IRS Income Discovery Methods

by chris on August 20, 2009

Recently, I was reading the IRS audit guide for retail establishments and a tax research text.  Both items discussed the methods the IRS has at its disposal for estimating a individual’s or business’s potentially unreported income. 

If you’ve been around small businesses or taxes for any time at all, you’re familiar with $20 or other dollar bills that escape the cash register and finds their way(unreported) into an owner’s pocket.  It is disappointing to hear about such shenanigans since one person’s illegal tax savings means higher tax rates for the  rest of us.  Non-the-less this disappearing income scheme is a significant part of the 2006 estimated $345 billion dollar national tax gap. 

Following is a brief explanation of some of the IRS income estimating techniques.

  • Bank Statement Method -  This method scrutinizes all bank accounts and assumes that all deposits are income, unless proven otherwise.  All withdrawals from the bank account must be substantiated as expenses.  This method can capture unreported income, but could easily miss un-deposited income.
  • Net Worth Method -  A comparison is made between a prior years net worth and the subsequent years net worth.  Net worth is the difference between the assets  owned and the liabilities owed.  Suppose your Net Worth increases from $250,000 to $350,000.  Typically this increase is caused by Net Income.  The amounts are adjusted for gifts or other sources of income that may not be subject to tax. 
  • Cash T Account Method – By focusing on the business cash inflow and cash outflows, the IRS can estimate the income and expenses of a business.  This process is much like creating a statement of cash flows. However, the flows are analyzed to see which are income and which may yield deductible expenses.

Another interesting estimating method is an assessment of your purchases and mark up percentages.  For the sake of an example, lets assume you purchase $1 million in inventory.  If you typically mark inventory up by 100%, assuming no year end remaining inventory, you should report $2 million in sales.   Business owners are required to report purchases, but even if owners fail to provide the appropriate data, the IRS can subpoena information from suppliers.  

All of the above methods have been tested and upheld in the courts! 

I can think of several reasons why business owners should focus on proper reporting, beyond the obvious one – that it is required by law. 

  1. Often your self employment income goes into your earnings record, ultimately impacting your benefits under social security.
  2. If you sell your business, the value is typically determined by some method that evaluates your accounting or tax income.   Keeping your income artificially low, reduces the sales value of your business.
  3. Accounting records are kept not only for compliance reasons, but also to help with business decision making.  If you are working with incomplete records, you may compromise your ability to make the best business decisions, which could ultimately cost you more than taxes.
  4. The penalty for fraud can be as high as 75% of the tax that should have been owed and can create a criminal case with prison terms up to 5 years.

I can’t help but reflect on some simple life lessons.  If you consistently cheat, more likely than not, you’ll eventually get caught.  Often when cheating, were really cheating ourselves.  Finally, it really isn’t all that hard to do the right thing.   The tax code is littered with IRS approved and congressionally sponsored ways to save taxes.  With a bit of tax code knowledge and some advance planning, you’re likely to enjoy all the savings without the risks and negative costs.

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Authored by: Steven Berger, CPA

ISBN# 1-58686-104-2

This book is part of a series of educational resources distributed by BoardSource. (www.boardsource.org)  BoardSource specializes in providing informational and educational resources for non-profit trustee members.  Understanding Non Profit Financial Statements would be particularly valuable to new Treasurers, CFO’s Executive Directors or Controllers entering the realm of non-profit financial’s.

Berger delivers a thorough and concise (78 pages) overview of the primary elements and issues related to financial statements.  Berger provides statement examples, outlines some of the non profit specific issues, and provides an introduction to some of the metrics trustees might use to evaluate performance. Additionally, an accompanying CD provides a PowerPoint presentation which could be used to further the knowledge and understanding of the entire board of trustees. 

This resource, in combination with a non-profits 990, IRS Instructions for the 990, and Financial Accounting Standards Board’s Statements 116 and 117, provide a valuable foundation for understanding the financial statement and reporting requirements of non-profits.  Berger’s resource is the ideal starting point for volunteer trustees or non profit executives looking to add value to there organization, while effectively meeting their fiduciary responsibilities.    

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