U.S. taxpayers must report their worldwide reportable income. In the event that a non-reporting non-compliant taxpayer is identified by IRS, it will initially determine the taxpayer’s taxable income.
When documentary evidence is available to IRS, it can easily determine the amount of a non-compliant taxpayer's tax due.
Without available direct evidence, IRS has to try to reconstruct a taxpayer’s financial portrait.
There are different methods available to IRS to reconstruct a taxpayer’s income.
- A simple T-Account is the method most often used by IRS revenue agents when trying to determine if taxpayer income has been underreported or not reported. The sources of cash funds are noted on the left side of the T-Account and expenditures of cash funds on the right side. An “imbalance” of the assets minus liabilities is examined year over year and has to be explained by the taxpayer. If unexplained net worth increases year after year, there is a presumption that the increase in net worth originated from unreported income. The T-Account method is also known as the Net Worth Method. It was the methodology used by the US Government to convict Al Capone.
- Requesting copies of bank statements. There could be sources of income noted in bank deposits that are not reportable as income. Examples could be an inheritance, a gift or proceeds from life insurance or a mortgage.
- A website: Does the taxpayer transact business over the Internet? A taxpayer might have products, memberships or services sold via the internet. E-commerce activity must be reported as a source of income.
- Business Ratio Analysis: IRS can compare a taxpayer’s business ratios to other similar businesses in the same industry. The comparison of financial ratios can indicate if income is understated or expenses are overstated.
- Information match: W-2s, 1099s, K-1s are forms that are sent to IRS, which in turn it enters into computer programs to match the information against the taxpayer’s tax return.
There are circumstances that assist IRS in determining if there might be irregularities in a taxpayer’s income reporting:
Inability to balance a taxpayer’s financial status or financial differences that can’t be explained.
- Taxpayer has irregular books and or weak internal controls.
- Financial ratio percentages that are very high or very low for that business industry or that change significantly from one year to another.
- Banks deposits without an explanation or made in cash.
- Net worth increases that are not supported by reported income.
- Non-existent books and records.
The Methods of Proof will be used if IRS agents have a suspicion that a taxpayer is failing to report income — whether it is inadvertent or a willful evasion. Don’t be a victim of your own making. Taxpayers should not be in a position where an Internal Revenue agent reconstructs his financial landscape.