Academic journal article Journal of Accountancy
When the IRS suspects a taxpayer is underreporting income, various IRC sections come into play. Section 6001 requires a taxpayer to keep adequate records to compute taxable income. When a taxpayer's accounting method does not clearly reflect income, section 446(b) gives the IRS authority to compute taxable income using an alternate method. This section allows the service to use reasonable means to determine income when accounting records do not support the income and deductions a taxpayer reports. If there is a reasonable indication of unreported income, the IRS can use an indirect method to reconstruct it. The available methods, which are listed in the Internal Revenue Manual, have been validated in various court cases. The Third Circuit Court of Appeals recently heard a case relating to income determination and the burden of proof.
Barbara Bacon and her spouse, Robert, filed joint returns for tax years 1988 through 1991. Robert Bacon was the sole shareholder of an S corporation. Its only activity was a restaurant and bar business. The couple made deposits to their joint bank account that exceeded their reported taxable income by several million dollars.
As the Bacons' accounting records did not show the source of the additional deposits, the IRS used the bank deposit method to reconstruct income. Under this method, the IRS determines income through analysis of bank deposits, canceled checks, currency transactions, electronic debits, electronic transfers and account credits. Cash expenditures not from deposited funds or nontaxable sources are added to the underreported income. Deductible expenses not accounted for in the taxpayers' return are allowed. (See Calhoun v. United States, 591 F2d 1243, 1245 (9th Cir. 1978)). Based on this reconstructed income, the IRS assessed the Bacons an additional tax for deficiencies and penalties for fraud. The Tax Court agreed with the IRS. In filing an appeal, Barbara Bacon (Robert Bacon withdrew from the appeal without explanation) contended the court had failed to properly prove unreported income and that it impermissibly shifted the burden of proof to her.
Result. For the IRS. Taxpayers must maintain adequate records to permit the IRS to determine their tax liability. When a taxpayer fails to do so, the IRS may use reasonable methods to reconstruct income. (See Agnellino v. Commissioner, 302 F2d 797, 798-99 (3d Cir. …