Income Reconstruction

Article excerpt

Forensic accounting is a practice whereby accountants use their business skills to investigate fraud, embezzlement of funds, theft of assets, or perhaps find evidence of hidden assets in divorce cases. One of the most useful tools available for the application of this skill is income reconstruction. But, the sword cuts both ways.

Authority to Reconstruct Income

The power to reconstruct income is based on IRC section 446(b). Subsection (b) states that, if the taxpayer does not use a method of accounting that clearly reflects income, the method for computation of taxable income can be determined by the Treasury Secretary. Treasury regulations section 1.446-1(a)(4) explains that every taxpayer must maintain accounting records to support the filling of a correct return. The regulations require accounting records to perform three essential functions:

Account for inventory,

Property classify between expense and capital accounts, and

With respect to depreciable assets, record additions to those accounts for improvements.

The obligation to maintain records is reiterated in IRC section 6001, which states that anyone liable for tax must keep records and file returns in accordance with rules and regulations the secretary may prescribe. The only reprieve for the taxpayer has come through the Cohan rule.

In a landmark case, George M. Cohan v. Comr. [39 F.2d 540 (CA-2 1930)], Mr. Cohan could not substantiate $55,000 in entertainment and travel expenditures. The IRS did not allow any part of the deduction because there was no substantiating documentation. The trial court concurred. However, the appeals court ordered the trial court to estimate a reasonable amount that could be deducted. The appeals court held that when some amount has definitely been spent, the IRS can use an estimated amount if the taxpayer has no records. The court gave the IRS the freedom to bias the estimate against the taxpayer "whose inexactitude is of his own making."

Using the Cohan rule, courts have allowed partial deductions for union dues, wages, utilities, and postage. The deduction depends on the credibility of the taxpayer and corroborating testimony. After 1962, the Cohan rule was no longer applicable to travel and entertainment expend es because of the explicit requirements of IRC section 274. However, Treasury regulations section 1.274-5T(c)(5) states that if records are lost due to circumstances beyond the control of the taxpayer, the taxpayer has the right to a deduction based on a "reasonable reconstruction of his expenditures."

The courts have refused to apply the Cohan rule when the taxpayer could have obtained duplicate records, but failed to do so. The courts will not estimate deductions when there is neither a reasonable basis for an estimate nor a reasonable method to allocate an expense into deductible and nondeductible portions. Deduction of expenses is, however, only half of the equation. Taxpayers are also responsible for the proper inclusion of income items. Calculation of gross income is often accomplished through the use of income reconstruction.

The IRS is not permitted to use income reconstruction in every circumstance. Properly kept records that show actual income cannot be disregarded by the IRS. Several tax court cases have established that mere suspicion that records do not accurately reflect income is not a sufficient reason to use income reconstruction, even if the records are not completely accurate. However, the burden of proof is on the taxpayer to show that the records clearly reflect income.

The IRS does not require that a preparer verify information against the taxpayer's actual records. Treasury regulations section 1.6694-1(e) states that the preparer may "rely in good faith" on information provided by the taxpayer. "The preparer is not required to audit, examine, or review" documents or records, but the preparer must make "reasonable inquiries" if the information seems to be incorrect or incomplete. …