4.10.4. Examination of Income

(1) With regards to IRC 7602(e), which addresses the use of financial status audit techniques, examiners should not routinely ask for bank statements, cancelled checks or deposit slips to complete the examination of income on nonbusiness returns. Requests for documentation supporting specific issues can be made and may include cancelled checks.

(2) There may be situations in which there is a reasonable indication of unreported income in the pre-contact stage of the examination; i.e., a grossly imbalanced financial status analysis or Forms 1099 for business income not included on the tax return. In such situations, the initial information document request (IDR) may include a request for personal banking records, including bank statements, cancelled checks, and deposit slips.

(1) Examiners may find that one or more of the minimum income probes cannot be performed in a particular case or that no value is added by performing a specific minimum income probe. The decision to deviate from one or more of the minimum income probe requirements must be based on the specific facts of the case as they relate to the taxpayer.

(2) When the examiner determines a deviation from a minimum income probe is warranted, the reason(s) must be documented in the appropriate minimum income probe workpapers. The factors considered and rationale for deviating must be specifically documented. The documentation must clearly support the decision.

(1) Prepare a financial status analysis of the taxpayer's cash flow to estimate whether there are sufficient funds to cover the taxpayer's expenses. The financial status analysis includes both business and personal financial activities. The analysis serves two purposes:

1. Determining the depth of the examination of income, and

2. Establishing that there is a reasonable likelihood of unreported income that justifies the use of a formal indirect method.

(2) The intent of the analysis is to determine whether there is a significant risk of a material misstatement of taxable income. Materiality is the significance or importance of an item in determining the correct tax liability and requires the examiner’s judgment regarding the return as a whole and the separate items that comprise the return. Among the factors which must be considered when determining whether the imbalance is material are:

1. Absolute amount of the imbalance;

2. Results of multi-year analyses;

3. Ratios and industry standards (it is recommended that the ratio analysis include three tax years, to the extent information is available, to provide a comprehensive financial picture and allow for trend analysis);

4. Relationship between the size of the imbalance and the tax liability.

(3) The financial status analysis should include consideration of all sources and expenditures of funds identified on the tax returns, information included as part of the case building, and sources of information such as asset locator people locator contract, Financial Crimes Enforcement Network (FinCEN), Information Document Retrieval System (IDRS), Corporate Files on Line (CFOL), and/or Compliance Data Environment (CDE). See Exhibit 4.10.4-2 for internal sources of information. Reasonable estimates for other expenses known to exist, but for which the exact costs are not known should be included in the analysis. Personal living expenses (PLE) must be estimated using Bureau of Labor Statistics (BLS) information or comparable statistics from a reliable source, except where the actual amount of the expense is disclosed on the tax return.

(4) The analysis should also be updated during the examination as additional information becomes available; i.e., nontaxable sources of funds or disallowed expenses. Refer to Exhibit 4.10.4-4, Example of Financial Status Analysis for Individual Business Return.

(5) The T-Account provides a quick and easy format for documenting and determining whether there is an indication of a potential understatement of taxable income. Enter sources of funds on the left side of the T-Account and expenditures of funds on the right side. Total sources are compared with total expenditures.

(6) Steps for completing a financial status analysis:

1. Prepare the financial status analysis (using the T-Account format) based upon the tax return data and information in the case file; e.g., records of monetary transactions (FinCEN). Use BLS or comparable statistics from another reliable source to estimate the taxpayer's personal living expenses. If the analysis indicates a material imbalance, the excess expenditures are considered to be a potential understatement of taxable income which requires further development during the audit.

2. An analysis of IRP information in the file should be completed to evaluate if there are any additional sources of income. Income not included on the tax return should be included in the T-Account.

3. Use subsequent interviews and information gathering during the examination to update the financial status analysis and resolve any imbalance. For example, when the profit margins are consistently low, but the taxpayer is able to continuously service substantial debt (mortgage), the examiner should make further inquiries.

4. The analysis should be updated as audit adjustments are identified. The adjustment may be the result of unreported gross receipts, overstated expenses, or from a combination of these items.

5. When completed, the financial status analysis should indicate that either income is sufficient to support the taxpayer's expenditures or there is a significant imbalance indicating the potential for unreported income.

(7) The completion of a financial status analysis does not trigger the provisions of IRC 7602(e), which states, "The Secretary shall not use financial status or economic reality examination techniques to determine the existence of unreported income of any taxpayer unless the Secretary has a reasonable indication that there is a likelihood of such unreported income." A financial status analysis is an analytical tool used to identify and estimate the materiality of cash flow imbalances. Financial Status Audit Techniques are the formal indirect methods used to make the actual determination of tax liability and are subject to the limitations of IRC 7602(e). See IRM 4.10.4.6.

(8) Income or losses reported on Schedule E, Supplemental Income and Loss, may not represent an actual flow of funds.

1. If the taxpayer is reporting income or loss from a partnership, S corporation, estate, or trust, review, for example, Form 1120-S Schedule K-1, Shareholder's Share of Income, Deductions, Credits, Etc., to identify actual capital contributions, withdrawals or distributions.

2. If the taxpayer is reporting income or a loss from a Real Estate Mortgage Investment Conduit (REMIC), review Schedule Q, Form 1066, U.S. Real Estate Mortgage Investment Conduit (REMIC) Income Tax Return.

(9) Common errors in a financial status analysis include failure to include loan payments as an application of funds, treating the cost of goods sold as an application of funds rather than current period costs (i.e., purchases, labor costs, materials and supplies, and other costs associated with inventory), and accepting unreasonably low estimates of personal living expenses.

(10) An examiner may consider observing a taxpayer's residence when completing a financial status analysis. However, observing a taxpayer's home should not be intrusive and generally should not include talking with the taxpayer's neighbors. Inspections of the inside of a taxpayer's home should be limited due to privacy issues and the intrusive nature. Note: the purpose of inspecting the interior of a taxpayer's home includes determining the validity of a deduction for an office or business located in the residence.

(11) The financial status analysis, as originally prepared based upon the tax return data and information in the case file and subsequently modified, will be made part of the examination workpapers. The analysis should indicate the information considered and the conclusions reached.

(12) If the financial status analysis indicates that the taxpayer's sources of funds are not sufficient to support the taxpayer's expenditures; the use of a formal indirect method can be justified.

(1) The examiner should conduct the initial interview with the taxpayer to gain an understanding of the taxpayer’s overall financial picture, the business history and operations, and an overview of the taxpayer’s recordkeeping practices. Interviews should be professional and not overbearing.

(2) IRC 7521(c) states that an examiner cannot require a taxpayer to accompany an authorized representative to an examination interview in the absence of an administrative summons. However, the taxpayer's voluntary presence can be requested through the representative as a means to expedite the examination process. Should an examiner find that a representative has unreasonably delayed or hindered an examination, an examiner can bypass the representative and deal directly with the taxpayer. See Exhibit 4.10.4-5, Bypassing Powers of Attorney.

(3) Question the taxpayer/representative concerning possible nontaxable sources of funds, gifts, loans, known errors/omissions on the return, and unreported sources of income. These questions should be addressed at the initial interview early in the examination. The information will be needed to reconcile the financial status analysis, analyze the bank accounts, and reconcile the income reported on the tax return to the books and records. Also, the information will be critical should it later become necessary to use a formal indirect method to make the actual determination of tax liability.

1. If loan proceeds are identified, verify the source and amount of the nontaxable funds.

2. If the loan is from a financial institution, consider whether the loan amount is consistent with the taxpayer's financial picture as represented on the tax return. Evaluate for consistency with other evidence; i.e., cash flows, anticipated gross receipts, etc. If inconsistencies are identified, request the loan application and attachments. Review the financial statements submitted with the application; look for information such as the disclosure of sources of income not included on the tax return or the disclosure of more profit than reported on the return. Consider when evaluating the credibility of the taxpayer's oral testimony and accuracy of the taxpayer's books and records.

3. If the loan or gifts are from family members or other individuals, verification may be difficult. The examiner should inquire as to why the amount provided was cash, when the amount was given, how it was given (one payment or multiple), and any provisions for repayment. Discrepancies should be resolved with the taxpayer's assistance. Nontaxable sources of funds can be eliminated by showing that the provider of the funds was incapable of generating the amounts stated by the taxpayer; i.e., the absence of any documentation reflecting the source of the funds and/or the absence of sources of funds available to the provider.

4. Refer to IRM 4.10.7.3, Evaluating Evidence, for additional guidance.

(4) If the IRP analysis reveals that there are additional known sources of income not included on the tax return, the examiner should question the taxpayer as to where they may have already reported this information.

(5) Question the taxpayer concerning bartering income. Bartering is the trading of one product or service for another. Usually there is no exchange of cash. Bartering may take place on an informal one-on-one basis between individuals and businesses, or it can take place on a third party basis through a modern barter exchange company.

(6) Obtain the beginning and ending balances for cash-on-hand from the taxpayer or representative for the year(s) under examination. See IRM 4.10.4.6.8.3 for complete discussion and Exhibit 4.10.4-1 for interview questions. Generally, cash-on-hand is currency associated with normal business practices and the need to complete cash transactions with customers. If additional years are examined, be sure to determine and document the beginning and ending cash-on-hand for those years. This information will be needed to complete the reconciliation of income as reported on the tax return to the taxpayer's books and records and will be critical should it later become necessary to use a formal indirect method to make the actual determination of tax liability.

(7) Determine the beginning and ending balances of accumulated funds for the year(s) under examination. Generally, accumulated funds is currency not associated with normal business practices. The funds may have been taxed in prior years, originate from nontaxable sources, or may represent taxable income in the year under audit. See IRM 4.10.4.6.8 for complete discussion and Exhibit 4.10.4-1 for interview questions.

(8) The examiner should ask the taxpayer for assistance to resolve a financial status analysis indicating a material imbalance.

(9) The examiner should ask the taxpayer to explain the accounting system, including:

1. The normal flow of each type of transaction from its initiation to its inclusion in the financial statements, and

2. The flow of funds into and out of the business.

(10) The examiner should question the taxpayer regarding business policies and practices for:

1. Product pricing and determining profit margins,

2. Accounting for cost of goods sold, and

3. Accounting for spillage, breakage, and theft losses.

(11) The examiner should determine the extent of the taxpayer's use of the Internet for e-commerce purposes. See Exhibit 4.10.4-7 for a list of interview questions.

(12) IRC 7521 (b)(2), Recording by IRS Officer or Employee, requires examiners to suspend interviews when taxpayers state that they wish to consult with a representative or otherwise seek advice. The taxpayer’s right of consultation will be strictly observed and interviews will be suspended and rescheduled accordingly. This provision does not apply to interviews initiated by administrative summons and will not be used to repeatedly delay or hinder the examination process.

(13) Examiners should use the appropriate Lead Sheet 125 in RGS to document the interview.

(14) Refer to IRM 4.10.7.3.2, Oral Testimony, for complete discussion and documentation requirements.

(1) Conduct a tour of the physical business site controlled by the taxpayer. Generally, the physical business site will be the principal location and any other locations acquired during the period under examination should be visited. The purpose of a tour is to:

1. Gain familiarity with the taxpayer’s business operation and internal controls,

2. Identify potential sources of unreported income, and

3. Confirm the existence of assets.

(2) A tour of the physical business site is not required for office audit cases. However, if appropriate (and with manager's approval), a tour of the business site may be conducted.

(3) The results of a tour and any observations and/or comments should be documented in the examination workpapers.

(4) See IRM 4.10.3.3, Tours of Business Sites, for complete discussion.

(5) Review the business websites controlled by the taxpayer. See IRM 4.10.4.3.7.2.

(1) Evaluate the internal controls to gain an understanding of the taxpayer’s business operations and control features. The evaluation will help examiners set the scope and depth of the examination of income and determine the appropriate audit techniques.

(2) Examiners should:

1. Document the business operation

2. Document the accounting system

3. Document assets

4. Document the flow of transactions

5. Document procedures established for safeguarding business operations

(3) The evaluation should not be limited to a consideration of the segregation of duties. See IRM 4.10.3.4, Evaluating the Taxpayer’s Internal Controls, for a complete discussion. Examiners should:

1. Determine the reliability of the books and records, regardless of the sophistication of the recordkeeping method. Refer to IRM 4.10.4.3.7.5 if the taxpayer maintains electronic books and records.

2. Gain an understanding of the taxpayer's business operations; i.e., how income is generated and recorded.

3. Determine how business assets are safeguarded; i.e., what steps the taxpayer takes to ensure that the business operates as intended and avoid misstatements of financial information.

(4) While there is no exhaustive definition of weak internal accounting controls which will impact the scope and depth of the examination of income, examples include:

1. Books and records that cannot be reconciled to the tax return

2. Transactions that are not properly authorized

3. Recorded transactions are not valid

4. Existing transactions are not recorded

5. Transactions are improperly valued

6. Transactions are improperly classified

7. Transaction are recorded at the improper time

8. Transactions are incorrectly summarized

9. Transactions all made by the same person or related parties

10. Significant commingling of business and personal funds

(5) Weak internal controls alone do not necessarily establish a reasonable likelihood of unreported income under IRC 7602(e) that justifies the use of a formal indirect method to make the actual determination of tax liability. Examiners must also demonstrate that there are irregularities in the taxpayer's books and records. See IRM 4.10.4.3.3.5.

(6) The workpapers will document the conclusions reached by the analysis of internal controls and their impact on the scope and depth of the examination.

(1) Reconcile the income reported on the tax return to the taxpayer’s books and records. Ask the taxpayer how income was computed and duplicate the taxpayer's steps. Refer to IRM 4.10.3.5.6, Step 6: Reconciling the Taxpayer's Books and Records to the Tax Return, for complete discussion.

(2) Analyze the information obtained in the initial interview, observed during the tour of the business site, and from the evaluation of the internal controls to determine if transactions were properly recorded.

1. Determine whether information provided by the taxpayer in the interview(s) is reflected in the book and records.

2. Confirm that income from all assets observed during the tour of the business is included in income.

3. Based on the evaluation of internal controls, identify weaknesses which could be overridden or compromised, allowing for the diversion of income. Test the weaknesses to determine whether income actually was diverted.

(3) Test whether income from e-commerce activities has been accounted for in the books and records and reported on the tax return. See IRM 4.10.4.3.7.

(4) If the income per the books and records cannot be reconciled with the income reported on the tax return, the examiner should ask the taxpayer to provide an explanation for the difference; i.e., how the accounts per books were accumulated for the tax return.

(5) Irregularities in a taxpayer's books and records, or inconsistencies in reporting transactions may be an indication of unreported income justifying the use of a formal indirect method to determine the actual understatement of taxable income.

(6) The lack of books and records or the underlying source documents will justify expansion of an income probe beyond the minimum income probes.

(7) The fact that a taxpayer's books and records were not prepared contemporaneously to the business activity does not, per se, permit the examiner to use a formal indirect method to make the actual determination of tax liability. The test of whether a formal indirect method can be used is whether there is a reasonable indication that there is a likelihood of unreported income.

(1) Test gross business receipts to verify that all the gross receipts are accounted for. For additional techniques, see IRM 4.10.3.9, Testing Gross Receipts or Sales.

1. Trace original entries in the books back to the original sales document (e.g., sales slips, cash register receipts, or job contracts, etc.).

2. Trace original sales documents to the corresponding entries in the books.

3. If original sales documents are numbered or otherwise sequenced, identify and account for missing sales documents.

4. Determine the method and adequacy of the accounting for merchandise withdrawn for personal use.

5. Scan sales agreements, contracts and other related documents to identify unreported bonuses, awards, kickbacks, etc.

6. Determine that all accounts receivables are included in income for accrual basis taxpayers.

(1) Perform an analysis of the taxpayer's business and personal bank accounts (including investment accounts); i.e., statements, deposit slips, and canceled checks, etc. The examiner should use judgment to determine the depth of the analysis and use of automation. The Service is not prohibited from asking for these records, as well as wire transfers, on the initial information document request (IDR) or at any time during the examination for an individual business return. See IRM 4.10.4.3.

(2) This analysis is used to:

1. Identify deposits which may be taxable income,

2. Determine whether business expenses may have been paid from other sources (such as cash-on-hand or accumulated funds) or are overstated,

3. Estimate the risk of commingled personal and business bank accounts, and

4. Determine whether cash is deposited.

(3) The steps of the bank account analysis are:

1. Analyze the deposits. Look for unusual deposits (size or source), frequency of deposits. Also check for deposits of cash, specific deposits that do not follow the taxpayer's normal routine or pattern, nontaxable deposits such as loans and transfers, commingling of personal and business activities, and cash-backs when a deposit is made.

2. Total the deposits and reconcile deposits of nontaxable funds and transfers between accounts. Particular attention should be paid to transfers in, out, and between accounts as previously unknown accounts may be identified. Checks deposited by the taxpayer but later returned by the bank (e.g., the maker of the check did not have sufficient funds in the account to pay the check) should be categorized as a nontaxable transactions. As a reminder, the nontaxable funds, transfers-in, and returned deposits need to be subtracted from total deposits to get "Taxable Deposits."

Note: This step is a duplication of the reconciliation of income reported on the tax return to the taxpayer's books and records if the taxpayer reported income based on bank deposits.

3. Determine disbursements by adding the opening bank balance to the total deposits and then subtracting out the ending balance.

4. To the extent possible, conduct a review of cancelled checks to determine whether nondeductible expenditures (personal expenses, investments, payments on asset purchases, etc.) are included with business expenses and if so, the dollar amount. If cancelled checks are unavailable, trace transactions from the bank statement to the check register and original document. Significant commingling of accounts warrants a more in-depth analysis.

5. Subtract the nondeductible expenditures from the total disbursements. The remainder should approximate the deductible business expenses on the tax return (other than non-cash expenses such as accruals and depreciation).

   Note: It may be easier to identify the business expenditures in some cases, which can then be subtracted from the total disbursements; the remainder will be personal expenses paid by check.

(4) Compare the total deposits with the reported Gross Income. Include all accounts, whether designated as personal or business.

(5) If the analysis results in the identification of excess deposits over the reported gross income, the excess represents potential unreported income.

1. If specific transactions or deposits can be identified as the source of the understatement, a specific item adjustment to income supported by direct evidence should be made.

2. If the specific transactions or deposits creating the understatement are not identified, an adjustment to taxable income may be made based on the circumstantial evidence. Technically, this is an adjustment due to the use of an indirect method. However, IRC 7602(e) governing the use of financial status audit techniques, is not triggered because the adjustment stems from an analysis of the taxpayer's books and records and does not require the extensive collection of detailed information. IRM 4.10.4.2.8, Indirect Method.

(6) If the business expenditures paid by check are less than the deducted business expenses on the return, then the taxpayer may be overstating expenses, paying expenses by cash (unreported income), or paying expenses from an undisclosed source of funds.

(7) If the analysis indicates significant commingling of funds, then the internal controls are weak and the books and records may be unreliable. IRM 4.10.4.3.3.4.

(8) A potentially material misstatement of taxable income identified through a bank account analysis establishes a reasonable likelihood of additional unreported taxable income justifying the use of a formal indirect method to make the actual determination of tax liability.

(1) The initial reconciliation of income per the books and records to the tax return provides the examiner with an understanding of how the taxpayer determined gross receipts. The books and records can also be used to evaluate the accuracy and reasonableness of the reported amount of income through the use of ratios.

(2) A horizontal analysis should be prepared, with documented conclusions, and be included in the case file for all business returns. A vertical analysis may not be appropriate for every case.

(3) Horizontal analysis - This analysis identifies changes over time and may result in the identification of LUQ items not readily identified from a review of a single return alone. The tax return under audit should be compared to the prior and subsequent year returns.

1. Examiners should consider absolute numeric entries, changes in key ratios, and any other changes indicative of a change in financial activities. The analysis should be based on expenses that vary with changes in production or volume of sales.

2. The analysis should include all schedules that report financial activity, including Schedules C, D, E, and F.

3. The analysis can be documented by notes on the CDE prints, or a prepared schedule.

4. This analysis should be completed in conjunction with the Required Filing Checks under IRM 4.10.5.3, Prior and Subsequent Year Returns.

5. Significant variations (5% or more) suggest changes in business or reporting practices that need to be discussed with the taxpayer.

   Example: In many industries, cost of goods sold bears a direct relationship to sales. An analysis of the prior and current year business ratios indicates consistency between years. The analysis for the current and subsequent year indicates a change in business practices that should be explained by the taxpayer. Horizontal Analysis for Prior and Current Year

   Description	Prior Year	Current Year	Change	% Change
   Sales	$90	$100	$10	11%
   COGS	$27	$30	$3	11%
   Fixed Costs	$30	$30	0	0
   Net Income	$33	$40	$7	45%

   Horizontal Analysis for Current Year and Subsequent Year

   Description	Current Year	Next Year	Change	% Change
   Sales	$100	$130	$30	30%
   COGS	$30	$42	$12	40%
   Fixed Costs	$30	$30	0	0
   Net Income	$40	$58	$18	25%

(4) Vertical Analysis - This analysis identifies differences between the taxpayer's business and the industry standards for a given year and is an indicator of the reasonableness of gross receipts and net profit reported on the tax return. Ask the taxpayer what the gross profit should be and test the gross profit percentage by tracing specific transactions from the purchase of a product for resale to the sale of the item. Industry standards can be found at http://www.bizstats.com. IRM 4.10.4.3.3.8 for complete discussion and examples.

1. Expenses are expressed as a percentage of gross receipts.

2. Potential underreporting of income which equals 10% or more of the reported income should be resolved with the taxpayer's assistance. Discrepancies can be caused by errors in reporting gross receipts, inventory, or purchases. See IRM 4.10.3.9.1, Gross Profit Ratio Test, paragraphs 12, 13, and 14 for lists of possible errors.

3. A comparison against industry norms alone, which indicates a discrepancy, is not justification for using a formal indirect method to make the actual determination of tax liability unless the taxpayer is uncooperative or nonresponsive.

(5) Examiners are not limited to the ratio demonstrated above. Any ratio or standard available for the taxpayer's industry can be used for the analysis. See IRM 4.10.3.9.1, Gross Profit Ratio Test.

(1) More information on e-commerce income issues can be found in IRM 4.10.4.3.7.1.

(1) Examiners may find that one or more of the minimum income probes cannot be performed in a particular case or that no value is added by performing a specific minimum income probe. The decision to deviate from one or more of the minimum income probe requirements must be based on the specific facts of the case as they relate to the taxpayer.

(2) When the examiner determines a deviation from a minimum income probe is warranted, the reason(s) must be documented in the appropriate minimum income probe workpapers. The factors considered and rationale for deviating must be specifically documented. The documentation must clearly support the decision.

(1) Prepare an analysis of the balance sheet and tax return information. The purpose of the analysis is to assist in the identification of issues to be examined.

(2) Significant changes to any accounts should be noted and resolved during the examination.

1. Analyze significant balance sheet accounts which show substantial increases or decreases that may indicate the misclassification of income and accounts.

2. Entries that reduce taxable income, such as a deferral or postponed recognition of income should be examined. A deferred income account (typically included in the liability section of the balance sheet), may indicate income from services performed or merchandise shipped and received by the customer. A deferral of income is not proper in these cases. Additional examples include "loans to shareholders," suspense accounts, and reserve accounts.

3. Cash accounts should always be analyzed to identify unusual transactions; i.e., transactions that are not part of the day-to-day operations, and transactions involving shareholders, partners, or employees. Review all adjusting entries. Compare year-end bank reconciliation to the books for all cash accounts. Review the cash receipts journal for any items that are not credits to income or accounts receivable. Look for entries from sources other than cash receipts or disbursements which may indicate unauthorized withdrawals or expenditures, the acquisition or disposition on an asset, omitted income, or undisclosed bank accounts.

4. Notes and accounts receivable should be identified (beginning and ending balances); tie the general ledger to the subsidiary ledger. Credit balances may indicate additional income or unrecorded sales. Old receivables, where no legal or collection action has taken place, should also be reviewed. The receivable may have been paid directly to a shareholder, partner or employee and left on the books.

5. Review inventory sheets and identify how the inventory value was determined (Cost or Market, LIFO or FIFO). Ending inventory can be manipulated to control new profit. Look for write-downs, review items valued at $0, and trace values back to purchase invoices.

6. Loans to shareholders should be analyzed to ensure entries to this account are not distributions of earnings, dividend income, or another form of taxable income reportable by the shareholder. If no interest is paid, consider imputing interest at the current rate. If no repayments have been made, consider whether the debt has been forgiven.

7. Buildings and other depreciable assets should be reviewed to verify additions and deletions. How was a purchase financed? Could the asset be for personal use? If assets are removed from the balance sheet, how did the disposition occur? Was the disposition accounted for? Assets may remain on the balance sheet, even if disposed of.

8. Accounts payable should be identified (beginning and ending balances); tie the trial balance to the general ledger; check for adjusting entries, netting of related accounts receivable, or reclassifications that may be unreported income or understatement of sales. Review taxpayer's policies for making payments; deviations should be reviewed. The majority of accounts payable should be inventory purchases; when the value of the account payable is similar to or greater than inventory, there may be a misstatement of ending Inventory.

9. Analyze the loans from shareholder account (beginning and ending balances), which may be consolidated with other accounts. Consider the possibility that diverted corporate income was lent back to the corporation. Make sure the transactions reflects a bona fide loan and loan repayments; there should be a loan instrument with terms and stated interest rate. Does the shareholder have the means to loan the money to the entity? If not, what was the source of funds? Consider whether the loan is a capital contribution and if the interest paid to the shareholder is really a dividend. Loans from financial institutions to the taxpayer, where the shareholder cosigned or guaranteed the debt, are not loans from shareholders; these loans should be included in Notes Payable.

10. The retained earnings account should be analyzed, including all adjustments and adjusting entries. Make sure the reasons for the adjustments are understood. Entries that are debited or credited to retained earnings have no affect on the profit and loss statement for the current year. Also review Schedules M-1 and M-2 and make sure items such as meals and entertainment, book versus tax depreciation, penalties, etc. are accounted for and that no item with potential tax impact is incorrectly included in retained earnings rather than addressed on the tax return.

11. IRM 4.10.3.8.4, Step 3: In-Depth Analysis, includes guidance for specific balance sheet accounts.

12. Review the corporate minutes to evaluate potential for accumulated earning tax under IRC 531. Corporations must have a business reason for accumulating earnings in excess of $250,000; otherwise, earnings should be distributed to shareholders as dividends. Review the dividend history to determine when (if ever) dividends were issued. If the business is consistently profitable and no dividends have been distributed to the shareholder, the shareholder's compensation may be unreasonably high.

(3) Use CFOL information or secure copies of subsequent and prior year returns from the taxpayer to complete the comparative analysis when the examination is initiated.

(4) Tie balance sheet accounts, such as cash, to their respective source documents (cash receipt/disbursement journals and bank reconciliations).

(5) Tie balance sheet accounts such as accounts receivable and accounts payable to the receivable/payable subsidiary ledger ending balance.

(6) Compare the adjusted trial balance to the balance sheet to ensure they match. Account grouping sheets should be requested for this analysis. This is an essential step in the examination of a double-entry set of books.

(7) Review the adjusting journal entries from the unadjusted trial balance to the adjusted trial balance for misclassifications, unusual debits to income accounts or possible manipulations of reported income. The adjusted trial balance should be tied to the general ledger to ensure there are no missing adjusting journal entries.

(8) The general ledger should be scanned for large, unusual or questionable items in the journal entries or adjusting journal entries, such as debit entries to income accounts or credit entries to asset accounts (i.e., accounts receivable that do not flow from the cash receipts journal).

(9) See IRM 4.10.3.8, Balance Sheet Analysis: Introduction, for additional instructions.

(1) Perform a reconciliation of Schedule M–1, Reconciliation of Income/Loss Per Books with Income Per Return, or equivalent schedule.

1. The entries on Schedule M-1 are not part of the taxpayer's double-entry account system. Normal accounting controls do not exist; and, therefore, errors can be frequent. Look for items that are deducted from the books and then again (erroneously) on the Schedule M-1; transpositions of numbers; an expense on the books but not on the tax return.

2. The taxpayer may disguise its Schedule M-1 adjustments by combining or netting items which normally are reported as separate line items.

3. Omitted Schedule M-1 items can be found by analyzing balance sheet accounts (especially liabilities), which are not affected by Schedule M-1 adjustments on the tax return.

4. See IRM 4.10.3.6.1, Schedule M-1, for a complete discussion and example.

(2) Perform a reconciliation of Schedule M–2, Analysis of Unappropriated Retained Earnings per Books, or equivalent schedule. The disposition of, or changes to, retained earnings can indicate whether monies have been distributed to a shareholder and where those funds originated. Refer to IRM 4.10.3.6.2, Schedule M-2, for complete discussion.

(3) Perform a reconciliation of Schedule M-3.

1. Schedule M-3, Net Income (Loss) Reconciliation for Corporations with Total Assets of $10 Million or More, is used by corporations filing Form 1120 whose total assets on Schedule L, Line 15, column (d) equal $10 million or more for taxable years ending on or after December 31, 2004. For tax years ending on or after December 31, 2006, the filing requirement is expanded to include taxpayers with total assets of $10 million or more and who file Form 1120S, 1120L, or 1120PC.

2. Part I primarily reconciles financial statement worldwide net income (loss) for the corporation (or consolidated financial statement group, if applicable) to net income (loss) per the income statement of the corporation for U.S. taxable income purposes. Parts II and III reconcile financial statement net income (loss) for the U.S. corporation (or consolidated tax group, if applicable) to taxable income reported on Form 1120. Part II generally reflects income, gain and loss items. Part III generally reflects expense and deduction items.

3. A partnership will be required to file M-3, Net Income (Loss) Reconciliation for Certain Partnerships, if it has $10 million or more in assets at the end of the year, $35 million or more in total receipts, or is 50% or more owned by a taxpayer.

4. Refer to LB&I's Schedule M-3 Technical Guidance website for more detail on analyzing Schedule M-3.

(1) Corporate and stockholder returns, as well as partnership and the associated partner returns, are considered related because the returns are for entities over which the taxpayer (stockholder or partner) has control and which can be manipulated to divert funds or camouflage transactions. Evaluate copies of the tax returns of significant shareholders or partners (greater than 20% direct or indirect ownership) for:

1. Examination potential (including issues unrelated to the corporate or partnership return),

2. The proper treatment of related transactions with the corporation or partnership, including losses from related parties, and

3. The likelihood of diverted funds.

(2) See Exhibit 4.10.4-8, Tax Treatment of Diverted Income, if funds diverted from a corporation to a stockholder are identified.

(3) Completion of the Required Filing Checks is not a violation of IRC 7602(e). See IRM 4.10.5, Required Filing Checks.

(4) Copies of related shareholder/partner returns should be obtained using CFOL or CDE first. If the CFOL and CDE information is insufficient, the return should be requested from either the campus or the taxpayer for inspection. See IRM 4.10.5.2.2, CFOL/IDRS and CDE.

(5) For cases in which entities related through a flow-through relationship are suspected, but cannot be otherwise identified, examiners should request research using the yK1 Link Analysis Tool. This tool provides a graphic representation of flow-through relationships created by partnerships, trusts, and S corporations. The tool uses Schedule K-1 data to depict ownership relationships and income/loss flows between payers and payees.

1. SBSE examiners can request research using Form 13680, Small Business/Self Employed yK1 Link Analysis Research Request.

2. For additional information or to request yK1 research, go to http://k1.soi.irs.gov/.

(6) Examiners should determine if the income from the related business entity was included on the shareholder/partner's individual return. If the income was reported and there are no other issues, the return should not be opened for examination. If the income from the related business entity was not reported on the return, the examiner should open the shareholder/partner's individual return for audit. For example, the business did not issue Form W-2, Wage and Tax Statement, to corporate officers. See IRM 4.10.5.4, Related Returns, for additional discussion.

(7) Independent of the potential underreported income from the business entity, the return should be opened for audit if the examiner notes that a financial status analysis based solely on the return indicates insufficient funds to support the identified expenses, or a large, unusual, or questionable item is identified.

(8) Examiners should determine whether the related return warrants examination from a classification perspective; i.e., trace the transactions between the individual and related business entity, complete a financial status analysis based on the return as filed and internal sources of information (Exhibit 4.10.4-2), and review the return for other potential issues.

(9) Should the related individual return be opened for audit, it is subject to the minimum income probes and examiners are expected to determine whether the taxpayer has reported the correct amount of taxable income. The depth of the examination of income and the techniques used are dependent on the facts and circumstances of the case.

(1) The initial interview should be held with the partnership's general partner, managing member if an LLC, Tax Matters Partner (TMP) if a TEFRA entity, or the corporate officer most familiar with the day-to-day operations of the business. From the taxpayer's perspective, an interview with an Internal Revenue examiner may be overwhelming. Therefore, initial interviews should be professional and not overbearing.

(2) Bartering income should be considered.

(3) IRC 7521(c) states that examiners cannot require a taxpayer to accompany an authorized representative to an examination interview in the absence of an administrative summons. However, the taxpayer’s voluntary presence can be requested through the representative. Should an examiner find that a representative has unreasonably delayed or hindered an examination, an examiner can bypass the representative and deal directly with the taxpayer. See Exhibit 4.10.4-5, Bypassing Powers of Attorney.

(4) Question the TMP, corporate officer, or representative concerning possible loans, gifts, or other nontaxable funds, known errors/omissions on the return, unreported sources of income and ask for any information necessary to resolve issues identified during the pre-audit analysis. If loan proceeds are identified, request the loan application documents to validate that financial reporting is consistent with the tax return. Discrepancies should be resolved with the taxpayer's assistance.

(5) Question the TMP, corporate officer, or representative about cash-on-hand and accumulated funds. See IRM 4.10.4.3.3.2, IRM 4.10.4.6.8.3, and see Exhibit 4.10.4-1 for additional discussion.

(6) Question the TMP, corporate officer, or representative about e-commerce activities. See Exhibit 4.10.4-7 for additional discussion.

(7) Question the TMP, corporate officer or representative about internal controls, including the segregation of duties, which can be verified during the audit. The flow of money should be established to determine any potential control weaknesses which could result in diversion of funds.

(8) Refer to IRM 4.10.3, Examination Techniques, and IRM 4.10.4.3.3.2 for additional interview questions. Although these questions are intended for individual business returns, they are equally applicable to other business entities.

(9) IRC 7521(b)(2) requires examiners to suspend interviews when taxpayers state that they wish to consult with a representative or otherwise seek advice. The taxpayer’s right of consultation will be strictly honored and interviews will be suspended and rescheduled accordingly. This provision does not apply to interviews initiated by administrative summons and will not be used to repeatedly delay or hinder the examination process.

(1) Conduct a tour of the physical business site controlled by the taxpayer. Generally, the physical business site will be the principal location and any other locations acquired during the period under examination should be visited, (see IRM 4.10.4.3.3.3). The purpose of a tour is to:

1. Gain familiarity with the taxpayer’s business operation and internal controls,

2. Identify potential sources of unreported income, and

3. Confirm the existence of assets.

(2) A tour of the physical business site is not required for office audit cases. However, if appropriate (and with manager's approval), a tour of the business site may be conducted.

(3) The results of a tour and any observations should be documented in the examination workpapers.

(4) Conduct a tour of the business websites controlled by the taxpayer. See IRM 4.10.4.3.7.2.

(1) Internal controls are the taxpayer's policies and procedures to identify, measure and safeguard business operations and avoid material misstatements of financial information. Evaluate the internal controls to gain an understanding of the taxpayer’s business operations and control features. See IRM 4.10.3.4, Evaluating the Taxpayer's Internal Controls. If the taxpayer maintains electronic books and records, refer to IRM 4.10.4.3.7.5.

(2) While there is no exhaustive definition of weak internal accounting controls, which will impact the scope of the examination of income, examples include:

1. Books and records that cannot be reconciled to the tax return

2. Transactions that are not properly authorized

3. Recorded transactions are not valid

4. Existing transactions are not recorded

5. Transactions are improperly valued

6. Transactions are improperly classified

7. Transaction are recorded at the improper time

8. Transactions are incorrectly summarized

9. Transactions all made by the same person or related parties

10. Recording and handling of assets by the same person or related parties

11. Income is diverted from the corporation or other business entity to a stockholder or other related entity

(3) If it is determined that the internal controls are weak, identify when and how income could be diverted.

1. Cash receipts could be skimmed if the sole shareholder makes all the deposits.

2. A large number of over-aged receivables or bad debts, where no debt collection agency is involved, may indicate that payments on account are being diverted by a shareholder.

3. Secondary sources of income (such as video arcade games or vending machines) that are not accounted for in the books and records are indicative of unreported income.

(4) Example: A taxpayer's business consists of small home repairs and construction projects. The taxpayer files a corporate tax return and is the 100% shareholder. The books and records tie to the corporation's income tax return and the invoices tie into the gross receipts shown on the return. The corporate return reflects a net profit of $5,000. The corporation did not pay the taxpayer a salary, but the taxpayer's spouse earned $30,000 in wages from an unrelated business (as reported on the shareholder's Form 1040 tax return). Although the cash flow analysis suggests sufficient funds to support the corporation's expenses, most of the gross receipts are cash and the internal controls are weak because the shareholder's spouse maintains the books.

1. The corporate and shareholder income tax returns are considered related because the returns are for entities over which the shareholder has control and which can be manipulated to divert funds or camouflage transactions. Therefore, the examination of the corporation cannot be completed without also examining the shareholder's individual return.

2. Once an audit of the related individual return is initiated, the examiner should request the personal bank records (statements, cancelled checks and deposit slips) for both spouses to determine if any corporate funds were diverted.

3. If, after reviewing these records, the examiner believes there is a reasonable indication that there is a likelihood of unreported income, a formal indirect method may be used to make the actual determination of tax liability.

(5) The workpapers will document:

1. The conclusions reached by the analysis of internal controls,

2. The impact on the scope of the examination, and

3. The impact on the depth of the examination of income.

(1) Analyze the information obtained in the initial interview, observed during the tour of the business site, and from the evaluation of the internal controls to gain a complete understanding of the taxpayer’s business operations and control features.

(2) Reconcile the bank records. The depth of bank record inspection will depend on the reliability of internal controls and the judgment of the examiner. See IRM 4.10.4.3.4.6, Evaluate Internal Controls, for complete discussion. In addition, consider the results of the analysis of the primary shareholders’ or partners’ individual returns. The initial IDR may include a request for the business bank records, including the statements, deposit slips and cancelled checks. See IRM 4.10.3.7, Bank Record Reconciliations.

(3) See IRM 4.10.3.9, Testing Gross Receipts or Sales, for a complete discussion and listing of audit techniques.

(4) See IRM 4.10.4.3.7.4, Identifying Gross Business Receipts from E-commerce Activities.

(1) The taxpayer's books and records can be used to evaluate the accuracy and reasonableness of the reported income through the use of ratios. A horizontal analysis, with documented conclusions, should be included in the case file for all business returns. A vertical analysis may not be appropriate for every case.

(2) Horizontal Analysis - This analysis identifies changes over time and may result in the identification of LUQ items not readily identified from a review of a single tax return. The tax return under audit should be compared to the prior and subsequent year returns. See IRM 4.10.4.3.3.8 for complete discussion and examples.

(3) Vertical Analysis - This analysis identifies differences between the taxpayer's business and industry standards for a given year and is an indicator of the reasonableness of gross business receipts and net profit reported on the tax return. A vertical analysis may not be appropriate for every case. Industry standards can be found at http://www.bizstats.com. See IRM 4.10.4.3.3.8 for complete discussion and examples.

(1) Refer to IRM 4.10.4.3.7.1 for additional information on e-commerce income issues.

(1) Examiners may find that one or more of the minimum income probes cannot be performed in a particular case or that no value is added by performing a specific minimum income probe. The decision to deviate from one or more of the minimum income probe requirements must be based on the specific facts of the case as they relate to the taxpayer.

(2) When the examiner determines a deviation from a minimum income probe is warranted, the reason(s) must be documented in the appropriate minimum income probe workpapers. The factors considered and rationale for deviating must be specifically documented. The documentation must clearly support the decision.

(1) Income probes for no show/no response cases may also include specific items or indirect methods to determine whether the taxpayer accurately reported income.

(1) When using the specific item method for adjustments based on unreported Information Return Program (IRP) income, if the taxpayer fails to respond or raise a "reasonable dispute" regarding the correctness of the IRP data, then the burden of proof remains with the taxpayer and does not shift to the government. In unreported income cases based on IRP information, there is no legal requirement pursuant to IRC 6201(d) to contact third parties to verify income items unless the taxpayer reasonably disputes the income and has fully cooperated with the Service.

(2) In no show/no response cases where the taxpayer has not responded or raised a frivolous dispute (wages are not income, etc.), there is no legal requirement for further verification with third parties and an income adjustment in the amount reflected on the IRP document is appropriate. Verification with third parties is required when IRP information is relied upon to support the civil fraud penalty (IRC 6663) or where the taxpayer disputes the IRP income information.

(3) Verification with third parties should also be made in no show/no response cases where there is an inconsistency noted in the file that would cause the examiner to question the validity of the IRP information.

(4) In cases involving large dollar income items (e.g., Form 1099-MISC amounts greater than $100,000), examiners, in consultation with their manager, should use their professional judgment in deciding whether it makes good business sense (given the circumstances) to verify IRP information. This discussion should be documented in the workpapers.

(1) If an indirect method is used, the use of statistical data must be tailored to the individual taxpayer.

(2) If an indirect method reveals an understatement of income in excess of $10,000 and the case is a no show, the examiner will take the following steps:

1. Examiners must use all available administrative tools, including summons enforcement, to gather necessary information before statistical data is used.

2. If a T-Account is used, do not reduce the expense side for disallowed expenses. Assume (even though disallowed) that the taxpayer spent the money.

3. Refer to IRM 4.10.4.6.1.3, Use of Bureau of Labor Statistics Data or Other Statistical Information to Reconstruct Taxable Income, to determine when income may be reconstructed using Bureau of Labor Statistics (BLS) data or comparable statistics from a reliable source. The analysis is completed using the tables for annual expenses, not income, because determining the expenses represents a better reflection of the actual costs to maintain a household.

4. The examiner and manager must determine if an income adjustment will be pursued based on the information contained in the indirect method, and if so, document it in the case file.

5. Prior and subsequent year’s returns should be considered for similar imbalances.

6. For TCO cases, discuss with the manager whether the case warrants transfer to the field. This would include any cases that are beyond the scope of an office audit for reasons such as the complexity of the issues or complexity of additional related businesses such as flow-through entities. See IRM 4.11.29, Transfer of Returns Open for Examination.

(1) In no show/no response cases the Service has no legal requirement to estimate expenses, including cost of goods sold. If the examiner has actual taxpayer information regarding expenses, then taxpayer specific information (not industry averages) should be used to determine expenses.

(2) If the sale of securities is an issue and in cases where the taxpayer has not substantiated stock basis, the Service has no legal requirement to obtain basis information from third party sources, despite the fact that the proceeds of stock sales are included in income.

(1) Penalties, such as negligence, will not be asserted solely due to the taxpayer’s failure to appear for an audit or respond to an inquiry or notice. However, the facts and circumstances from the return and the case file may warrant assertion of the accuracy-related penalty attributable to negligence.

(2) See IRM 20.1.5.7.1, Negligence, and IRM 20.1.5.8.2, Substantial Understatement, paragraph 5. The examiner should document actions and decisions using Form 9984, Examining Officer's Activity Record.

(1) Determining whether a taxpayer uses the Internet can be done during any phase of the examination. However, if it can be identified, the website should be reviewed during the pre-contact stage.

(2) Examination issues for e-businesses are published on MySB/SE Issues and Procedures Module. Select Electronic Business from the drop down menu for "Filter by Program Area." Internet activity provides techniques on finding websites, analyzing and saving websites, the tax treatment of domain names, and finding the owner of a website using "whois" tools. Online Sales provides sample document requests and interview questions with explanations. Interview questions should be tailored to the taxpayer and appropriate follow up questions asked. Items to consider:

1. Research the business name. The business name maybe included in an Internet domain name; i.e., "mycompany.com."

2. Research the taxpayer's name, business name, or phone number using a search engine such as Google®, Bing®, or Yahoo® to determine whether the taxpayer has web page listings. Be alert for multiple listings.

3. Look for deductions on the return that are common to e-commerce businesses, such as depreciation for networking equipment or high telecommunications expenditures, or payments to a Internet Service Provider (ISP) or an Application Service Provider (ASP).

4. Review business cards for website reference. Generally, business cards will include a website address, if one is available.

5. Review advertisement in the Yellow Pages which may include an Internet address.

(3) In every case, examiners should search for an Internet presence using a search engine such as Google. Examiners should also ask the taxpayer about Internet use. Effective web searching provides tips on using the advanced search features of popular search engines to narrow results. Internet use and e-commerce activities provide examples of appropriate open ended questions.

(1) If a website is discovered, viewing it can provide insight into the taxpayer's activities. Reviewing a taxpayer's website is a complement to touring the physical business site; e.g., to gather information helpful to understanding the business activities.

(2) To see how the website looked in the year under audit, search the Internet Archive at http://www.archive.org. The search feature is call the "Wayback Machine." The Examiner will be provided with a historical copy of all available archived copies of the website.

(3) Use http://www.linkpopularity.com to identify websites with hyperlinks that are linked to the taxpayer's website. Linkpopularity.com is a metasearch website that uses the reverse link feature to find websites that have hyperlinks pointing to a website.

(4) Evidence of an unreported e-business activity can be found by reconciling credit card payments, as a taxpayer may consolidate all credit card or payment vouchers when submitting them to the e-payment provider.

(5) When reviewing a website, consider the following questions:

1. What purpose does the website serve? Some websites are used as advertisement or for information sharing with no elements of e-commerce.

2. Is there a unique term that the taxpayer uses to advertise the site? If so, an Internet search may identify additional websites or business operations.

3. Does the website provide information about the business? Often, there will be an "About Us" page with information about officers, owners and key employees.

4. Does it provide information on how to contact the business?

5. Does the business gather information about its customers on the website? Would a customer need a password to sign in?

6. Are goods and/or services sold on the website?

7. Can purchases be processed through the website?

8. What methods of payments are accepted?

9. Does the website include links to other websites controlled by the taxpayer? Links, banners, and pop-up windows may provide information about additional income from advertisements, reciprocal links to generate traffic, marketing partners, and related websites.

10. Does the website disclose information about business partners? For example, a wholesaler in the furniture industry may furnish a list of retailers selling their product.

11. Is the website available in multiple languages? If so, this would indicate global markets.

(6) Further inquiry will be needed to determine how the website is supported; i.e., whether the website is hosted by a third party or maintained on the taxpayer's own web servers, the location of the web servers, what equipment or computers are used, who has access to the servers, what records are maintained, and when the website was placed in service.

(7) To document the case file, save the website or make hard copies of the website pages. Documenting the website content before the taxpayer limits access may be important to the development of, or providing evidence for, an unreported income issue.

(1) The taxpayer should be interviewed regarding Internet use for e-commerce activities. For individual business returns, the taxpayer should be asked about both personal and business use. Payments made over the Internet need to be considered as part of the minimum income probes.

(2) Exhibit 4.10.4-7 is a list of interview questions specific to Internet and website use.

(1) This section provides an overview of common sources of taxable income generated by e-commerce activities and associated audit techniques.

(1) The Uniform Electronic Transaction Act (UETA) defines electronic records as a record created, generated, sent, communicated, received, or stored by electronic means. The UETA is suggested legislation that the National Conference of Commissioners on Uniform State Laws, in 1999, drafted and recommended be adopted by all states. More information about the UETA can be found at http://www.uniformlaws.org/Act.aspx?title=Electronic Transactions Act.

(2) Rev. Rul. 71-20, 1971 -1 C.B. 392, establishes that all machine-sensible data media used for recording, consolidating, and summarizing accounting transactions and records within a taxpayer's Automatic Data processing (ADP) system are records within the meaning of IRC 6001 and Treas. Reg. 1.6001-1, and are required to be retained so long as the contents may become material in the administration of any internal revenue law.

(3) Rev. Proc. 98-25, 1998-1 C.B. 689, specifies the basic requirements that the Service considers essential when a taxpayer maintains records within an ADP.

(4) Rev. Proc. 98-25 provides an exemption for small business taxpayers with assets of less than $10 million at the end of its taxable year in complying with the record retention requirements of Rev. Rul. 71-20 and Rev. Proc. 98-25. For purposes of meeting that exemption, a controlled group of corporations (as defined in IRC 1563) is considered to be one corporation and all assets of all members of the group are aggregated. Also, a small business taxpayer will not meet the exemption provided in Rev. Proc. 98-25 if any of the following three conditions exist:

1. All or part of the information required by IRC 6001 is not in the taxpayer's hardcopy books and records, but is available in machine-sensible records;

2. Machine -sensible records were used for computations that cannot be reasonably verified or recomputed without using a computer (e.g., Last In, First-Out (LIFO) inventories); or

3. The taxpayer is notified by the Service that machine-sensible records must be retained to meet the requirements of IRC 6001.

(5) An "ADP System" consists of an accounting and/or financial system (and subsystems) that processes all or part of a taxpayer's transactions, records, or data by other than manual methods. It includes, but is not limited to, a mainframe computer, stand-alone or networked microcomputer system, Data Base Management System (DBMS), and a system that uses or incorporates Electronic Data Interchange (EDI) technology or an electronic storage system. Key requirements include:

1. Machine-sensible records (data in an electronic format intended for use by a computer) must be retained as long as the contents may become material to the administration of the internal revenue laws. The taxpayer may enter a record retention limitation agreement with the Service to provide for the establishment and maintenance of records as agreed upon by the Service and the taxpayer.

2. Machine-sensible records must provide sufficient information to support and verify entries made on the taxpayer's return and to determine the correct tax liability; i.e., the machine-sensible records must reconcile with the taxpayer's books and the taxpayer's return, and provide an audit trail to transaction-level details in the books of original entry.

3. Machine-sensible records must contain sufficient transaction-level detail so that the information and the source documents underlying the machine-sensible records can be identified.

4. All machine-sensible records required to be maintained must be made available to the Service upon request and must be capable of being retrieved, manipulated, printed on paper, and produced as output on electronic media.

5. A taxpayer is not required to create any machine-sensible record other than that created either in the ordinary course of business or to establish tax return entries.

6. A taxpayer that used EDI technology must retain machine-sensible records that alone, or in combination with any other records, contain all the information required of hardcopy books and records. The required detail may by captured at any level within the accounting system. However, the taxpayer must establish audit trails between the retained records and books, and between the retained records and the tax return.

7. Taxpayers continue to be responsible for retaining hardcopy records that are created or received in the ordinary course of business. Alternatively, such records can be retained in microfiche/microfilm format (see Rev. Proc. 81-46, 1981-2 C.B. 621) or in an electronic storage system (see Rev. Proc. 97-22, 1997-1 C.B. 652).

8. The taxpayer must provide the Service (at the time of examination) with the resources (e.g., appropriate hardware and software, terminal access, computer time, personnel, etc.) necessary to process machine-sensible books and records.

9. The taxpayer must maintain and provide (upon request) documentation of the processes that create, modify, and maintain its records. The documentation must support and verify entries made on the taxpayer's return and determine the correct tax liability, and evidence the authenticity and integrity of the taxpayer's records. Documentation includes records of internal controls that reflect: (1) the functions being performed as they relate to the flow of data through the system; (2) the internal controls used to ensure accurate and reliable processing; (3) the internal controls used to prevent the unauthorized addition, alteration, or deletion of retained records; and (4) the charts of accounts and detailed account descriptions.

(6) Understanding the reliability of electronic books and records is critical to evaluating internal controls, reconciling the books and records to the tax return, and obtaining records. The following attributes of electronic records need to be considered when evaluating the reliability of electronic books and records:

1. Software may include features to create a second set of books and records, or allow for manipulation of sales by reducing and/or deleting of sales transactions entirely.

2. Third party software programs, commonly referred to as "zapper" programs, can be used to selectively delete electronically recorded sales records. Methods or practices of deleting electronic sales records, usually cash sales are referred to as "zapping."

3. Electronic records are, in general, considered less reliable than their paper counterparts due to the ease with which they can be manipulated.

(7) Rev. Proc. 97-22, 1997-1 C.B. 652, provides guidance to taxpayers that maintain books and records by using an electronic storage system that either images their hardcopy (paper) books and records or transfers their computerized books and records to an electronic storage media, such as an optical disk, which allows books and records to be viewed or reproduced without the use of the original program. Key requirements include

1. Reasonable controls to ensure the integrity, accuracy, and reliability of the electronic storage system;

2. Reasonable controls to prevent and detect the unauthorized creation of, addition to, alteration of, deletion of, or deterioration of electronically stored books and records;

3. An inspection and quality assurance program evidenced by regular evaluations of the electronic storage system including periodic checks of electronically stored books and records;

4. A retrieval system that includes an indexing system;

5. The ability to reproduce legible and readable hard copies of electronically stored books and records or when displayed on a video display terminal;

6. The information in an electronic storage system must provide support for the taxpayer's books and records; and

7. The taxpayer must maintain and make available to the Service upon request, a complete description of the electronic storage system, including all procedures relating to its use and the indexing system, and provide the Service with the resources (e.g., appropriate hardware and software) necessary to locate, retrieve, read, and reproduce (including hard copies) of any electronically stored books and records.

(8) A taxpayer is not in compliance with the recordkeeping requirements under IRC 6001 (and associated regulations) if the taxpayer's electronic storage system fails to meet the requirements of Rev. Proc. 97-22, and a Notice of Inadequate Records pursuant to Treas. Reg. 1.6001-1(d) should be issued. See IRM 4.10.8.16, Inadequate Records Notices: Overview, for complete discussion of Notices of Inadequate Records.

(1) Banks and other financial institutions that previously maintained account information such as signature cards, loan applications, and account activity in hard copy may now do so electronically. There are online banks that only do business on the Internet. Taxpayers can maintain accounts with banks across the country or even overseas, rather than with banks in close proximity to the their physical location.

(2) The Internet has resulted in new third party record keepers whose information may be of help in resolving tax issues. These new third party record keepers may be able to supply information regarding website ownership, related websites owned by the taxpayer, location of the business, contact information, and the taxpayer's bank accounts. Examples include:

1. Internet Domain Name Registrars

2. Internet Hosting Providers

3. Internet Access Provides (IAP)

4. Internet Service Providers (ISP)

5. Application Service Providers (ASP)

6. E-Payment Providers, e.g., PayPal

(1) Formal indirect methods and the techniques used to support their development are collectively known as "financial status audit techniques" and trigger IRC 7602(e), which states that "the Secretary shall not use financial status or economic reality examination techniques to determine the existence of unreported income of any taxpayer unless the Secretary has a reasonable indication that there is a likelihood of such unreported income."

(2) "Financial Status Audit Technique" was defined as the use of formal indirect methods in the Government Accounting Offices's report, "More Criteria Needed on IRS' Use of Financial Status Audit Techniques," GAO/GGD-98-38.

(1) "Examination techniques" include examining and testing the taxpayer's books and records, analytical tests, observing, and interviewing the taxpayer. None of these techniques are unique to the use of a formal indirect method and do not trigger the limitation of IRC 7602(e).

(2) Examiners should adjust PLE based on information received during the interview and update the T-Account during the audit process. In developing the PLE for the T-Account, examiners should only use the PLE information that was made available through the minimum income probes.

(3) Obtaining PLE information beyond the minimum income probes will likely trigger the limitation of IRC 7602(e). If there are indications of unreported income and you need to go beyond the minimum income probes, use a Financial Status Audit Technique and document your files with the reasons to support your use of the indirect method.

(4) Form 4822, Statement of Annual Estimated Personal and Family Expenses, may be used as a guide by the examiner for determining the taxpayer's personal living expenses. The form lists the typical expenses incurred by most individuals. It is inappropriate to ask the taxpayer to complete the form independently.

(5) Care should be taken to avoid duplicating amounts when modifying estimates for actual costs.

(1) In certain cases, as described below, income may be reconstructed using Bureau of Labor Statistics (BLS) data or comparable statistics from a reliable source. The analysis is completed using the tables for annual expenses, not income, because determining the expenses represents a better reflection of the actual costs to maintain a household.

(2) The BLS data can be accessed at www.bls.gov, select "Inflation and Consumer Spending." Tables specific to year, region within the United States, and individual expenses are available.

(3) Statistical data cannot be used as a substitute for reconciling the taxpayer's books and records. If the taxpayer provides information, or information becomes available, which shows that income in a specific amount was earned, statistical data cannot be used to increase income to the national average.

(4) In court proceedings involving individuals, IRC 7491(b) may shift the burden of proof. IRC 7491(b) provides that the Service will have the burden of proof for any item of income where income is reconstructed using only BLS data or other comparable statistical information on unrelated taxpayers.

(1) The use of a formal indirect method to make the actual determination of tax liability should be considered when the factual development of the case leads the examiner to the conclusion that the taxpayer's tax return and supporting books and records do not accurately reflect the total taxable income received and the examiner has established a reasonable likelihood of unreported income.

(2) The following list, which is not intended to be all inclusive, identifies circumstances that, individually or in combination, would support the use of a formal indirect method.

1. A financial status analysis that cannot be balanced; i.e., the taxpayer's known business and personal expenses exceed the reported income per the return and nontaxable sources of funds have not been identified to explain the difference.

2. Irregularities in the taxpayer's books and weak internal controls.

3. Gross profit percentages change significantly from one year to another, or are unusually high or low for that market segment or industry.

4. The taxpayer's bank accounts have unexplained items of deposit.

5. The taxpayer does not make regular deposits of income, but uses cash instead.

6. A review of the taxpayer's prior and subsequent year returns show a significant increase in net worth not supported by reported income.

7. There are no books and records. Examiners should determine whether books and/or records ever existed, and whether books and records exist for the prior or subsequent years. If books and records have been destroyed, determine who destroyed them, why, and when.

8. No method of accounting has been regularly used by the taxpayer or the method used does not clearly reflect income. See IRC 446(b).

(1) The selection of a formal indirect method is critical to effectively and efficiently determine the tax liability. For example, although the Bank Deposits and Cash Expenditures Method and the Source and Application of Funds Method are frequently used, they are not the most effective methods if cash is not deposited and/or the cash outlays cannot be determined unless voluntarily disclosed by the taxpayer. Realistically, it may be difficult to identify significant personal acquisitions or expenditure that the taxpayer has deliberately camouflaged. These weaknesses can be overcome by using a formal indirect method based on the taxpayer's business activities to make the actual determination of tax liability; i.e., the Markup Method or Unit and Volume Method.

(2) The following factors should be considered when selecting a formal indirect method:

1. The industry or market segment in which the taxpayer operates,

2. Inventories are a principle income producing activity,

3. Suppliers can be identified and/or merchandise is purchased from a limited number of suppliers,

4. Merchandise and/or service pricing is reasonably consistent,

5. The volume of production and variety of products,

6. Availability and completeness of the taxpayer's books and records,

7. The taxpayer's banking practices,

8. The taxpayer's use of cash to pay expenses,

9. Expenditures exceed income,

10. Stability of assets and liabilities, and

11. Stability of net worth over multiple years under audit.

(1) The reasons why the examination of income was expanded to include the use of a formal indirect method to make the actual determination of tax liability should be documented in the workpapers, as well as why a specific method was selected. Notations on the lead sheet is not sufficient. The documentation should include a narrative explaining how the evidence in the file establishes the likelihood of unreported income, and justifying the use of a formal indirect method. The documentation should include:

1. A summary of the facts relevant to the decision,

2. Procedures and audit techniques used up to that point,

3. Manager's comments (if appropriate),

4. Any other information relevant to the decision, and

5. Conclusions.

(2) Document likely sources of taxable income. It is not essential to pinpoint the specific source, but only to indicate the possibility of, or the opportunity for, likely sources of taxable income. To the extent that the possible source(s) can be identified, the more credible the results of a formal indirect method will be. Possible sources can be demonstrated by:

1. Specific omissions,

2. Demonstrating that the taxpayer's business had the capacity to generate more gross receipts, or

3. Comparisons over time.

(3) The documentation should be prepared concurrent to the decision; i.e., before using a formal indirect method to make the actual determination of tax liability.

(1) Group manager approval is not required when initiating the use of a formal indirect method, except for the Net Worth Method (see IRM 4.10.4.6.7.2 (2)).

(1) The use of the Source and Application of Funds Method of proof in establishing unreported income received the Supreme Court’s approval in United States v. Johnson, 319 U.S. 503 (1943). In addition to proving the taxpayer owned gambling establishments whose winnings were unreported, it was proven that in three of the years involved, the taxpayer’s personal expenditures exceeded his current income plus his declared accumulated funds.

(1) This method is based on the theory that any excess expense items (applications) over income items (sources) represent an understatement of taxable income.

(2) The Source and Application of Funds Method is recommended in the following situations:

1. The review of a taxpayer’s return indicates that the taxpayer’s deductions and other expenditures appear out of proportion to the income reported.

2. The taxpayer’s cash does not all flow from a bank account which can be analyzed to determine its source and subsequent disposition.

3. The taxpayer makes it a common business practice to use cash receipts to pay business expenses.

(1) Sources of funds are the various ways the taxpayer acquires money during the year. Decreases in assets and increases in liabilities generate funds. Funds also come from taxable and nontaxable sources of income. Unreported sources of income even though known, are not listed in this computation since the purpose is to determine the amount of any unreported income. Specific items of income are denoted separately. Examples of sources of funds include:

1. Decrease in cash-on-hand, in bank account balances (including personal and business checking and savings accounts), and decreases in accounts receivable,

2. Increases in accounts payable,

3. Increases in loan principals and credit card balances,

4. Taxable and nontaxable income, and

5. Deductions which do not require funds such as depreciation, carryovers and carrybacks, and adjusted basis of assets sold.

(2) Application of funds are ways the taxpayer used (or expended) money during the year. Examples of applications of funds include:

1. Increases in cash-on-hand, increase in bank account balances (including personal and business checking and savings accounts), business equipment purchased, real estate purchased, and personal assets acquired,

2. Purchases, business expenses,

3. Decreases in loan principals and credit card balances, and

4. Personal living expenses.

Determining the beginning amount of cash-on-hand and accumulated fund for the year is important. See IRM 4.10.4.6.8.3 below for possible defenses the taxpayer might raise regarding the availability of nontaxable funds.

(3) See Exhibit 4.10.4-10 for an example.

(1) Since the results of this method are on a cash basis, adjustments must be made for an accrual basis taxpayer. Accounts receivable at the beginning of the period examined are shown on the debit side, as they are presumed to be collected during the period. Ending accounts receivables are a credit adjustment, required to effect a non-cash increase in income.

(2) Accounts payable are shown as adjustments in the reverse order of accounts receivables. Beginning accounts payable are a credit adjustment having the result of increasing income and transferring a current period cash expenditure to the prior period in which it was incurred and deductible under the accrual method. Conversely, ending accounts payable balances are a debit adjustment having the effect of reducing income to result in a non-cash reduction of income.

(3) See Exhibit 4.10.4-10.

(1) The classic bank deposits case is Gleckman v. United States, 80 F.2d 394 (8th Cir. 1935). The court held that standing alone bank deposits and large items of receipts do not prove additional tax due. On the other hand, if it is shown that these amounts can be associated with a business or income-producing activity, then the income is taxable. Since the Gleckman case, the Bank Deposits Method has received consistent judicial approval.

(2) The Gleckman case, and the cases that followed, taught that in order to use the Bank Deposits and Cash Expenditures Method in determining income, it must be shown that:

1. The taxpayer was engaged in a business or income-producing activity,

2. The taxpayer made periodic deposits of funds into a bank account or accounts,

3. An adequate investigation of deposits was made by the examiner in order to negate or eliminate the likelihood that the deposits arose from nontaxable sources of income, and

4. Unidentified bank deposits have the inherent appearance of income; i.e., the size of the deposits, odd or even amounts, source of checks deposited, dates of deposits, etc.

(1) The Bank Deposits and Cash Expenditures Method should not be the automatic choice when selecting a formal indirect method. For example, cash intensive businesses, where significant amounts of gross receipts are not deposited and numerous cash outlays occur, do not lend themselves to this method.

(2) If the Bank Deposits and Cash Expenditures Method is the method of choice, the entire analysis must be completed; shortened versions that do not account for business and personal cash expenditures are insufficient.

(3) The Bank Deposits and Cash Expenditures Method is recommended when:

1. The taxpayer’s books and records are unreliable, unavailable, withheld, or incomplete.

2. The taxpayer makes periodic deposits of funds into bank account(s) which appear to be generated from an income-producing activity.

3. The taxpayer pays most business expenses by check.

4. The taxpayer previously used bank account deposits to determine and report taxable income.

(4) The advantages of the Bank Deposits and Cash Expenditures Method include:

1. Provides a complete picture of the taxpayer's activities; it clearly reflects the size and scope of the taxpayer's financial activities.

2. Avoids necessity of documenting business expenses, with the exception of technical adjustments such as depreciation.

3. When the taxpayer overstates business expenses, the overstatement is automatically accounted for in the mechanics of the computation. It is not necessary to audit expenses claimed on the tax return.

(1) Total deposits include amounts deposited from both taxable and nontaxable sources to all bank accounts (both business and personal) maintained or controlled by the taxpayer, as well as deposits made to accounts in savings and loan companies, investment trusts, brokerage houses, credit unions, and other financial institutions.

(1) Gross receipts represents the total or gross taxable receipts of the taxpayer during the year from all sources, not reduced by returned sales and allowances, cost of goods sold, basis, or expenses. gross receipts, or gross business receipts, can be determined by computing the sum of the three items listed below and deducting nontaxable and/or nonbusiness receipts, duplicated deposits, etc.

1. Funds received by a taxpayer during the year, which were deposited in financial institutions, such as banks, savings and loan associations, investment accounts, etc.

2. Funds expended that were not deposited.

3. Funds accumulated and not deposited.

(2) Gross receipts includes, but is not limited to the following:

1. Gross sales of a trade or business

2. Gross fees and commissions

3. Gross wages, salaries, tips, and gratuities

4. Gross dividends, interest, rents, royalties, pensions, and annuities

5. Gross income from estates, trusts, and partnerships

6. Gross proceeds from the sale of assets

7. Gross farm income

(3) Gross receipts does not include nontaxable income, such as, but not limited to, gifts, inheritances, loan proceeds, transfers between accounts, checks to cash redeposited, tax exempt interest, insurance proceeds, and federal tax refunds.

(1) Are there any unusual or extraneous deposits which appear unlikely to have resulted from reported sources of income?

1. Size of Deposit — Due to the need for expediency, the examiner may limit the examination to large deposits or deposits over a certain amount. However, the identification of smaller regular deposits may be indicative of dividend income, interest, rent, or other income, leading to a source of investment income.

2. Kind of Deposit — An item of deposit may be unusual due to the kind of deposit, check or cash, in its relationship to the taxpayer’s business or source of income. An explanation may be required if a large cash deposit is made by a taxpayer whose deposits normally consist of checks. Also, a bank statement noting only one or two large even dollar deposits, in lieu of the normal odd dollar and cents deposits, would be unusual and require an explanation.

3. Pattern and Frequency of Deposits — Many taxpayers, due to the nature of their business or the convenience of the depository used, will follow a set pattern in making deposits. Deviation from this pattern may bear questioning.

4. Frequency of Deposits — Bank statements or deposit slips which indicate repeat deposits of the same amount on a monthly basis, quarterly or semi-annual basis may indicate rental, dividend, interest or other income accruing to the taxpayer.

5. Location of Bank On Which the Check Was Drawn — The examination of deposit slips may indicate items of deposit which appear questionable due to the location of the bank on which the deposited check was drawn. It is common practice when preparing a deposit slip to list either the name of the bank, city of the bank or identification number of the bank upon which the deposited check was drawn. If an identification number is used, the name and location of the bank can be determined by reference to the banker’s guide. In all cases, if the location of the bank on which the check for deposit was drawn bears little relation to the taxpayer’s business location or source of income, it may indicate the need for further investigation.

(2) Are there any loan proceeds, collection of loans, or extraneous items reflected in deposits? In the analysis of bank deposits, the examiner should identify all items of this nature. This is a necessary step before comparing receipts to deposits.

1. If loan proceeds are identified, request the loan application documents to verify the source and amount of the nontaxable funds. Review the loan application information for consistency with other information; i.e., cash flows, assets, anticipated gross receipts, etc. Discrepancies should be resolved with the taxpayer's assistance.

2. If repayments of loans are identified, request the debt instruments to establish that a loan was made, the terms of the debt, and the repayment schedule. Ask the taxpayer to document the flow of funds to the borrower (e.g., a cancelled check) and to explain where the money came from (e.g., Accumulated Funds). Ask how much money has been collected to date and whether the taxpayer reported interest earned. Contact the party receiving the loan and ask for a notarized statement outlining the terms of the loan, when it was received, and the amount of money repaid.

(3) Are there transfers between bank accounts or redeposits?

1. Before an examiner can reach any conclusion about the relationship between deposits and reported receipts, transfers and redeposits must be eliminated.

2. For example, if a taxpayer draws a check to cash for the purpose of cashing payroll checks and then redeposits these payroll checks, the examiner would be incorrect if total deposits were compared to receipts reported without adjusting for this amount. The taxpayer has done nothing more than redeposit the same funds in the form of someone else’s checks.

(4) Are there personal or nonbusiness bank accounts?

1. Unreported income may be found in personal accounts. If the analysis is limited to an inspection of the business bank accounts only, omitted taxable income in personal accounts may not be discovered.

2. The examiner should ascertain whether the deposits, as reflected in these accounts, can be accounted for by withdrawals or transfers from business accounts or from other known sources of funds.

3. The examiner should not overlook the possibility of more than one personal or business bank account.

(5) Are the deposits in personal and business accounts, as adjusted, during short periods of time, accounted for by the records?

1. It is not unusual to find that total deposits will reconcile on a yearly basis with the total receipts for the year reported on the tax return.

2. A closer examination of deposits on a weekly or monthly basis may indicate that these deposits do not reconcile with the receipts reported during the same periods.

3. Reported receipts may not be deposited in the closing months of the year to balance out the excess of deposits and the understatement of receipts in the earlier months.

(1) The Bank Deposits and Cash Expenditures Method is used to determine gross receipts from all sources; i.e., it is not limited to consideration of business receipts and it is not necessary to audit or verify expenses deducted on the return. The basic formula for computing the understatement of taxable income is outlined here. An example is shown in Exhibit 4.10.4-9, The Bank Deposits and Cash Expenditures Method. Also, see the example of computation of gross receipts below:

(1) The Bank Deposits and Cash Expenditures Method does not account for non-cash expenses claimed on the tax return that do not represent a current outlay of funds. Examples include depreciation, depletion, bad debts, and inventory. Therefore, these expenses should be separately considered and specific item adjustments made if necessary. For example, if the bank deposit computation revealed an adjustment of $5,000 and depreciation claimed was found to be overstated in the amount of $1,000, there would be two adjustments:

1. Unreported income in the amount of $5,000

2. Adjustment to depreciation in the amount of $1,000

(1) In United States v. Fior D'Italia, Inc., 536 U.S. 238 (2002), the majority held that IRC 446(b) does not limit authority to use aggregate estimation of income taxes (unreported tip income).

(2) In Barragan v. Commissioner, T.C.M. 1993-92, the Service properly determined gross receipts from a gas station based on the supplier's delivery records and the retail prices per an independent market survey. Similarly, in Stafford v. Commissioner, T.C.M. 1992-637, the Service properly determined gross receipts from gas stations based on Bureau of Labor Statistics data.

(3) In Nichols v. Commissioner, T.C.M. 1983-242, the Service was upheld in applying an established tip rate to the taxpayer's gross receipts to determine unreported tip income.

(4) In Webb v. Commissioner, 394 F.2d 366, 371-372 (5th Cir. 1966), aff'g T.C.M. 1966-81, the government determined Webb's income from liquor sales using the Markup Method.

(5) It was held in the Estate of Bernstein v. Commissioner, T.C.M. 1956-260, that the inability to use other "formal" indirect methods is not prerequisite for using a percentage method.

(6) In the case of Yorkville Live Poultry Co. v. Commissioner, 18 BTA 47 (1929), the Board of Tax Appeals approved a net income computation based upon four percent of the net sales where no books were available.

(1) The Markup Method is recommended in the following situations:

1. When inventories are a principal income producing factor and the taxpayer has nonexistent or unreliable records.

2. Where a taxpayer’s cost of goods sold or merchandise purchased is from a limited number of sources, these sources can be ascertained with reasonable certainty, and there is a reasonable degree of consistency as to sales prices.

(2) This method is effective for industries such as liquor stores, taverns, gasoline retailers, restaurants, and jewelry stores.

(3) Examiners should address the following issues when applying the Markup Method:

1. Use the taxpayer's own records and oral testimony to establish the markup percentages based on known costs and sales prices. This should be the best source of information. Plausible explanations for why the taxpayer's markup percentages differ from national averages should be accepted.

2. If it appears that the cost of goods sold and/or purchases are also understated, issue a summons to the taxpayer's suppliers for sales records.

3. Judgment should be exercised by examiners when using industry standards or surveys to make sure the comparisons are valid and are for similar situations. Consider the availability of valid sources of information containing the necessary percentages and ratios. Adjust percentages and ratios to reflect those during the time of the return under audit. IRC 7491(b) places the burden of proof on the Service with respect to any item of income that was reconstructed solely through the use of statistical information on unrelated taxpayers.

(1) The gross profit to sales ratio indicates the average markup on products. The calculation divides the gross profit margin (sales less cost of goods sold) by total sales:

(2) Example: A taxpayer sells two products, A and B, and reports $140,000 in gross sales. The costs for product A are $50,000 and the costs for product B are $80,000. The costs are verified with the third party supplier and adjusted for opening and closing inventory.

(1) Using the cost of sales to gross receipts ratio is a variation of the gross profit margin to sales ratio. It also is a comparison of costs to sales.

(1) In Salami v. Commissioner, T.C.M. 1997-347, the court held that a cab driver's gross income could be determined using claimed gas expenses, price per gallon, miles per gallon, occupancy rates, etc. Same for the cab driver in Irby v. Commissioner, T.C.M. 1981-399.

(2) In Maltese v. Commissioner, T.C.M. 1988-322, the Service was upheld in determining gross income by determining the number of pizza crusts per 100 pounds of flour times the average price per pizza.

(3) In Stanoch v. Commissioner, T.C.M. 1959-132, the Service established gross receipts for a tavern by allowing a specific measurement of liquor per drink and a percentage for spillage.

(1) The Unit and Volume Method is recommended for making the actual determination of tax liability when:

1. The examiner can determine the number of units handled by the taxpayer and also know the price charged per unit.

2. The business has only a few types of products which are sold or there is little variation in the types of services performed, and the charges made by the taxpayer (sales price) for merchandise or services are relatively the same throughout the tax period.

(1) Examiners should be aware of the following when considering the Unit and Volume Method:

1. Is there a common denominator for the business that drives gross receipts?

2. Can the number of units handled or consumed by the taxpayer be ascertained?

3. Is the price per unit or profit per unit obtainable?

4. Is there a third party from whom the taxpayer's consumption, units of production, or sales are available?

(1) This example is for a coin operated laundry, where the known unit is the amount of water needed for each unit of sale (load of laundry). Per the utility bills, the taxpayer consumed 3,000,000 gallons of water.

(2) The price per dryer load is $1.50. Based on observations on different days of the week, the examiner determines that customers' use of dryers is 75% of their wash loads. The price per dryer load is $1.50. Therefore, the gross receipts for dryer use is .75(109,259) x $1.50 = $122,916.

(3) Summarize the gross receipts for all the services and compare to the gross receipts reported on the tax return.

(1) The Net Worth Method is a very old method of determining income. See United States v. Frost, 25 F.Cas. 1221 (N.D. Ill. 1869). The first criminal case involving the Net Worth Method was United States v. Beard, 222 F.2d 84 (4th Cir. 1955), which involved delinquent returns.

(2) The use of the Net Worth Method of proof has been approved by the Supreme Court in: Holland v. United States, 348 U.S. 121 (1954). Holland set forth the following requirements that the government must meet when using the Net Worth Method:

1. Establish an opening net worth, also known as the base year, with reasonable certainty.

2. Negate reasonable explanations by the taxpayer inconsistent with guilt; i.e., reasons for the increased net worth other than the receipt of taxable funds. Failure to address the taxpayer's explanations might result in serious injustice.

3. Establish that the net worth increases are attributable to currently taxable income.

4. Where there are no books and records, willfulness may be inferred from that fact coupled with proof of an understatement of taxable income. But where the books and records appear correct on their face, an inference of willfulness from net worth increases alone might not be justified.

5. The government must prove every element beyond a reasonable doubt, though not to a mathematical certainty.

(1) The Net Worth Method is generally recommended in the following situations:

1. Two or more years are under examination.

2. Numerous changes to assets and liabilities are made during the period.

3. No books and records are maintained.

4. The books and records are inadequate or not available.

5. The books and records are withheld by the taxpayer.

(2) The Net Worth Method should be used only if:

1. The group manager concurs that the Net Worth Method is the more appropriate method and should be used, or

2. Criminal Investigation has requested that the Net Worth Method be used.

(3) The fact that the taxpayer’s books and records accurately reflect the figures on a return does not prevent the use of the Net Worth Method of proof. The government can still look beyond the "self-serving declarations" in a taxpayer’s books and records and use any evidence available to determine whether the books accurately reflect the taxpayer's financial history.

(4) While the Net Worth Method was originally used against taxpayers whose principal source of income was from an illegal activity, it is now regularly recommended in fraud cases, especially where significant changes in net worth have occurred and other methods of proof are insufficient.

(5) In addition to being used as a primary means of proving taxable income so that an actual determination of tax liability can be made, the Net Worth Method is relied upon to corroborate other methods of proof and test the accuracy of reported taxable income.

(1) The formula for computing income using the Net Worth Method is as follows:

(2) A complete discussion of the computation for the Net Worth Method and associated audit techniques is included in IRM 9.5.9.5.4 through IRM 9.5.9.5.9.

(1) An example of the Net Worth Method can be found at Exhibit 9.5.9-1, Net Worth Statement.

(1) Bank Deposits and Cash Expenditures Method — Most challenges to the accuracy of this method focus on the nature of the individual deposits in the account(s). The taxpayer may claim that the deposits consist of taxable and nontaxable items that were not correctly classified by the examiner. Deposits of loan proceeds, gifts and inheritances, as well as transfers from other accounts are some of the most common claims. Redeposits of items, such as insufficient funds checks, may also cause inaccuracy if counted twice. The examiner should carefully review the analysis and attempt to identify the source and character of each deposit before presenting results as an understatement of taxable income.

(2) Source and Application of Funds Method — Challenges are made to the adjustments for the accrual method of accounting and the handling of loan transactions; i.e., loan payments are an application of funds. Also, the taxpayer may claim that purchases, labor costs, materials and supplies, and other current period costs associated with inventory are an application of funds rather than the cost of goods sold.

(3) Markup Method — The main challenges to this method are to show that the computation relies upon improper percentages, improper cost of sales, or that the examiner’s computation fails to give adequate consideration to significant items such as spillage, breakage, or theft losses. These issues should be addressed and quantified during the initial interview. Since the method relies on a comparison of a situation similar to that under examination, defenses could be formulated based on dissimilarities in several areas such as type of merchandise handled, size of the operation, locality, time period covered, or general merchandising policy.

(1) The taxpayer may attempt to refute the findings of the examiner’s formal indirect method by claiming the unexplained difference is actually caused by the receipt of nontaxable sources of funds.

(2) If it can be shown that all nontaxable sources of income have been considered, then it can be concluded that the only likely source remaining is a taxable one. Examiners need to show that increases in taxable income arose from a likely taxable source. This can be demonstrated by specific omissions, showing the taxpayer’s business had the capacity to generate more sales, or comparisons over time. To the extent that the possible source can be identified, the more acceptable the computation will be.

(1) The taxpayer may attempt to refute the findings of the examiner’s formal indirect method by claiming the unexplained difference is actually caused by the use of nontaxable funds accumulated in prior years.

(2) Since cash-on-hand and accumulated funds are important fundamental aspects of the examination of income and the formal indirect methods, examiners should establish the amount and verify the taxpayer’s statements of cash accumulations during the initial interview. This is necessary because:

1. Cash-on-hand and accumulated funds can explain potentially significant imbalance in the Financial Status Analysis. The issue can be resolved quickly and with the least amount of burden to the taxpayer if it is addressed early in the examination.

2. The information is needed to determine whether a formal indirect method should be used, and which method is most appropriate.

3. An adjustment for unreported income can be challenged if the availability of cash-on-hand and accumulated funds is not addressed at the beginning of the audit. The after-the-fact "cash in the mattress" defense cannot be used if the actual cash-on-hand and accumulated funds have already been established.

(3) In order to avoid any misunderstanding by the taxpayer, it is important that the meaning of cash-on-hand and accumulated funds be explained prior to answering any inquiry. Taxpayers must understand the term cash-on-hand means any undeposited currency and coins used for normal business transactions. Accumulated funds refers to cash accumulated by the taxpayer and is not associated with normal business practices and/or transactions with customers. The funds may have been taxed in prior years, originate from nontaxable sources, or may represent taxable income in the year under audit. Once the terms are understood, the examiner should inquire as to the existence of any cash-on-hand and accumulated funds. See Exhibit 4.10.4-1, Interview Questions Addressing Accumulated Funds.

(4) If a taxpayer attempts to avoid answering questions concerning cash, examiners should try to pinpoint amounts by starting with an estimate such as "over or under $10,000" and narrowing the range until the taxpayer agrees with a general amount.

(5) A commitment should be sought concerning whether an individual had any large accumulations of cash during the tax period under audit. Examiners should ask the taxpayer to make an affirmative statement regarding the existence or nonexistence of cash-on-hand and accumulated funds.

(6) If taxpayers allege that they have what appears to be an inordinate amount of cash, the examiner should further inquire to establish:

1. The amount of cash-on-hand at the end of each year under examination to the present (at the time of the interview).

2. How it was accumulated.

3. Where it was kept and in what denominations.

4. Who had knowledge of it.

5. Who counted it.

6. When and where any of it was spent.

7. Why did the taxpayer accumulate the cash-on-hand

(7) Information regarding cash-on-hand and accumulated funds is necessary to establish the consistency and reliability of the taxpayer’s statement. Usually no direct corroborating evidence is available, but statements made about the source and use of the funds can be verified. Look for inconsistencies. For example:

1. The taxpayer may not have had sufficient taxable or nontaxable income in prior years to accumulate cash.

2. Taxpayer claims of substantial cash-on-hand or accumulated funds might be discredited by showing that the taxpayer borrowed money, made installment purchases, incurred large debts, was delinquent on accounts, had a poor credit rating, or filed for bankruptcy. Demonstrating that the taxpayer lived sparingly may suggest that the taxpayer does not have accumulated funds, but showing that the taxpayer lived sparingly does not necessarily discredit a taxpayer's assertion that they had substantial accumulated funds. Cultural differences and individual philosophies regarding money management may explain the taxpayer's chosen lifestyle.

3. Financial statements filed by the taxpayer at banks and other places could be reviewed to see if the taxpayer disclosed the cash-on-hand on these statements.

(8) A taxpayer’s explanation for cash-on-hand or accumulated funds may change during an examination. The examiner should document the information as it is received. The documentation should include when and where the information was received, who was present, what was said, and when the documentation was prepared; i.e., contemporaneously to the event.

(1) The following procedures must be followed to protect SARs and SAR data:

1. Attach Form TD F 15-05.11 (2007), Sensitive But Unclassified (SBU) Cover Sheet, to the outside of any case file containing a SAR or SAR information. This cover sheet is used to prevent unauthorized or inadvertent disclosure when SBU information is removed from an authorized storage location and persons without a need-to-know are present or casual observation would reveal SBU information.

2. Keep all SARs and SAR information inside a sealed confidential envelope labeled "SAR Information". This includes both SARs filed on the case subject and SARs filed by the case subject. Attach Form TD F 15-05.11 (2007) to the outside of the envelope.

3. Every effort should be made to exclude from the workpapers any reference to the fact that the case involves a SAR. If workpapers include information regarding the SAR or information derived from the SAR, the workpapers must be maintained in the confidential envelope.

4. Upon advice of Counsel and the Disclosure Office, compliance employees must respond to public inquiries on how information contained in a SAR became known by replying:
   I cannot disclose that information. The authority to withhold that information is contained in Internal Revenue Code section 6103(e)(7).

5. When closing the case, the confidential envelope must be placed inside the case file on top of all other documents.