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© 2009 CCH. All Rights Reserved. Chapter 6 55 Chapter 6 Indirect Methods of Reconstructing Income CHAPTER SUMMARY Overview This chapter identi f es the major indirect methods of proof used by the IRS, discusses the signi f cance and application of these methods from the viewpoint of an IRS agent, and describes which method is appropriate for each type of business. Understanding the IRS practices helps a forensic accountant gain an understanding of the special tools and concepts involved in the indirect methods. Forensic Audit Approaches Used by the IRS The IRS’s use of indirect methods exempli f es the pros and cons of techniques that can prove fraud as well as invade taxpayers’ privacy. In the plus column, indirect methods have been used in the successful prosecution of a signi f cant number of criminal tax fraud cases. In the negative column are listed overzealous intrusions of privacy by agents, prompting congressional limits to be imposed. ¶6001 Minimum Income Probes The use of indirect methods to reconstruct income by the IRS is limited by Code Sec. 7602(e), which prohibits f nancial status or economic reality techniques to determine the existence of unreported income unless the agent has a reasonable indication that there is a likelihood of such unreported income. The Internal Revenue Manual sets forth minimum income probes. For nonbusiness returns (having no Schedule C or F), an agent is to question the taxpayer or the representative about possible sources of income other than reported on the return. If there is no other information in the f le indicating potential unreported income, the minimum income probe is met. However, for taxpayers who are self-employed and f le a Schedule C or F, an analysis is made from tax return information to determine if reported income is suf f cient to support the taxpayer’s f nancial activities. ¶6011 Lifestyle Probes Just like an IRS agent, a forensic accountant should be aware of the lifestyles of employees of companies as well. The lifestyle of a taxpayer or employee may give clues as to the possibilities of unreported income. ¶6021 IRS’s Financial Status Audits The theory in the use of lifestyle audits is valid for both IRS agents and private sector forensic accountants. If someone is spending beyond his or her apparent means, there should be a concern. If a forensic accountant suspects fraud or unreported income, a form of f nancial status audit may be appropriate that will enable the investigator to check the lifestyles of the possible perpetrators. Indirect Methods An indirect method should be used when the taxpayer has inadequate books and records, the books do not clearly re F ect taxable income, or there is a reason to believe that the taxpayer has omitted taxable income. An indirect method also is appropriate when there is a signi f cant increase in year-to-year net worth, when gross pro f t percentages change signi f cantly for that particular business, or when the taxpayer’s expenses (both business and personal) exceed reported income, and there is no obvious cause for the difference.
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This note was uploaded on 01/12/2012 for the course ACCT 555 taught by Professor Briggs during the Spring '11 term at University of Texas at Dallas, Richardson.

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