardest for a taxpayer to rebut. Where the IRS is using the specific item method of proof, the IRS attempts to document specific transactions that were not completely or accurately reflected on the taxpayer’s income tax return. Additionally, the IRS must show that the specific omissions of income were made willfully for the purpose of understanding the taxpayer’s income tax liability.

There are four general categories of Specific Item Methods of Proof:

  1. Specific Items Are Not Reported on the Tax Return. For example, the taxpayer received $100,000 in income from the sale of real property and did not report the sales proceeds on a tax return.
  2. Total Amount Received More than Reported. Same as the example above, but the taxpayer reports income of $60,000 from the sale of the real property instead of $100,000.
  3. Failure to Report Income of A Business. For example, a business that is paid in cash does not account for and report all cash transactions.
  4. Overstated Deductions or Expenses. These may include fictitious deductions or legitimate deductions that are overstated. For example fictitious or overstated charitable contributions. In addition, in egregious cases, a business paying for and deducting the personal expenses of its owner or owners.

The IRS will use an Indirect Method of Proof when sources of income may not be spefically identifiable. Therefore, taxable income often has to be computed indirectly based upon the taxpayer’s application or use of funds. Courts have upheld the use of the net worth, expenditures, and bank deposits methods of proving income, on the theory that proof of unexpended funds or assets may establish a prima facie understatement of income which requires a taxpayer to overcome the logical inference drawn therefrom.

There are three general categories of Indirect Methods of Proof:

1. Net Worth Analysis Method. This method is used when a taxpayer does not have adequate books and records to reconstruct income. To use the net worth method, the IRS must:

a. Prove a beginning-of-a-year net worth with reasonable certainty;
b. Prove an end-of-the-year net worth; and
c. Prove the likely source of income from which the net worth increase arose and negate any nontaxable sources of income.

The Net Worth Formula is: Taxable Income = Net Worth at End of Year - Net Worth at Beginning of Year + Nondeductible Expenditures - Nontaxable Income.

2. Expenditures Method. This method is devised to establish the amount of a taxpayer’s purchases of goods and services which are not attributable to the resources at hand at the beginning of the year or to non-taxable receipts during the year. To using the expenditures method the IRS must:

a. Prove an opening net worth and demonstrate that the taxpayer’s expenditures did not result from cash on hand, or the conversion of assets on hand, at the beginning of the period;
b. Prove that the expenditures charged by the taxpayer are nondeductible; and
c. Prove a likely source of income from which the expenditures sprang, or negate nontaxable sources of income.

The Expenditures Formula is: Taxable Income = Nondeductible Expenses - Expenses Paid With Assets Held at Beginning of Year.

3. Bank Deposits Method. This method reconstructs of all deposits made in bank accounts, canceled checks, and currency transactions. Under this method, all deposits to the taxpayer’s bank and similar accounts in a single year are added together to determine the gross deposits. An effort is made to identify amounts deposited that are non-taxable, such as gifts, transfers of money between accounts, repayment of loans and cash that the taxpayer had in his possession prior to that year that was deposited in a bank during that year. The IRS must prove a likely taxable source for unreported income, and that the deposits do not come from a pre-existing cash hoard.

The Bank Deposits Formula is: Taxable Income = Total Deposits - Transfers Between Accounts - Redeposits of Cash Previously Withdrawn + Payments Made in Cash – Non-Income Deposits.

Like the Specific Methods of Proof, the Indirect Methods of Proof require the IRS to establish that the underreporting of income was made willfully for the purpose of understanding the taxpayer’s income tax liability.

As discussed in a prior blog post (HERE), an attorney who represents a client under criminal tax investigation will usually hire a Kovel accountant to do a shadow analysis of the IRS’ method of proof.

If you have any questions related to this blog post or any other civil tax or criminal tax-related matter, please feel free to contact me at (214) 749-2456 or at jcrouch@meadowscollier.com.