By Stanley I. Foodman
A variety of commercial, civil and family law cases can be investigated with the use of the “Methods of Proof” (methods) used by IRS special agents during criminal tax investigations. The Internal Revenue Manual (IRM) of procedures incorporates six methods, five of which are commonly used and detailed below. The IRM breaks down these methods into two categories: direct or “indisputable” methods and indirect or “circumstantial” methods. When using the indirect or circumstantial approach during an investigation, the IRM recommends using two of the methods to support findings. The Direct method or Specific Item method is best suited for matters of income understatements, expense overstatements, or fraudulent claims for credits and exemptions. Criminal and civil tax matters, other economic crime issues, commercial litigation and family law may contain all three of these conditions. It is best suited to situations involving a small number of clients or customers with large dollar per transaction amounts of business. It encompasses two approaches: the basic approach and the aggregate approach.
The basic approach reconciles income and expenses on filed tax returns with underlying records. Unreported income and exaggerated expenses are improper activity. This approach can only be used when the income is itemized and detailed in some form of record or bookkeeping. It includes individual customer contact to assess the actual unreported income.
The aggregate applies when income is not detailed. Receipts documented by third parties are used to prove that income is higher than reported. It does not require proving what the extra income was; only that it exceeded what was reported.
The Indirect methods are more commonly used because proper bookkeeping is not usually present when an individual is inaccurately reporting. Income may not be identifiable as it is in the direct method. So, income and expense is computed using several different approaches. According to reported cases, courts currently permit net worth, expenditures, bank deposits, and cash methods as viable indirect methods of proof. Based on the IRM, indirect methods are sustainable if, and only if, the defendant cannot provide logical and factual explanation on the discrepancies between computed and reported incomes.
The Net Worth Method
Income is calculated based on applications of asset accumulation, liability reduction, expenditures, and other financial data. The net worth under review is calculated and then compared to the net worth of the previous year. The change in net worth from year to year as adjusted is compared to the filed tax returns, financial statements, etc. Differences between income reported and increases in net worth constitute a measure of income not accurately reported. This method is most commonly used when dealing with individuals whose books are nonexistent, inaccurate, or inadequate.
Using the Net Worth method requires meeting all three of the following requirements.
1. Net worth previous to the period in question must be accurately calculated,
2. The Net Worth method must refute reasonable explanations of the person under review, and
3. There must be a clear connection between increase in net worth and currently taxable income.
The Expenditures Method
Is based on the principal that if it is found that subject’s expenditures exceed their reported income and they do not have a loss reported on their tax return, there must be unreported income. Like net worth, expenditures also require a look at the period in question compared to previous years. It is used when the subjects’ net worth does not experience any significant change over the period in question. Rather they spend large quantities of money on consumable goods as opposed to durable goods that effect net worth. After negating any nontaxable income that the subject explains, whatever expenditures exceed the reported income is considered to be unreported income.
Bank Deposits Method
If a subject deposits most of his or her income into banks, then the recommended method of proof is Bank Deposits method when access to bank statements is possible. This uses the bank account records to calculate understated income. This method is based on the idea that a subject is limited to three activities once money is received: spend it, deposit it, or hoard it. Deposits minus expenditures plus increases in cash in hand equals income under this method. Income under this method is then compared with reported income.
Using the Bank Deposits method requires meeting all four of the following factors:
1. Existence of a profit producing business, activity, or profession,
2. Periodic and scheduled deposits into the business bank accounts of which the subject had control.
3. The deposits counted as income must be from taxable sources, and
4. Unidentified deposits must resemble income.
Cash
Using the Cash method, unreported income is calculated based on cash expenditures. It is an expansion of the expenditure method applicable to individuals or business taking part in business “outside of records.” It requires examining the extent of cash expenditures comparing them to non-taxable and declared income. This method is used when attempting to deal with a subject whose major fluctuations of wealth and business are done in currency.
Using of the Cash method requires meeting all four of the following factors:
An accurate opening net worth and cash on hand, The expenditures during period in review, A reasonable source for unreported income, and Knowledge of all potentially nontaxable sources of income.
I have used these above methods as part of our work during a corporate embezzlement investigation requiring calculation of the amounts embezzled and the amounts retained and spent by the embezzler. Our findings were used during successful recovery negotiations with a bank that was compromised by the embezzler into aiding him.
In a particular divorce case, we used these methods to convince the court that the husband was using his corporate entity to move and hide what should have been assets of the marital estate into other entities permitting him to maintain his actual style of living while claiming a reduced income stream.
During an investigation of the alleged diversion of insurance proceeds resulting from a natural disaster, we were able to use these methods to demonstrate how members of the board of directors of a condominium association used those proceeds to unjustly enrich themselves through unauthorized expenditures for the repair and restoration of their condominium units.
In our experience working under attorney-client privilege and outside of the attorney-client privilege, we have been able to adapt these methods very effectively for use in other matters such as embezzlement/defalcation investigations, family law and commercial litigations. After all, it’s always about the money!
Stanley I. Foodman is CEO of Foodman CPAs & Advisors and a recognized forensic accountant and litigation support practitioner. Specializing in complex domestic and international tax matters, Foodman has served as an expert witness and forensic accountant for some of the nation’s most challenging, high-profile economic crime cases. Foodman and his team of accountants also assist clients with a full range of accounting matters including compliance, voluntary disclosure, corporate and individual taxation, family law litigation, estate and trust tax and wealth planning. Consistently ranked as one of the top accounting firms in South Florida, Foodman CPAs & Advisors assists clients locally, nationally and internationally. www.foodmanpa.com
South Florida Legal Guide Midyear 2013 Edition