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March, 2003 Tax Tip


IRS Would be Happy to Construct your Income – At Your Peril 

Have you ever wondered how the IRS can prove how much income you have?  As you might have guessed there are several ways.  There is no limit on the methods the IRS can use to compute income if either you don't have adequate records or you haven't filed a return.  The courts set two requirements for the IRS: (1) Prove the taxpayer had some income and (2) use a reasonable technique to estimate the amount.   "It's not incumbent upon the IRS to prove the exact amount," one judge said. "It's incumbent upon the taxpayer to show that the agency's determination was erroneous."

Courts have been receptive to the IRS' methods of constructing a taxpayer's income including information it obtains from suppliers, customers and banks.  Here are a few "real life" cases:

-- A scrap metal company didn't have records.  The IRS contacted some of their suppliers and used their numbers to derive a new income amount resulting in a significant tax balance owing.

-- Based on a well known corporation's recipe, for every 100 pounds of flour bought, the bakery sold 1,100 bagels. Using the prices the bakery charged, the IRS determined a much higher income figure.

-- A couple who owned a beauty salon drove a new Buick and a new Cadillac, put a swimming pool in their backyard and went on a nice vacation. The IRS added cash paid for these luxury items and for living expenses to their bank deposits. The revised income figure provided a jolt to the couple.

-- A former IRS employee operated a return preparation business and bookkeeping service. To check the accuracy of his reported income, the IRS contacted several of his clients.  After several of them disagreed with the amount he said they paid, the IRS used the discrepancies to obtain a new income amount for the preparer. It analyzed bank deposits and records, including amounts on file folders for clients. These left little doubt that he under-reported his income.

The IRS also uses information it obtains from other agencies, as evidenced by the following:

-- A salesman admitted he had commission income, but refused to meet with the agent. The IRS determines taxable income based on Bureau of Labor Statistics reflecting average income.

-- The Federal Narcotics Bureau sent seized money to the IRS.  To justify keeping the money, the IRS prepares a "dummy" return showing the suspect owed taxes in the amount seized.

The foregoing situations don't even consider the ammunition that the IRS gleans from information it can obtain from the taxpayer or his files, books, and records.

THE MORAL:   Keep adequate records to ward off IRS scrutiny.



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