Among the various methods of proving unreported or underreported taxable income, the specific item method is the most preferred. Most subjects report their income and expenses by the specific item method using books and/or records in which their financial transactions are contemporaneously recorded. Their transactions are usually summarized and shown on the tax return.

There are three broad categories of schemes which are suited to the specific item method of proof:

A false tax return may include any or all of these schemes. Unreported Income can be proved using the basic or aggregate approaches discussed in the following subsections:

Small amounts of expenses claimed on the false return sometimes have to be allowed or accepted because the special agent is unable to properly trace or document the actual amounts, or he/she lacks the time to do so.

Indirect methods require the special agent to gather and present evidence to support the allegation. The special agent will use evidence to determine what income should have been reported on the subject ’s return and compare that to the amount shown on the return, if a return was actually filed.

Sources of income may not be identifiable, as in a specific item method of proof. Therefore, taxable income often has to be computed indirectly based upon the taxpayer’s application or use of funds.

The courts have upheld the use of the net worth, expenditures, bank deposits and cash 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 defendant to overcome the logical inference drawn therefrom.

With respect to the establishment of a prima facie investigation by such evidence, courts have been careful to point out that findings of fraud have been sustained if, but only if, the defendant has offered no adequate explanation of the discrepancies between (on the one hand) expenditures, bank deposits, and increases in net worth and (on the other hand) the amount of income reported by the defendant.

Another indirect method of proof is the percentage markup method of proof. Pending the establishment of judicial precedents, the percentage markup method of proof should only be used as a primary method of proof, on a limited basis, and not used to corroborate other methods. ( See IRM 9.5.9.9, Percentage Markup Method of Proving Income.)

The unit and volume method of proof can be utilized when the number of units handled and the price or profit charged per unit is known.

Omitted income, fictitious deductions, false exemptions, or false tax credits are means whereby taxes may be evaded.

Omitted income results from a subject ’s failure to report any of the numerous items of taxable income set forth in the Internal Revenue Code (IRC).

During investigations of proprietors and/or their businesses, sales or gross receipts are the most frequently encountered item of omitted income.

During investigations of individuals, omitted income is frequently encountered in the form of salaries, interest, dividends, commissions, gains from the sale of property, and fees.

Overstatement of expenses results from the subject ’s attempt to reduce taxable income by claiming false or inflated expenses. During investigations of proprietors and/or their businesses, overstated expenses can be hidden in any expense reported on the tax return. During investigations of individuals, the overstated expenses are most frequently encountered on Schedules A, C, D, and F. Additionally, subjects attempt to evade income taxes by claiming false deductions and exemptions. In all of the investigations described above, the specific item method of proof is ideally suited to proving the violation.

Specific omissions of gross income are most easily shown when the subject has a small number of significant sources of income. During the investigation, the special agent determines the specific amount of income reported from each source and then compares those figures with the total amount of income documented in the subject’s books and records, and reported on his/her tax return. The following examples illustrate the appropriate use of the specific item method of proof:

When the subject of an investigation generates small amounts of income from numerous customers or clients, as would be the investigation with subjects owning bars, restaurants, and grocery stores, it is difficult, if not impossible, to match reported amounts of income with specific sources of income. In these situations the specific item method may not be the best method to use; indirect methods may be more appropriate.

There are two approaches to the specific item method of proof, i.e., the basic approach and the aggregate approach. Depending upon the facts and circumstances of the investigation, the special agent will use one of the two approaches to prove unreported income.

The basic approach to the specific item method of proof requires the special agent to trace the reported items of income through the subject’s books and records to the tax return. Upon doing so, the special agent can specifically identify the unreported income items.

The aggregate approach to the specific item method of proof simply requires that the special agent identify the total amount of income the subject should have reported in any given year. The special agent then compares the total amount of income with the aggregate amount of income reported on the return, and arrives at an understatement of income.

There is no statutory provision defining the net worth method and specifically authorizing its use by the Commissioner. However, every judicial circuit has endorsed the net worth method of proof and the Supreme Court has approved its use in a number of investigations. The following is a listing of some of the more prominent of those investigations:

These investigations outline the broad principles governing the prosecution and review of investigations based on the net worth method of proving income.

The net worth method of proof is most often used when one or more of the following conditions exist:

The fact that the subject’s books and records accurately reflect the figures on the return does not prevent the use of the net worth method of proof. The government can look beyond the self-serving declarations in the subject’s books and records and use any evidence available to refute the accuracy thereof.

In addition to being used as a primary method of proving taxable income in civil and criminal income tax investigations, the net worth method can be used:

The net worth method of proof is not limited by the subject’s method of accounting. The net worth statement may reflect the subject’s corrected taxable income by whichever method of accounting (cash, accrual, etc.) is appropriate. Reflecting a certain accounting method in the net worth computation is accomplished by including certain accounts in the net worth statement and omitting others. For instance, to compute the income of a physician on the cash basis, patient accounts receivable and business accounts payable at the beginning and end of each year would be omitted. If the physician used the accrual method of accounting, these accounts would be included in the net worth computation.

In preparing a net worth statement or summary for use in a criminal investigation, special agents should ensure that:

The net worth formula expanded:

In determining the value of assets, all assets in the computation are entered at cost or other tax basis. Fluctuations in fair market value are of no consequence in determining taxable income. Paper gains or losses resulting from changes in fair market value of assets are not taxable or deductible until said gain or loss is realized.

The key to a successful net worth investigation is establishing a reliable beginning net worth (opening net worth) which includes all of the assets and liabilities on hand. It is this starting point from which all future increases or decreases will be calculated. This starting point is normally referred to as the base year. In a net worth computation, it is extremely important to firmly establish a beginning net worth (starting point or base year) with the best evidence available.

In calculating annual net worth, be aware that an inverse relationship exists between one year and the next. If the subject ’s opening net worth is understated, there is a resulting overstatement of the increase in net worth for the following year. Conversely, if the subject’s opening net worth is overstated, there would be a resulting understatement of the increase in net worth for the following year.

The first step to establishing a firm starting point is to determine the date (opening or base year) best suited for the investigation. The interview with the subject will strengthen the starting point. While questioning the subject, the special agent should attempt to develop all information relating to the subject’s assets and liabilities for the years involved. The subject should be questioned about the value of any item which cannot be determined from available books and records, e.g., cash on hand as of a particular date, personal living expenses, assets held in the names of others, gifts, inheritances, loans, and other nontaxable sources of income.

The establishment of cash on hand is critical. The inability to establish a firm and accurate amount of cash on hand can be fatal to the investigation. Uncertainty about the amount of cash on hand is a common defense in net worth investigations. It will be easier to refute this defense if the special agent has established a firm beginning and an ending cash on hand amount is established. Cash on hand is almost always proved by circumstantial evidence.

The best source of information in establishing an accurate cash on hand figure may be obtained from the subject during an interview. The special agent may not always have the opportunity to interview the subject in every investigation. However, when the opportunity does exists, the special agent should attempt to establish the beginning and ending cash on hand. In determining a firm cash on hand figure, the following subsections offer insight into possible techniques to employ during a subject interview.

During the subject interview, the subject should be questioned in detail about cash on hand. The questioning should be preceded with an explanation of what constitutes cash on hand and elicit the subject ’s answer as to cash on hand. Cash on hand is coin and currency (bills, Federal Reserve notes, etc.) in the subject’s possession, i.e., on the subject’s person, in the subject’s residence, or other place, in nominee hands, or in a safe-deposit box. It does not include any money the subject has on deposit in any account with any type of financial institution.

The special agent should use caution in using terms such as cash because people often refer to money on deposit in banks as cash on hand. The special agent should be specific and explain that he/she is referring to undeposited coin and currency in all locations.

Most people have difficulty recalling specific dates and amounts, especially when several dates are involved, and they extend back for a number of years. Direct questions, such as "How much cash on hand did you have on December 31, ____" will frequently be answered with "I don’t know" or "I can’t remember that far back" . In such investigations, the special agent should persist in questioning about whether the subject had a depository for coins or currency and/or whether the subject placed any coins or currency in the possession of another person. The special agent should obtain a description of the depository. If the depository is a safe-deposit box or home safe, the special agent should relate the questions to when and where the box was rented or purchased. The special agent should obtain a description of the depository and a description of the funds (their denomination and quantity) to determine whether it was possible to have such a sum of money in that particular depository.

The special agent may determine the amount of cash on hand by asking questions about the maximum amount of cash that the subject could possibly have had at any particular time. For example, such questions as, "Did you ever have more than $100 in cash on hand? More than $5,000? More than $10,000?," may result in admissions that can establish the total amount of cash on hand at a particular date.

Discussing the accumulation and purpose of the cash on hand may establish the minimum and maximum amount on a particular date. Determining the ultimate disposition of this cash on hand can provide a lead to a specific amount of cash on hand on a particular date. For example, a statement like "I used all my cash on hand to pay for my house in 1994" indicates how much cash the subject had on the date of payment. It also provides a cut-off date for cash on hand, since the subject evidently had no more cash after using all the cash on hand to pay for the house. The special agent should question the subject further to elicit an admission that the subject did not have any additional cash on hand as of the specified date.

The special agent’s questioning should be directed toward developing:

In addition to questioning the subject about cash on hand, also:

In addition to interviewing the subject, the following investigative steps should be taken when establishing a firm starting point in a net worth investigation:

In order for income to be taxable, it must come from a taxable source, Commissioner v. Glenshaw Glass Co,75 S. Ct. 473 (1955). In the Holland investigation, the Supreme Court opined that, an "Increase in net worth, standing alone, cannot be assumed to be attributable to currently taxable income. But proof of a likely source, from which the jury could reasonably find that the net worth increases sprang, is sufficient. . ." Holland, supra at 138.

Following the Holland decision, it appeared that proof of a likely source was necessary in every net worth investigation. This premise was clarified by the Supreme Court in United States v. Massei, 78 S. CT. 495 (1958) when it stated:

In view of these decisions, it appears that the government must either prove a likely source of taxable income or negate all nontaxable sources of income. In investigations where the government resorts to negating all nontaxable sources of income, it is even more critical to establish a firm starting point, particularly with reference to cash on hand.

Proof of a likely taxable source of income has been found sufficient in a number of criminal investigations by:

A likely source of income is established in net worth investigations by showing the source of income identified by the subject had the potential to produce income substantially in excess of that reported.

Negating nontaxable sources of income may be accomplished by substantiating the subject’s admissions as to the receipt or non-receipt of loans, gifts, and inheritances. If the subject alleges to have received nontaxable sources of income, the special agent should verify the claim by reviewing Federal gift tax returns filed by the alleged donor or probate records of the deceased relatives’ estates. Additionally, the special agent should interview the person who allegedly made the gift to the subject. However, if the subject advances a specific explanation as to the sources of nontaxable funds expended, the government does not have to pursue other possible nontaxable sources of income when the one given is proven false.

When a subject offers leads or information during a net worth investigation that, if true, would establish his/her innocence, such leads must be pursued. This also applies if the subject offers leads or information after the completion of an investigation but within sufficient time before trial.

During the trial, if the government fails to show an investigation into the validity of the leads provided by the subject, the trial judge may consider the defendant’s information as true and the government’s investigation insufficient to go to the jury.

Most leads refer to cash hoards, gifts, inheritances, and loans. These leads should be checked as routine steps taken during the investigation.

The courts have held that the government does not have to investigate leads that are not reasonably verifiable. This is a question of judgment and, in the final analysis, is always a matter for the court to determine.

In investigations utilizing a detailed computation of net worth, the factual data may be best presented via a summary of the details broken down into at least one main appendix and various sub-appendices.

An appendix is a document developed to summarize and present, in a concise manner, voluminous information that is contained in the exhibits of an investigation. A sub-appendix supports the main appendix and is generally prepared when there are a number of items of a particular type of asset, liability, or other adjustment. Sub-appendices are also used when there are numerous witnesses or exhibits to support a particular net worth item. Keep the main appendix as simple and brief as possible to aid in its presentation and clarity. While there is no set format for a sub-appendix, it should be organized in a manner which presents the information in a clear and concise manner.

A copy of each appendix and sub-appendix must accompany each copy of the final prosecution report. The exhibits to the investigation accompany only the original report. If sub-appendices are used, they must refer to the proper witness, the exhibit number, and a description of the evidence used to support the item.

Sub-appendices are prepared to summarize the pertinent information that is found in the exhibits. The totals from the sub-appendices are forwarded to the main appendix, where the information is summarized. The main appendix is then cited in the body of the final report. Multiple main appendices are common in net worth investigations.

During a trial of an income tax investigation involving the net worth method of proving taxable income, the special agent may introduce the sub-appendices and main appendix used to support the final report. It is important to remember that the special agent’ s work product (main appendix and supporting sub-appendices) is not evidence. These schedules and appendices should summarize documents and testimony already admitted into evidence during the trial. These schedules and appendices are admitted for the purpose of aiding and assisting the jury in considering the evidence admitted. The admissibility and use of appendices and summaries are discussed in IRM 9.6.4, Trial.

The special agent should become most familiar with the appendix or summary showing the computation of taxable income. (See Exhibit 9.5.9-1.)

In addition to appendices, schedules, and summaries, net worth computations have been presented to the jury through the use of graphs and charts.

Special agents can overcome the following common defenses in net worth investigations by thoroughly investigating them at the onset of the investigation.

Like the net worth method, there is no statutory provision defining the expenditures method of proof and expressly authorizing its use by the Commissioner. There are, however, many investigations in which the courts have approved the use of this method. The following is a list of some of the more prominent investigations:

These investigations outline the broad principles governing the prosecution and review of investigations based on the expenditures method of proving income.

The expenditures method of proof is used when the subject’s net worth does not substantially increase during the period under investigation, or when significant extravagant living expenditures are apparent. Therefore, when a subject has spent substantial income on consumable goods and services such as food, vacations, travel, gifts to third parties, etc., as opposed to durable and tangible property such as stocks, bonds, or real estate, the expenditures method of proof would be an appropriate method of proving income.

In investigations where the subject has several assets (and liabilities) whose cost basis remains the same throughout the prosecution period, the expenditures method may be preferred over the net worth method because a more concise presentation can be made of the computation of taxable income. This is true because assets and liabilities which do not change during the investigation period may be omitted from the expenditures statement.

The expenditures method is used most often in investigations where the subject spends income to support a lavish life-style and has little, if any, net worth.

In an expenditures investigation, it is desirable to prepare a complete net worth statement which may be required to rebut a defense that the funds in question came from the conversion of some asset not considered in the expenditures computation.

In submitting a prosecution report based upon an expenditures investigation, the special agent should also submit proof of the subject’s unreported taxable income using the net worth method of proof. Because these two methods of proof are so similar, in that they require the same investigative steps be taken, proving unreported income through both methods substantially strengthens the prosecution recommendation.

If both methods are shown, the trial attorney can make the final decision as to which method of proof best presents the investigation to the jury.

The expenditures method of proof formula is as follows:

To establish a starting point, the subject ’s assets at the beginning of the tax periods under investigation should be identified and monitored to determine if any assets were converted for use as personal expenditures.

While establishing a starting point, special agents may prefer to use a net worth analysis, depending upon the facts and circumstances surrounding the investigation. (See IRM 9.5.9.5.5, Establishing the Starting Point.)

See Exhibit 9.5.9-2, Expenditures Statement, to view an expenditures statement which may be used to summarize the evidence supporting the computation of taxable income.

The following steps have been found helpful in the preparation of an expenditures statement:

Money spent or applied on nondeductible items, i.e., personal living expenses, Federal income tax payments, etc., should be posted to the following sections:

Nontaxable source items i.e., gifts, inheritances, etc., received by subject should be posted to the following sections:

The defenses regarding the net worth method of determining income are equally applicable to the expenditures method. (See IRM 9.5.9.5.9, Common Defenses.)

There is no statutory provision defining the bank deposits method of proving income and specifically authorizing its use by the Commissioner. The bank deposits method of proof is not defined by the USC or regulations. It is primarily based upon the Supreme Court ’s decision inGleckman v. United States, 80 F. 2d 394 (8th Cir. 1935), which affirmed a lower court ruling that recognized the bank deposits method as an acceptable method of proving income.