Indirect IRS Audit Methods

[Snaggletooth]

This comes from the Emptyhead thread below which has been going on in so many directions I wanted to start a new thread so we could focus on the Indirect IRS Audit Methods discussed by Dyne and Uncle Sam.

I have no input here as I suspect both of the aforementioned have been auditors at one point or another and I haven't ever been one. At one point in the flurry of posts, Dyne listed five criteria frequently measured by IRS auditors.

My question is about those five criteria and the subsequent discussion of those methods. I wish to point out that ALL of those criteria depend upon the offender to deposit his unreported earnings into a bank. From what I've been exposed to, the overwhelming cheating occurs when the violator is too smart to leave records of the unreported transaction. Even large amounts of money can be unrecorded - one guy traded $80,000 for a Hummer straight up and recorded some piddly amount as consideration on the bill of sale and gave the car dealership something else under the table. He wasn't my client, but more than one of my customers told me about it.

Another example is the open-air meat and vegetable markets in Philadelphia. All cash transactions. The IRS will NOT go there. They are licensed by powerful friends in city and state governments, and even if they went in there they couldn't find evidence because there is no record -- the market owners take cash and pay cash for everything - even their light bill.

I would like to hear more from Uncle Sam and Dyne - auditing methods to catch the slick people who don't leave records of their unreported income. Only the village idiot would make bank deposits and E-bay sales if they didn't intend to report it.

[Jiggers]

Cash income

How many of you report your income from e-Bay sales? And, how many of you report the sales to your state sales tax authority and collect sales tax?

Just curious.

Could be an embarassing situation if audited and you, as a tax return preparer, didn't report the income!

[dyne]

IRS indirect methods

I mentioned several badges of fraud which are indications that a civil or fraud penalty
should perhaps be asserted. I imagine that is what Snaggletooth refers to as
criteria but I try not to make assumptions as assumptions are usually wrong.
NO, all indirect methods MUST include cash expenditures and money which was
NOT deposited. This can become difficult to determine sometime. Some
taxpayers will provide estimates of personal living expenses but IRS obtains most living
expenses from examining cancelled checks and ADDING cash expenditures also.
IRS also has statistics it can use which provides average food cost, clothing, etc.
ALL indirect methods do NOT assume that all income is deposted but actually assume
that unreported income was NOT deposited. Cash on hand is important and must be tied down!
ALL indirect methods should provide the exact same answer and WILL if done
correctly.

The IRS restructuring and Reform Act of 1998 added IRC Sect 7602(e) which says:
"The Secretary shall not use financial status or ecomonic relality examinations
(indirect methods) to determine the existance of unreported income of any taxpayer
unless the secretary has a reasonable indiction that there is a likelihood of such
unreported income."

I suggest that you search Google for: IRS economic reality audit. There are pages and
pages of interesting sites. Also search Google for: IRS indirect methods.
Often the loan and home mortage payments ALONE would exceed the reported income
by a taxpayer.Imagine $10,000 in such loan payments and yet a net business profit of
$3,000 was reported or even a net loss. If taxpayers were not so greedy, they might
get by with not reporting all income. But most ARE greedy. The live in expensive homes
and drive Mercedes and report a business loss or a net business profit of $3,000 etc. If
they only omitted $10,000 or $20,000 of sales per year, they might not get caught. But
instead they omit $100,000 in sales per year and are surprised when IRS catches them.
I am in FAVOR or them getting caught. IRS auditors and Agents are GOOD at their job
and I am thankful for that. I recommed that all tax preparers become knowledgeable
about the indirect methods so it does not come as a surprise when they encounter it.


I have tremendous difficulty in getting the text to line up properly on the
right-hand side of this message board. Does anyone know the secret to correcting this easily. I have been using Windows for about 4 years but still have difficulty
with it at times. Thank you Uncle Sam! Best wishes.

[Jan]

How many of you report your income from e-Bay sales? And, how many of you report the sales to your state sales tax authority and collect sales tax?

Just curious.

Could be an embarassing situation if audited and you, as a tax return preparer, didn't report the income!

I sold many items on craigslist, never reported the money. (Of course, the items were sold at a loss).
How many of you sold items for more then what you paid you them?

[dyne]

indirect methods

Many practioners would be amazed at how COOPERATIVE most taxpayers are with
IRS auditors. There are a few uncooperative hateful taxpayers but MOST are friendly
and cooperative with IRS. The reason is that: 1. They are honest and feel they have
nothing to fear OR 2. They are cheating but are confident that IRS will not be able to
catch them. OVERCONFIDENCE on the part of taxpayers is a tremendous advantage
to IRS Auditors. Taxpayers help drive the nails in their own coffins and help convict
themselves. IRS Auditors ask many questions which seem innocent to the taxpayer but
which WILL be used to convict them or at least uncover unreported income. The
psychology of it is facinating! Catching tax cheats is like taking candy from a baby
as far as IRS is concerned. The more confident the taxpayers is, the easier it is to catch
them. The taxpayers must think:" I only reported half of my gross business sales and
there is no way IRS can discover this." IRS does this 8 hours a day, 5 days a week and
to IRS it is simple! The only danger is once in a while the IRS auditor will make a mistake
and overlook VA benefits, an inheritance or some type non-taxable income. Practioners
need to concentrate on this type of error. ASK the taxpayer: HOW did you live or
upon what did you live?
Many HONEST taxpayers are also caught by IRS and owe a large tax deficiency simply
because they did not understand the tax laws. Generally no penalty is assessed against
them however.

[dyne]

indirect methods

There are TWO bank deposit methods. The first is simply where IRS adds all bank
deposits and compares it to reported gross sales. This computation is performed
in ALL business audits.
The second is the IRS bank deposit method where again all deposits are addded
and cash expenditures NOT taken from checks written to cash are added. This
is not used as often.
The cash T account method and Source and Application of Funds method are
virtually the same and are the most commonly used methods.
All of these simply add all know expenditures and subtract known income sources.

The net worth computation is quite differant and much more difficult. It is the same as
the above method except the COST of all assets (residences, cars) are included at the
beginning of the year and at the end of the year. Increases represent EXPENDITURES.
Determining the cost (to date) of all assets can be tedious. The net worth method
is poorly named. Worth has nothing to do with it. If the fair market value of the residence
is included, the answer obtained will be wrong! The net worth method is similar to the
balance sheet required on most other returns such as corporations, etc.

Proper subtractions or adjustments to ALL of these methods is essential.
Money borrowed, non-taxable income, etc. The list is long. Personal items
such as clothing, old car, etc. sold at a loss would be non-taxable income which
should be subtracted on the indirect method computation.

IRS often uses the net worth computation when they plan to prosecute the taxpayer or
assert the civil fraud penatly.

[dyne]

IRS Auditors Attitute

Most IRS Auditors and Agents are honest, hard working, smart and good at their job.
IRS management concerns me. They expect to much from the auditors. Imagine
being an Auditor and being required to perform 8 audits per day every day. After a
number of years it simply will wear you out. And management wants MORE! MORE!
Many Auditors quit after a few years. That is why there are so many former IRS
Auditors who are now tax preparers. And consider that 75% or more of the taxpayers
audited are cheating on their taxes to some extent. After awhile all taxpayers begin
to appear like criminals or cattle to the auditor. Their attitude becomes jaded. Many nice
people became hateful after being an audtior for years. Burn-out is part of the problem.
An auditor can never do enough to satisfy management. Management always wants
more tax money to be found or less time to be spent on each audit .Auditors who are
ruthless and rake in the tax money are praised and promoted. Those who do not are
critized and hounded. This tends to encourage auditors to be more ruthless. Friends
who work for IRS advise me that it has only gottern worse lately. I knew a GS-13
senior IRS Agent who worked with the Large Case Group. He had been with IRS
for more than 30 years and was planning to retire soon. IRS management began
harrassing him during his last two years for no justified reason. He survived until he
retired. But it turned him against IRS.

[Uncle Sam]

Indirect Audit Methods

Dyne pretty much gave you the lowdown on calculation methods IRS uses to determine unreported income.
However, if you're interested in knowing what the "economic reality" audits are all about- IRS looks at your residence address - what type of neighborhood you live in, where you socialize, where you go to church or house of worship, make and model cars you own, investments you have, which organizations you hold memberships in, how you finance your childrens' educations, pay insurance policies, second residences (if any), vacation habits, charge and credit card activities, etc. Then IRS compares cost analysis to income reported on the tax return to see if it's reasonable to pay these living expenses on income shown.
Yes, the IRS certainly does use a lot of the techniques detailed by Dyne, but if they can't get their hands on what they're looking for by these methods and are certain there's material unreported income.
I first became aware of this in the mid 1990's when MSSPs came out, and I authored a home-study CPE course for a professional organization on MSSPs before all the publishing companies came out with them - and through reading the material - learned how they conduct the indirect methods when the direct methods are unreliable in detecting unreported income.

[dyne]

indirect methods

The STATE auditors perform many audits of taxpayers, often using the net worth
method. When completed the taxpayer might owe $500 tax (for example) A year later IRS
will receive a copy of the state report. Then IRS will bill the taxpayer for the federal
tax and self-employment tax which might be $8,000 (for example). Then the taxpayer
will argue that the state audit report is wrong. Their only recourse is to go back to the state
and have them correct the state audit report and of course that is never going to happen
because the state audit report is correct.

Taxpayers who omit income are usually self-employed. So, they owe federal tax
and self-employment or social security tax. After years of not paying their proper tax
they eventually reach retirement age and guess what? They are entitled to little or
no social security benefits. Surprise!

Often a husband or wife will operate a business and report a net loss. The spouse will
report wages. The question is: why did this person operate a business for years and
years at a loss? If he or she truly has a loss, money must be borrowed or taken from
the wage-earner spouse every year to cover the loss.

Think about it! They are asking you believe that they work hard 40 or 80 hours per week
at their business only to LOSE money each year! The answer of course is that there
is NO business loss! Some taxpayers argue that they operate the business at a loss
every year so they will have a business to support them when they retire.If it is NOT
supporting them NOW, why should it provide a living then? Sometimes it is a hobby but
more often income is being ommitted.

[dyne]

indirect methods

Yes, IRS has the authority to issue a subpeona.
IRS Auditors are trained to :close the barn door before the horse gets out or in other words
they must eliminate every excuse the taxpayer may bring up in advance.
Cash on hand must be established so the taxpayer does not try to explain the
discovered unreported income by claiming he was living upon cash saved in prior years.
Usually this is easy to disprove as the prior years generally report a business loss or
low business profit also. And IRS can turn it against the taxpayer and TAX a cash
hoard on the theory that it must have come from unreported income. Many of the
questions asked by an IRS Auditor are done so that the taxpayer cannot later claim
that he borrowed the money from a friend or some similar lame excuse. IRS will
simply audit the friend to see if he reported enough income to live upon and loan money
to the taxpayer. The smartest taxpayers who attempt to cheat on their taxes are no match for even a mediocre IRS Auditor. IRS has expertise and experience in uncovering unreported income that would astonish the smartest taxpayers. The battle is lost before it begins. My recommendation: be honest and report all of your income. God and IRS is watching.

[Joe Btfsplk]

Small time cheaters

I have prepared tax returns that look pretty fishy to me which have been audited and came out smelling like a rose. Some report very low income and even losses yet manage to pay their bills. The only client I've ever had who was assessed tax based on his cost of living exceeding his reported income was an old lawyer who claimed he only made about $ 7000 per year.

Since I am only required to question information that I know to be wrong, I accept records as submitted. And, in view of the audit results I have seen, the IRS probably follows the same approach in its audits in most cases. Their best auditors are probably looking for bigger fish to fry and do not want to waste time assessing $ 1000 when they could be working on a job that might come up with $ 50000.

I have worked as a state auditor and as an auditor for an oil company and spent most of my time looking for the big bucks. Once I made an audit and only came up with $ 5000 and was told that my time probably cost more than the results of the audit. Most years, with the oil company, I would come up with over $ 1 million auditing co-owners, processing plants and transmission lines. If I had done a lot of $ 5000 audits, my total results would have been much lower.