IRS Net Worth Audit

Among the government’s most powerful weapons to prove unreported income is the net worth method of proof. This method of proving unreported income, often used in tax evasion and civil fraud cases, is one of a number of methods that assume that the taxpayer has hidden his income; therefore, true income cannot be proven directly. Since the Supreme Court has long overcome all objections to its legitimacy, the net worth method is easy for agents to use and often traps taxpayers by their own prior statements and admissions.

WHEN THE IRS USES THE NET WORTH AUDIT
The IRS will typically undertake a net worth investigation when one or more of the following conditions exist:

• The taxpayer maintains no books and records;

• The books and records are not available;

• The books and records are inadequate; or

• The taxpayer withholds his books and records.

Although often used to reveal and prove illegal activity (the proceeds of which are often invested in visible assets), the net worth method can also be used in more general cases, particularly when there is a significant change in net worth and other methods of proof are insufficient. The IRS can also use net worth to corroborate or confirm other methods of proving income. The IRS does not have to rely on the taxpayer’s books and records, even if they are adequate and accurate. Sometimes the government views these records as “self serving” and may use any evidence to confirm or contradict the taxpayer’s records.

Typically, the IRS will look at all available records, the taxpayer’s inventories, physical assets, financial statements to other creditors or other government agencies, bank records, securities, personal inventories, and any other statements of assets.

TYPICAL NET WORTH CASE
The net worth method is premised on the following reasoning: When a taxpayer accumulates wealth during a tax year, he invests it (in assets) or spends it. Increases in the taxpayer’s net worth throughout the year presumptively represent taxable income. Nondeductible expenditures are then added to these increases in net worth. However, deductible expenditures are not added to net worth, since tax-deductible expenditures are already taken into account in the net worth formula.
  Thus, the basic net worth formula is as follows:

• Net worth end of year – net worth beginning of year = increase in net worth;

• Increase in net worth + nondeductible expenditures – nontaxable income = adjusted gross income; and

• Adjusted gross income – adjusted gross income per return = understatement of adjusted gross income.

GOVERNMENT’S BURDEN OF PROOF
In a net worth case, the government must establish a likely source of income and follow up leads. The government may also attempt to show that the increase in net worth is not due to a nontaxable source of income.

Source of Income
The Holland case established the requirement that increases in net worth, standing alone, cannot be assumed to represent taxable income and that proof of likely source of taxable income is necessary. This does not require that the government prove a negative: that there are no nontaxable sources of net worth, but rather only that there is a likely source of taxable income.
Usually this element is not hard to prove. The government generally shows that the taxpayer failed to report specified income on his returns, or compares the taxpayer’s business income for various years. The government does not have to prove that an exact amount of money came from a likely source, only that there was indeed some source from which it could be inferred that the unreported income arose.

The government will usually try to negate nontaxable sources of net worth increases, such as returns of capital when an asset is sold, redemption of other capital assets, gifts, inheritances, loans, and life insurance or other insurance proceeds that are not normally taxable (example, disability proceeds).

Follow Up of Leads
Holland and subsequent cases require that the IRS follow up leads the taxpayer supplies or that the agents discover if they are “reasonably susceptible” of being verified. Failure to do so allows the taxpayer to defend on the ground that the lead, and the information from the lead, is true. Most special agents and revenue agents will follow up leads as to gifts, inheritances, loans and evidence of cash hoards. The agents are not required to chase every rabbit down the hole, but only leads that are reasonable. Since this is a judgment call, agents tend to err on the side of caution so that at trial they can say that they gave the taxpayer every break and still have proved the case.

HOW THE AGENT INVESTIGATES THE CASE
In the typical investigation, the agent starts by contacting the taxpayer and asking for a statement of net worth. The agent is encouraged by training and the Internal Revenue Manual to make as thorough an initial investigation as possible, especially at the initial interview, so as to obtain admission that may prove damaging to the taxpayer. If a taxpayer furnishes a statement of net worth, that is an admission usable against the taxpayer at a later trail. The Internal Revenue Manual contains a long list of topics that the agent must cover, including bank accounts, nontaxable sources, a survey of personal assets (securities, stocks, bonds, etc.) as well as household assets. The agent will also investigate liabilities, line by line.
If the taxpayer initially resists, the agent is trained to encourage cooperation, but also to pursue third party leads when necessary. The agent may use the summonses power, IRC Sections 7602 through 7611, but summons are not absolutely necessary. Under IRC section 7601, the IRS may make informal inquires without the compulsion of the summons. Third parties are often willing to provide information to the IRS. Every time the agent interviews a third party, he writes up the interview, under oath if possible, and obtains the witness’s signature. The agent also makes notes in his case history file. Often the taxpayer has given financial histories to banks, credit unions, mortgage companies, etc. The agent will obtain these and question the taxpayer on every item.

If the taxpayer gave a financial statement, the agent will verify it line by line. This includes all taxable and non-taxable sources, especially the “cash on hand” item.

Before ending the investigation, the agent writes up a net worth statement using the formula set forth above. Typically, the agent will give the taxpayer the benefit of every deduction the taxpayer took on the return (except clearly incorrect deductions).
The agent will also determine the taxpayer’s living cost, as these must be added to the eventual net worth computation. Case law allows the agent to estimate living costs when the taxpayer cannot furnish them. Thus, the agent will consult living costs statistics that are widely available for the government and other sources for such items as clothing, food, transportation, and the like. Every item on the net worth computation will have a third party source of evidence.

DEFENSES TO NET WORTH CASES
Cash on Hand
The “cash hoard” defense is probably the most often used. Here, the taxpayer claims that he had a large amount of cash on hand at the beginning of the net worth period (or periods), and the agent failed to give him credit for it. The cash may have been in a bank account the agent never found, in a mattress, or in the back yard.
Example: In proving additional cash on hand, the taxpayer introduced evidence that he had been a bootlegger, and that during that period he had amassed a large cash hoard. The taxpayer and his wife had moved from place to place, lived modestly (showing by evidence those modest expenses for personal living items). The court concluded that if only half of what the taxpayers showed was true, there was more than enough cash on hand to negate the IRS case.

Example: The taxpayer proved he had $13,000 cash on hand at the start of the first net worth year. The court said it was “common knowledge concerning the Greeks who came to this country” that they tend to save money, often gravitate to the restaurant business, and succeed. The taxpayer confirmed these findings by proving that he had operated a restaurant, that witnesses said he and his partner divided the profits, that they had no expensive living habits, etc.
Example: Taxpayer alleged that he kept “substantial amounts of money in the house,” specifically in a metal box, about 12” x 14” x 5”, which the taxpayer and his brothers testified to.

A variation is the taxpayer’s allegation that the ending cash balance for some years are incorrect. Agents are encouraged at the initial interview to pin down the amount of cash on hand so as to negate this defense later on. Thus, they ask how much the taxpayer has on the interview date, who knew about it, where it was kept, how it was kept, whether it was spent and what records are available to prove it was spent, as well as the denominations. Furthermore, the agent’s investigation of the taxpayer’s financial history and work history may reveal no obvious sources for a large amount on cash on hand, a fact that tends to prove that on does not exist. For example, in Epstein v. United States, the IRS introduced financial statements that the taxpayer had prepared for his bank, as will as Dun & Bradstreet reports, to show that the amount of cash the taxpayer had on hand at the beginning of the period was less than the amount that the taxpayer had claimed.

Jointly Owned Assets
The taxpayer alleges in this defense that he should not be charged with an increase in net worth because another person, such as a spouse, owns all or part of the assets. Usually, the taxpayer tries to prove this by showing that he gave the spouse an interest in the asset before the years in question, that the spouse paid for it, or by providing other evidence of such ownership. Possibly the taxpayer may own an asset in name only and the real owner may not be under investigation. Also, in community property states, the assets may be divisible by operation of law.

Liabilities
The taxpayer tries in this defense to maximize his liabilities so as to minimize net worth. The practitioner should investigate all liabilities, including interest and penalty charges on loans, judgments and the like.

Overstated Inventory
The taxpayer tries in this defense to prove that his inventories were overstated in the net worth computation and that they cost far less but, for some reason, the value was somehow overstated on another document. Usually the government will try to negate this defense by interviewing the taxpayer or his employees, obtaining copies of the inventory records, and the like.

Net Operating Loss Carry-forward
The taxpayer claims in this defense an operating loss going into the years under investigation in order to minimize any increase in taxable income. The government fights this defense by taking the net worth computation back several years before the years in questions, and then either allowing the loss or proving that it is not allowable.