Indirect methods of income reconstruction.

• Author: Carney, Robert

The Role of the CPA When Taxpayers Maintain Inadequate Records

Robert Carney, Ph.D., CPCU Associate Professor of Finance College of Business Administration University of Wisconsin-La Crosse La Crosse, Wisc.

John Gardner, Ph.D., CPA Professor of Accountancy College of Business Administration University of Wisconsin-La Crosse La Crosse, Wisc.

Kenneth Winter, Ph.D., CPA Assistant Professor of Accountancy College of Business Administration University of Wisconsin-La Crosse La Crosse, Wisc.

Income reconstruction, by indirect methods, is an area of tax practice with which many CPAs are not familiar. Typically, a CPA becomes involved in an income reconstruction case during an audit if the CPA is representing a client, is retained by an attorney to assist the attorney in representing the attorney's client or acts as an expert witness. In civil tax liability cases, the failure of the taxpayer to maintain the "accounting records" required by the Code necessitates the reconstruction of income.

This article will review the requirements that a taxpayer maintain adequate books and records; address the principal indirect methods of income reconstruction; examine the CPA's role in the income reconstruction process; and, because the Service has required procedures and methodologies for indirect income reconstruction, discuss the practices used by IRS personnel.

Maintenance of Books and Records

If all taxpayers kept available the books and records required by law, there would be no need for indirect methods. Because some taxpayers do not keep sufficient books and records, while others will not make them available to the IRS, indirect methods are an important tool for the IRS. Although indirect methods do not produce updated books and records, they are legal avenues of proof of underreported income available to the Service?

Sec. 446(a)requires that the computation of taxable income be based on the method of accounting under which the taxpayer "regularly computes his income in keeping his books." Sec. 446(b) provides, however, that if a taxpayer does not regularly use a method of accounting or if the accounting method "does not clearly reflect income,'' the IRS may make the computation under a method that will best meet the test(s)under Sec. 446.

Indirect methods of income reconstruction do not constitute "methods of accounting." Rather, they are the means of providing the Service with economic information on which to base calculations of adjusted gross income (AGI) under the taxpayer's method of accounting or a method of accounting that most clearly reflects income?

According to Regs. Sec. 1.446-l(a)(4), all taxpayers must maintain accounting records that will ensure that a correct tax return can be filed. This requirement is supported by Regs. Sec. 1.6001 - 1 (a), which provides in part that "any person subject to [income] tax... shall keep such permanent books of account or records, including inventories, as are sufficient to establish the amount of gross income, deductions, credits, or other matters...."

Challenge to the adequacy of books and records arises during a tax audit. The IRS prefers to use direct methods to challenge adequacy as they are the best method of proof. If direct methods or data are not available, however, the Service may use indirect income reconstruction--unless the courts have already accepted the taxpayer's books and records as reliable. Indirect methods of reconstruction of income are ordinarily employed during investigations of civil fraud and criminal tax evasion when books and/or records are not available or are nonexistent.3

The IRS Process

When the issue of possible civil and criminal sanctions arises during an audit, the IRS may employ indirect methods and direct evidence from information returns or third parties' records to establish the existence of underreported income for either criminal or civil fraud or nonfraud civil cases. The flowchart on page 547 describes the IRS decision process for fraud cases. Typically, a revenue agent will make a decision about a course of action based on a preexamination analysis, a personal interview with the taxpayer and relevant documentary evidence. The revenue agent will recommend that the Service

--issue a no-change report, which effectively ends the case,

--proceed for the tax due and interest;

--proceed with civil fraud; or

--proceed with criminal fraud.

When the information appears to warrant proceeding under criminal fraud, the agent will make the recommendation to the IRS Criminal Investigation Division (CID). After an investigation by a CID special agent, a recommendation will be made to the Justice Department to seek criminal sanctions or return the case to the Examination Division. The Examination Division could continue the civil case, which might result in the assertion of the civil fraud penalty. When a criminal case is pursued, civil action will be delayed until the criminal case is completed?

As highlighted in the flowchart, there are several levels of IRS and/or Justice Department review, any of which can defeat the decision to prosecute. During this entire process, the IRS provides opportunities to disprove the Service's assertions.5

When a taxpayer is charged with criminal tax fraud for "willfully attempt[ing]... to evade or defeat any tax imposed by this title," he may be prosecuted under Sec. 7201. The taxpayer may also be charged under Sec. 7206111 for willfully filing a false tax return or penalized for civil tax fraud under Sec. 6663(a).

Indirect Methods

The IRS will rely on the indirect process, which provides only circumstantial evidence,6 when direct methods cannot be employed. The audit process often begins with a preexamination analysis that includes a cash-T (described below}. If the results of this analysis suggest the existence of underreported income, a more detailed methodology will be employed: cash expenditures, net worth, bank deposit or a hybrid/combination approach.7

When the results of the preliminary...