Although the vast majority of Americans file accurate returns and promptly pay their taxes, unfortunately a significant minority of U. S. taxpayers fail to accurately report their income and promptly pay their taxes. IRS studies show that approximately 83% of taxpayers are fully compliant while 17% fail to accurately report their income, file their tax returns or fail to timely pay their taxes. By contrast, only about 50% of Greek taxpayers are compliant and that may explain why that country needed a European Union bailout. Below is a breakdown of compliance rates in other advanced economies according to Reuters:
United Kingdom 77.97%
Switzerland 77.70%
France 75.38%
Austria 74.80%
Netherlands 72.84%
Belgium 70.15%
Portugal 68.09%
Germany 67.72%
Italy 62.49%
Many individual taxpayers have little opportunity to under report their income since they receive Form W-2s from their employers and Form 1099s from their banks and brokers. Selfemployed individuals and businesses have many more opportunities to fail to meet their tax obligations and unfortunately many of them do game the system. Because of massive, improvident budget cuts by Congress, the IRS has less opportunity to find noncompliant businesses. Sine 2010, Congress has gutted the IRS budget and as a result it now only audits .8% of tax returns which is a substantial drop from 2010 when it audited 1.1% of returns.
Those businesses among the unlucky few who are audited can expect an intense review of their returns by an IRS revenue agent. Over the years the IRS has developed a variety of techniques to discover underreported business income. Since many noncompliant businesses seek to hide their omissions the IRS will not only review receipts but use indirect methods to discover them.
Indirect Methods
When the taxpayers’ records are not available or are inadequate the examiner may consider the use of the following indirect methods:
• Bank deposit analysis
• Fully developed cash T method
• Source and application of funds
• Net worth method
• Percentage of markup method
• Unit and volume method
The following is a discussion of the indirect methods. If any of these methods rely on estimates, they must be corroborated by other methods to establish a stronger position.
Bank Deposits Method
Each field audit will start with the agent using a bank deposits method. He or she will trace cash through a bank deposit analysis or use the source and application of funds method. Several unique facets of this analysis operations should be recognized.
• Cash payouts are not deposited, but the money used to make the cash purchases originated from sales. This is cash that would not be deposited into a bank account and must be added back to the bank deposit analysis.
• In a restaurant business, cash payment of employee credit card tips is money that is not deposited, but originated from sales. Again, this cash must be added back to the bank deposit analysis.
• Sales tax collected from customers for cash sales is money deposited that is not a source of income. In many states the sales tax for restaurants and bars is higher than the sales tax for other retail businesses.
• Cash collected from vending machines is cash that needs to be deposited and included in gross receipts. If significant coin and currency deposits are not found on the deposit slips the examiner may need to determine the amount of income from this source and add it to the bank deposit analysis.
• Credit card payments from credit card companies for sales will include deposits of employee tips plus the sales taxes plus the sale. Only the portion representing the sale is taxable.
• Loans from shareholders are a non-taxable source of cash. Proof of payment is necessary to establish facts.
• Transfers between bank accounts are non-taxable.
The bank deposit analysis method assumes the business owner deposits all income in a bank account. In a cash-intensive business such as a bar or restaurant, this may not be the case. For that reason, the bank deposits analysis should generally be supplemented with another indirect method when auditing a bar or restaurant.
Use of Another Method to Support an Indirect Method
Another examination technique may be used such as having the examiner inspect the supply invoices to find the name of the company that prints the guest checks. This printing company can provide the number of guest checks purchased by the restaurant in a year. A projected income can then be determined from the average amount of the guest check times the number of checks. If these methods are used in combination, they strengthen the case.
In examining a bar, it is possible the bar owner may remove cash from his or her drawer, purchase liquor off the shelf of a store, sell the drinks in his or her establishment and pocket the profits. (In most states this practice is illegal and bar owners cannot purchase liquor off the shelf or in discount stores.) In such case, there may be no indication in the books that anything is wrong as neither the invoice nor the income touches the books. An indirect method may uncover this.
Specific Items Method of Determining Income
Before we begin analysis of indirect methods we should discuss the specific items method. This method is preferable to an indirect method as it is based upon direct evidence of income. For example, a restaurant owner may receive rebates from a supplier. A copy of the supplier’s invoices and cancelled checks establishes the amount of income from these rebates.
The specific items method relies on evidence gathered from source documents, rather than estimates. If records cannot be obtained from the taxpayer, the IRS may contact third parties. The specific items method of establishing income, supplemented by the bank deposit method, is illustrated in Ketler v. Commissioner, T.C. Memo. 1999-68. During 1990 and 1991, Warren Ketler operated two sole proprietorships, including a catering operation doing business as California Barbecue. Mr. Ketler failed to file Federal income tax returns for 1990 and 1991. The Service determined Mr. Ketler’s unreported income for these years by reference to Forms 1099 provided by payers. Prior to trial, the Service obtained 1990 and 1991 bank records for all of Mr. Ketler’s accounts and identified various nontaxable transfers and deductible business expenses. Based on this analysis, the Service asked that the Tax Court find increased income tax deficiencies. After trial, the Tax Court found that Mr. Ketler received the income reflected on the Forms 1099. It also found that the Service had properly performed the bank deposits analysis, and, therefore, Mr. Ketler was also liable for increased income tax deficiencies.
Kikolos v. Commissioner, T.C. Memo 2004-82, involved liquor store owners, Nick and Helen Kikalos. At the end of each day Mr. Kikalos would receive a bag from his store containing receipts which, among other things, included the cash register tapes (known as “Z tapes”) from the store. The Z tapes from these store registers would have allowed for an accurate calculation of the Kikalos’ gross income. However, after entering the information in his log books, Mr. Kikalos threw away all of the Z tapes.
When IRS used a mark-up percentage to figure accurate gross receipts, the Kikaloses wanted to use a different indirect method and filed their petition in court. The court said that arithmetic precision was originally and exclusively in the hands of the Kikaloses, who had simply to keep their papers and data. Having defaulted in this duty, they cannot, in essence, “frustrate the Commissioner’s reasonable attempts by compelling investigation and re-computation under every means of income determination.” The Court said that other indirect methods of estimating the Kikalos’ income are not relevant.
Quoting the Fifth Circuit, the court stated, “While the absence of adequate records “does not give the Commissioner carte blanche for imposing Draconian absolutes,” such absence does weaken any critique of the Commissioner’s methodology. Webb v. Commissioner, 394 F.2d 366, 373 (5th Cir. 1968).The court said, “Indirect methods are by their very nature estimates and courts reject the notion that the IRS should have checked their calculations by other methods.”
Bank Deposit Analysis
A bank deposit analysis (BDA) is used to identify deposits that may be taxable, to determine if business expenses were paid from other sources and to determine if business and personal accounts were comingled. The deposited items will show whether cash is deposited.
The examiner will analyze the deposits and reconcile nontaxable deposit sources, comparing the total deposit with the reported gross income. If the retail business is cash intensive, where a significant amount of receipts are not deposited and there are many expenses paid with un-deposited cash, a bank deposit analysis would not be a good indirect method for proving income. However the total known deposits should be added to cash expenditures to show the total amount of funds used. This method is best for retailers whose books are unreliable, but who make periodic bank deposits and pay expenses by check.
The bank deposits method of establishing income is illustrated in Ng v. Commissioner, T.C. Memo. 1997-248. From 1986 through 1990, Big Hong Ng owned interests in several business entities, including various restaurants. Ms. Ng controlled several bank accounts in the United States and Hong Kong. She commingled her personal funds with those of the business entities in which she had an interest. The Service conducted a bank deposit analysis and determined that Ms. Ng failed to report significant amounts of taxable income during the years in issue.
In analyzing the bank deposits, the Service separated cash, checks, cashier’s checks and wire transfers. It examined the source of each deposit and separated items subject to self-employment tax from those not subject to such tax. Further, to the extent possible, the Service eliminated those items that had been reported on Ms. Ng's income tax returns or that came from nontaxable sources (for example, transfers and refinancing proceeds). The Service also analyzed Ms. Ng's cash expenditures. The expenditures that could not be traced to a nontaxable source or reported income were considered unreported income.
Source and Application or Cash T
This method analyzes cash flows in comparison to all known expenditures, and shows that if there are excess expense items (applications) over income items (sources) an understatement of taxable income exists. These methods may be useful for a retail business that has unreported sources of income and when business and personal expenses can be verified.
Markup Method
This method reconstructs income based on the use of percentages or ratios for the type of retail business. For example, the examiner would determine the industry markup for a particular type of retailer and apply that markup percentage to the verified cost of goods sold of the taxpayer under examination.
Alternately, the examiner can use the taxpayer’s own markup percentages, if possible. A ‘shelf test’ can be performed where the current sales prices can be compared to the cost of those items to determine the markup percentage. This will be effective if there are only a few types of purchases or only a few suppliers of goods, such as for a gasoline retailer.
This method works well for a business that is cash intensive or one that does not use bank accounts to deposit receipts, or for a taxpayer where total expenditures (such as personal expenses) cannot be determined. This method is also recommended when inventories are present, but records are unreliable.
Percentage Markup Method of Determining Income
IRS examiners will use the percentage markup method in the following situations:
1. When inventories are a factor and the taxpayer has nonexistent or inadequate records.
2. Where a taxpayer's cost of goods sold or merchandise purchased is from one or two sources and these sources can be ascertained with reasonable certainty and there is a reasonable degree of consistency as to sales prices.
Computations in the Percentage of Markup Method
Possible daily volume x Average check per seat = Daily sales
The possible daily volume would be the number of seats in the establishment multiplied by how many times in a day they are occupied. The possible daily volume can be broken down into time periods in a day (breakfast, lunch, or dinner) to get a more accurate tally. The average check per seat can be obtained from the taxpayer during the initial interview or from examining the sales tickets.
The daily sales can be extended to weekly and yearly sales based on the days open per week and the weeks open per year.
Daily sales x Days open in a week = Weekly sales
Weekly sales x Weeks open in a year = Yearly sales
These estimates will take into account the number of vacant seats and people who walk out before paying their bill. The examiner will also look at the taxpayer’s advertising account to test the accuracy of reported income. Are specials advertised? How often? Specials may refer to certain menu items or discounted prices or both. Are the times during which specials are offered (for example, happy hour or weekly breakfast hours) reflected in the daily receipts ledger?
Net Worth Method
This method measures the difference between a taxpayer’s net worth (total assets less total liabilities) at the beginning and at the end of the year. An overall increase in net worth represents taxable income. This method works when there is an entire business element missing, such as a retailer that does not report sales from an internet business, or a taxpayer who has additional income from an illegal source.
The net worth method can also be used to corroborate other methods of proof or to test the accuracy of reported taxable income.
The net worth method of establishing income is illustrated in Michas v. Commissioner, T.C. Memo. 1992-161. During 1984, the taxpayers owned several sole-proprietorships, including a liquor store. The Service determined that the books and records of these sole-proprietorships were inadequate and analyzed the taxpayer’s net worth to determine whether all taxable income had been reported. The Service performed this analysis by determining the cost of the taxpayer's business and personal assets at the beginning and end of 1984. The Service then reduced these amounts by the taxpayer’s liabilities at the beginning and end of the year. Then, the difference was adjusted by adding nondeductible expenditures (for example, living expenses) and by subtracting nontaxable sources of income (for example, gifts and loans).
The Court largely agreed with the Service, but found that certain adjustments to net worth were not proper. Accordingly, the Court reduced the amount of unreported income determined by the Service.
In summary a non-compliant business may think they can hide income from the IRS but once they come under examination the IRS will doggedly search for omissions.
Robert E. McKenzie of the law firm of Arnstein & Lehr LLP of Chicago, Illinois, concentrates his practice in representation before the Internal Revenue Service and state tax agencies. He previously served as a member of the IRS Advisory Council (IRSAC) which is a group appointed by the IRS Commissioner from 2009 to 2011.
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