With regards to IRC 7602(e), which addresses the use of financial status audit techniques, examiners should not routinely ask for bank statements, cancelled checks or deposit slips to complete the examination of income on nonbusiness returns. Requests for documentation supporting specific issues can be made and may include cancelled checks.

There may be situations in which there is a reasonable indication of unreported income in the pre-contact stage of the examination; i.e., a grossly imbalanced financial status analysis or Forms 1099 for business income not included on the tax return. In such situations, the initial information document request (IDR) may include a request for personal banking records, including bank statements, cancelled checks, and deposit slips.

Examiners may find that one or more of the minimum income probes cannot be performed in a particular case or that no value is added by performing a specific minimum income probe. The decision to deviate from one or more of the minimum income probe requirements must be based on the specific facts of the case as they relate to the taxpayer.

When the examiner determines a deviation from a minimum income probe is warranted, the reason(s) must be documented in the appropriate minimum income probe workpapers. The factors considered and rationale for deviating must be specifically documented. The documentation must clearly support the decision.

Prepare a financial status analysis of the taxpayer's cash flow to estimate whether there are sufficient funds to cover the taxpayer's expenses. The financial status analysis includes both business and personal financial activities. The analysis serves two purposes:

The intent of the analysis is to determine whether there is a significant risk of a material misstatement of taxable income. Materiality is the significance or importance of an item in determining the correct tax liability and requires the examiner’s judgment regarding the return as a whole and the separate items that comprise the return. Among the factors which must be considered when determining whether the imbalance is material are:

The financial status analysis should include consideration of all sources and expenditures of funds identified on the tax returns, information included as part of the case building, and sources of information such as asset locator people locator contract, Financial Crimes Enforcement Network (FinCEN), Information Document Retrieval System (IDRS), Corporate Files on Line (CFOL), and/or Compliance Data Environment (CDE). See Exhibit 4.10.4-2 for internal sources of information. Reasonable estimates for other expenses known to exist, but for which the exact costs are not known should be included in the analysis. Personal living expenses (PLE) must be estimated using Bureau of Labor Statistics (BLS) information or comparable statistics from a reliable source, except where the actual amount of the expense is disclosed on the tax return.

The analysis should also be updated during the examination as additional information becomes available; i.e., nontaxable sources of funds or disallowed expenses. Refer to Exhibit 4.10.4-4, Example of Financial Status Analysis for Individual Business Return.

The T-Account provides a quick and easy format for documenting and determining whether there is an indication of a potential understatement of taxable income. Enter sources of funds on the left side of the T-Account and expenditures of funds on the right side. Total sources are compared with total expenditures.

Steps for completing a financial status analysis:

The completion of a financial status analysis does not trigger the provisions of IRC 7602(e), which states, "The Secretary shall not use financial status or economic reality examination techniques to determine the existence of unreported income of any taxpayer unless the Secretary has a reasonable indication that there is a likelihood of such unreported income." A financial status analysis is an analytical tool used to identify and estimate the materiality of cash flow imbalances. Financial Status Audit Techniques are the formal indirect methods used to make the actual determination of tax liability and are subject to the limitations of IRC 7602(e). See IRM 4.10.4.6.

Income or losses reported on Schedule E, Supplemental Income and Loss, may not represent an actual flow of funds.

Common errors in a financial status analysis include failure to include loan payments as an application of funds, treating the cost of goods sold as an application of funds rather than current period costs (i.e., purchases, labor costs, materials and supplies, and other costs associated with inventory), and accepting unreasonably low estimates of personal living expenses.

An examiner may consider observing a taxpayer's residence when completing a financial status analysis. However, observing a taxpayer's home should not be intrusive and generally should not include talking with the taxpayer's neighbors. Inspections of the inside of a taxpayer's home should be limited due to privacy issues and the intrusive nature. Note: the purpose of inspecting the interior of a taxpayer's home includes determining the validity of a deduction for an office or business located in the residence.

The financial status analysis, as originally prepared based upon the tax return data and information in the case file and subsequently modified, will be made part of the examination workpapers. The analysis should indicate the information considered and the conclusions reached.

If the financial status analysis indicates that the taxpayer's sources of funds are not sufficient to support the taxpayer's expenditures; the use of a formal indirect method can be justified.

The examiner should conduct the initial interview with the taxpayer to gain an understanding of the taxpayer’s overall financial picture, the business history and operations, and an overview of the taxpayer’s recordkeeping practices. Interviews should be professional and not overbearing.

IRC 7521(c) states that an examiner cannot require a taxpayer to accompany an authorized representative to an examination interview in the absence of an administrative summons. However, the taxpayer's voluntary presence can be requested through the representative as a means to expedite the examination process. Should an examiner find that a representative has unreasonably delayed or hindered an examination, an examiner can bypass the representative and deal directly with the taxpayer. See Exhibit 4.10.4-5, Bypassing Powers of Attorney.

Question the taxpayer/representative concerning possible nontaxable sources of funds, gifts, loans, known errors/omissions on the return, and unreported sources of income. These questions should be addressed at the initial interview early in the examination. The information will be needed to reconcile the financial status analysis, analyze the bank accounts, and reconcile the income reported on the tax return to the books and records. Also, the information will be critical should it later become necessary to use a formal indirect method to make the actual determination of tax liability.

If the IRP analysis reveals that there are additional known sources of income not included on the tax return, the examiner should question the taxpayer as to where they may have already reported this information.

Question the taxpayer concerning bartering income. Bartering is the trading of one product or service for another. Usually there is no exchange of cash. Bartering may take place on an informal one-on-one basis between individuals and businesses, or it can take place on a third party basis through a modern barter exchange company.

Obtain the beginning and ending balances for cash-on-hand from the taxpayer or representative for the year(s) under examination. See IRM 4.10.4.6.8.3 for complete discussion and Exhibit 4.10.4-1 for interview questions. Generally, cash-on-hand is currency associated with normal business practices and the need to complete cash transactions with customers. If additional years are examined, be sure to determine and document the beginning and ending cash-on-hand for those years. This information will be needed to complete the reconciliation of income as reported on the tax return to the taxpayer's books and records and will be critical should it later become necessary to use a formal indirect method to make the actual determination of tax liability.

Determine the beginning and ending balances of accumulated funds for the year(s) under examination. Generally, accumulated funds is currency not associated with normal business practices. The funds may have been taxed in prior years, originate from nontaxable sources, or may represent taxable income in the year under audit. See IRM 4.10.4.6.8 for complete discussion and Exhibit 4.10.4-1 for interview questions.

The examiner should ask the taxpayer for assistance to resolve a financial status analysis indicating a material imbalance.

The examiner should ask the taxpayer to explain the accounting system, including:

The examiner should question the taxpayer regarding business policies and practices for:

The examiner should determine the extent of the taxpayer's use of the Internet for e-commerce purposes. See Exhibit 4.10.4-7 for a list of interview questions.

IRC 7521 (b)(2), Recording by IRS Officer or Employee, requires examiners to suspend interviews when taxpayers state that they wish to consult with a representative or otherwise seek advice. The taxpayer’s right of consultation will be strictly observed and interviews will be suspended and rescheduled accordingly. This provision does not apply to interviews initiated by administrative summons and will not be used to repeatedly delay or hinder the examination process.

Examiners should use the appropriate Lead Sheet 125 in RGS to document the interview.

Refer to IRM 4.10.7.3.2, Oral Testimony, for complete discussion and documentation requirements.

Conduct a tour of the physical business site controlled by the taxpayer. Generally, the physical business site will be the principal location and any other locations acquired during the period under examination should be visited. The purpose of a tour is to:

A tour of the physical business site is not required for office audit cases. However, if appropriate (and with manager's approval), a tour of the business site may be conducted.

The results of a tour and any observations and/or comments should be documented in the examination workpapers.

See IRM 4.10.3.3, Tours of Business Sites, for complete discussion.

Review the business websites controlled by the taxpayer. See IRM 4.10.4.3.7.2.

Evaluate the internal controls to gain an understanding of the taxpayer’s business operations and control features. The evaluation will help examiners set the scope and depth of the examination of income and determine the appropriate audit techniques.

Examiners should:

The evaluation should not be limited to a consideration of the segregation of duties. See IRM 4.10.3.4, Evaluating the Taxpayer’s Internal Controls, for a complete discussion. Examiners should:

While there is no exhaustive definition of weak internal accounting controls which will impact the scope and depth of the examination of income, examples include:

Weak internal controls alone do not necessarily establish a reasonable likelihood of unreported income under IRC 7602(e) that justifies the use of a formal indirect method to make the actual determination of tax liability. Examiners must also demonstrate that there are irregularities in the taxpayer's books and records. See IRM 4.10.4.3.3.5.

The workpapers will document the conclusions reached by the analysis of internal controls and their impact on the scope and depth of the examination.

Reconcile the income reported on the tax return to the taxpayer’s books and records. Ask the taxpayer how income was computed and duplicate the taxpayer's steps. Refer to IRM 4.10.3.5.6, Step 6: Reconciling the Taxpayer's Books and Records to the Tax Return, for complete discussion.

Analyze the information obtained in the initial interview, observed during the tour of the business site, and from the evaluation of the internal controls to determine if transactions were properly recorded.

Test whether income from e-commerce activities has been accounted for in the books and records and reported on the tax return. See IRM 4.10.4.3.7.

If the income per the books and records cannot be reconciled with the income reported on the tax return, the examiner should ask the taxpayer to provide an explanation for the difference; i.e., how the accounts per books were accumulated for the tax return.

Irregularities in a taxpayer's books and records, or inconsistencies in reporting transactions may be an indication of unreported income justifying the use of a formal indirect method to determine the actual understatement of taxable income.

The lack of books and records or the underlying source documents will justify expansion of an income probe beyond the minimum income probes.

The fact that a taxpayer's books and records were not prepared contemporaneously to the business activity does not, per se, permit the examiner to use a formal indirect method to make the actual determination of tax liability. The test of whether a formal indirect method can be used is whether there is a reasonable indication that there is a likelihood of unreported income.

Test gross business receipts to verify that all the gross receipts are accounted for. For additional techniques, see IRM 4.10.3.9, Testing Gross Receipts or Sales.

Perform an analysis of the taxpayer's business and personal bank accounts (including investment accounts); i.e., statements, deposit slips, and canceled checks, etc. The examiner should use judgment to determine the depth of the analysis and use of automation. The Service is not prohibited from asking for these records, as well as wire transfers, on the initial information document request (IDR) or at any time during the examination for an individual business return. See IRM 4.10.4.3.

This analysis is used to:

The steps of the bank account analysis are:

Compare the total deposits with the reported Gross Income. Include all accounts, whether designated as personal or business.

If the analysis results in the identification of excess deposits over the reported gross income, the excess represents potential unreported income.

If the business expenditures paid by check are less than the deducted business expenses on the return, then the taxpayer may be overstating expenses, paying expenses by cash (unreported income), or paying expenses from an undisclosed source of funds.

If the analysis indicates significant commingling of funds, then the internal controls are weak and the books and records may be unreliable. IRM 4.10.4.3.3.4.

A potentially material misstatement of taxable income identified through a bank account analysis establishes a reasonable likelihood of additional unreported taxable income justifying the use of a formal indirect method to make the actual determination of tax liability.

The initial reconciliation of income per the books and records to the tax return provides the examiner with an understanding of how the taxpayer determined gross receipts. The books and records can also be used to evaluate the accuracy and reasonableness of the reported amount of income through the use of ratios.

A horizontal analysis should be prepared, with documented conclusions, and be included in the case file for all business returns. A vertical analysis may not be appropriate for every case.

Horizontal analysis - This analysis identifies changes over time and may result in the identification of LUQ items not readily identified from a review of a single return alone. The tax return under audit should be compared to the prior and subsequent year returns.

Vertical Analysis - This analysis identifies differences between the taxpayer's business and the industry standards for a given year and is an indicator of the reasonableness of gross receipts and net profit reported on the tax return. Ask the taxpayer what the gross profit should be and test the gross profit percentage by tracing specific transactions from the purchase of a product for resale to the sale of the item. Industry standards can be found at http://www.bizstats.com. IRM 4.10.4.3.3.8 for complete discussion and examples.

Examiners are not limited to the ratio demonstrated above. Any ratio or standard available for the taxpayer's industry can be used for the analysis. See IRM 4.10.3.9.1, Gross Profit Ratio Test.

More information on e-commerce income issues can be found in IRM 4.10.4.3.7.1.

Examiners may find that one or more of the minimum income probes cannot be performed in a particular case or that no value is added by performing a specific minimum income probe. The decision to deviate from one or more of the minimum income probe requirements must be based on the specific facts of the case as they relate to the taxpayer.

When the examiner determines a deviation from a minimum income probe is warranted, the reason(s) must be documented in the appropriate minimum income probe workpapers. The factors considered and rationale for deviating must be specifically documented. The documentation must clearly support the decision.

Prepare an analysis of the balance sheet and tax return information. The purpose of the analysis is to assist in the identification of issues to be examined.

Significant changes to any accounts should be noted and resolved during the examination.

Use CFOL information or secure copies of subsequent and prior year returns from the taxpayer to complete the comparative analysis when the examination is initiated.

Tie balance sheet accounts, such as cash, to their respective source documents (cash receipt/disbursement journals and bank reconciliations).

Tie balance sheet accounts such as accounts receivable and accounts payable to the receivable/payable subsidiary ledger ending balance.

Compare the adjusted trial balance to the balance sheet to ensure they match. Account grouping sheets should be requested for this analysis. This is an essential step in the examination of a double-entry set of books.

Review the adjusting journal entries from the unadjusted trial balance to the adjusted trial balance for misclassifications, unusual debits to income accounts or possible manipulations of reported income. The adjusted trial balance should be tied to the general ledger to ensure there are no missing adjusting journal entries.

The general ledger should be scanned for large, unusual or questionable items in the journal entries or adjusting journal entries, such as debit entries to income accounts or credit entries to asset accounts (i.e., accounts receivable that do not flow from the cash receipts journal).

See IRM 4.10.3.8, Balance Sheet Analysis: Introduction, for additional instructions.

Perform a reconciliation of Schedule M–1, Reconciliation of Income/Loss Per Books with Income Per Return, or equivalent schedule.

Perform a reconciliation of Schedule M–2, Analysis of Unappropriated Retained Earnings per Books, or equivalent schedule. The disposition of, or changes to, retained earnings can indicate whether monies have been distributed to a shareholder and where those funds originated. Refer to IRM 4.10.3.6.2, Schedule M-2, for complete discussion.

Perform a reconciliation of Schedule M-3.

Corporate and stockholder returns, as well as partnership and the associated partner returns, are considered related because the returns are for entities over which the taxpayer (stockholder or partner) has control and which can be manipulated to divert funds or camouflage transactions. Evaluate copies of the tax returns of significant shareholders or partners (greater than 20% direct or indirect ownership) for:

See Exhibit 4.10.4-8, Tax Treatment of Diverted Income, if funds diverted from a corporation to a stockholder are identified.

Completion of the Required Filing Checks is not a violation of IRC 7602(e). See IRM 4.10.5, Required Filing Checks.

Copies of related shareholder/partner returns should be obtained using CFOL or CDE first. If the CFOL and CDE information is insufficient, the return should be requested from either the campus or the taxpayer for inspection. See IRM 4.10.5.2.2, CFOL/IDRS and CDE.

For cases in which entities related through a flow-through relationship are suspected, but cannot be otherwise identified, examiners should request research using the yK1 Link Analysis Tool. This tool provides a graphic representation of flow-through relationships created by partnerships, trusts, and S corporations. The tool uses Schedule K-1 data to depict ownership relationships and income/loss flows between payers and payees.

Examiners should determine if the income from the related business entity was included on the shareholder/partner's individual return. If the income was reported and there are no other issues, the return should not be opened for examination. If the income from the related business entity was not reported on the return, the examiner should open the shareholder/partner's individual return for audit. For example, the business did not issue Form W-2, Wage and Tax Statement, to corporate officers. See IRM 4.10.5.4, Related Returns, for additional discussion.

Independent of the potential underreported income from the business entity, the return should be opened for audit if the examiner notes that a financial status analysis based solely on the return indicates insufficient funds to support the identified expenses, or a large, unusual, or questionable item is identified.

Examiners should determine whether the related return warrants examination from a classification perspective; i.e., trace the transactions between the individual and related business entity, complete a financial status analysis based on the return as filed and internal sources of information (Exhibit 4.10.4-2), and review the return for other potential issues.

Should the related individual return be opened for audit, it is subject to the minimum income probes and examiners are expected to determine whether the taxpayer has reported the correct amount of taxable income. The depth of the examination of income and the techniques used are dependent on the facts and circumstances of the case.

The initial interview should be held with the partnership's general partner, managing member if an LLC, Tax Matters Partner (TMP) if a TEFRA entity, or the corporate officer most familiar with the day-to-day operations of the business. From the taxpayer's perspective, an interview with an Internal Revenue examiner may be overwhelming. Therefore, initial interviews should be professional and not overbearing.

Bartering income should be considered.

IRC 7521(c) states that examiners cannot require a taxpayer to accompany an authorized representative to an examination interview in the absence of an administrative summons. However, the taxpayer’s voluntary presence can be requested through the representative. Should an examiner find that a representative has unreasonably delayed or hindered an examination, an examiner can bypass the representative and deal directly with the taxpayer. See Exhibit 4.10.4-5, Bypassing Powers of Attorney.

Question the TMP, corporate officer, or representative concerning possible loans, gifts, or other nontaxable funds, known errors/omissions on the return, unreported sources of income and ask for any information necessary to resolve issues identified during the pre-audit analysis. If loan proceeds are identified, request the loan application documents to validate that financial reporting is consistent with the tax return. Discrepancies should be resolved with the taxpayer's assistance.

Question the TMP, corporate officer, or representative about cash-on-hand and accumulated funds. See IRM 4.10.4.3.3.2, IRM 4.10.4.6.8.3, and see Exhibit 4.10.4-1 for additional discussion.

Question the TMP, corporate officer, or representative about e-commerce activities. See Exhibit 4.10.4-7 for additional discussion.

Question the TMP, corporate officer or representative about internal controls, including the segregation of duties, which can be verified during the audit. The flow of money should be established to determine any potential control weaknesses which could result in diversion of funds.

Refer to IRM 4.10.3, Examination Techniques, and IRM 4.10.4.3.3.2 for additional interview questions. Although these questions are intended for individual business returns, they are equally applicable to other business entities.

IRC 7521(b)(2) requires examiners to suspend interviews when taxpayers state that they wish to consult with a representative or otherwise seek advice. The taxpayer’s right of consultation will be strictly honored and interviews will be suspended and rescheduled accordingly. This provision does not apply to interviews initiated by administrative summons and will not be used to repeatedly delay or hinder the examination process.

Conduct a tour of the physical business site controlled by the taxpayer. Generally, the physical business site will be the principal location and any other locations acquired during the period under examination should be visited, (see IRM 4.10.4.3.3.3). The purpose of a tour is to:

A tour of the physical business site is not required for office audit cases. However, if appropriate (and with manager's approval), a tour of the business site may be conducted.

The results of a tour and any observations should be documented in the examination workpapers.

Conduct a tour of the business websites controlled by the taxpayer. See IRM 4.10.4.3.7.2.

Internal controls are the taxpayer's policies and procedures to identify, measure and safeguard business operations and avoid material misstatements of financial information. Evaluate the internal controls to gain an understanding of the taxpayer’s business operations and control features. See IRM 4.10.3.4, Evaluating the Taxpayer's Internal Controls. If the taxpayer maintains electronic books and records, refer to IRM 4.10.4.3.7.5.

While there is no exhaustive definition of weak internal accounting controls, which will impact the scope of the examination of income, examples include:

If it is determined that the internal controls are weak, identify when and how income could be diverted.

Example: A taxpayer's business consists of small home repairs and construction projects. The taxpayer files a corporate tax return and is the 100% shareholder. The books and records tie to the corporation's income tax return and the invoices tie into the gross receipts shown on the return. The corporate return reflects a net profit of $5,000. The corporation did not pay the taxpayer a salary, but the taxpayer's spouse earned $30,000 in wages from an unrelated business (as reported on the shareholder's Form 1040 tax return). Although the cash flow analysis suggests sufficient funds to support the corporation's expenses, most of the gross receipts are cash and the internal controls are weak because the shareholder's spouse maintains the books.

The workpapers will document:

Analyze the information obtained in the initial interview, observed during the tour of the business site, and from the evaluation of the internal controls to gain a complete understanding of the taxpayer’s business operations and control features.

Reconcile the bank records. The depth of bank record inspection will depend on the reliability of internal controls and the judgment of the examiner. See IRM 4.10.4.3.4.6, Evaluate Internal Controls, for complete discussion. In addition, consider the results of the analysis of the primary shareholders’ or partners’ individual returns. The initial IDR may include a request for the business bank records, including the statements, deposit slips and cancelled checks. See IRM 4.10.3.7, Bank Record Reconciliations.

See IRM 4.10.3.9, Testing Gross Receipts or Sales, for a complete discussion and listing of audit techniques.

See IRM 4.10.4.3.7.4, Identifying Gross Business Receipts from E-commerce Activities.

The taxpayer's books and records can be used to evaluate the accuracy and reasonableness of the reported income through the use of ratios. A horizontal analysis, with documented conclusions, should be included in the case file for all business returns. A vertical analysis may not be appropriate for every case.

Horizontal Analysis - This analysis identifies changes over time and may result in the identification of LUQ items not readily identified from a review of a single tax return. The tax return under audit should be compared to the prior and subsequent year returns. See IRM 4.10.4.3.3.8 for complete discussion and examples.

Vertical Analysis - This analysis identifies differences between the taxpayer's business and industry standards for a given year and is an indicator of the reasonableness of gross business receipts and net profit reported on the tax return. A vertical analysis may not be appropriate for every case. Industry standards can be found at http://www.bizstats.com. See IRM 4.10.4.3.3.8 for complete discussion and examples.

Refer to IRM 4.10.4.3.7.1 for additional information on e-commerce income issues.

Examiners may find that one or more of the minimum income probes cannot be performed in a particular case or that no value is added by performing a specific minimum income probe. The decision to deviate from one or more of the minimum income probe requirements must be based on the specific facts of the case as they relate to the taxpayer.

When the examiner determines a deviation from a minimum income probe is warranted, the reason(s) must be documented in the appropriate minimum income probe workpapers. The factors considered and rationale for deviating must be specifically documented. The documentation must clearly support the decision.

Income probes for no show/no response cases may also include specific items or indirect methods to determine whether the taxpayer accurately reported income.

When using the specific item method for adjustments based on unreported Information Return Program (IRP) income, if the taxpayer fails to respond or raise a "reasonable dispute" regarding the correctness of the IRP data, then the burden of proof remains with the taxpayer and does not shift to the government. In unreported income cases based on IRP information, there is no legal requirement pursuant to IRC 6201(d) to contact third parties to verify income items unless the taxpayer reasonably disputes the income and has fully cooperated with the Service.

In no show/no response cases where the taxpayer has not responded or raised a frivolous dispute (wages are not income, etc.), there is no legal requirement for further verification with third parties and an income adjustment in the amount reflected on the IRP document is appropriate. Verification with third parties is required when IRP information is relied upon to support the civil fraud penalty (IRC 6663) or where the taxpayer disputes the IRP income information.

Verification with third parties should also be made in no show/no response cases where there is an inconsistency noted in the file that would cause the examiner to question the validity of the IRP information.

In cases involving large dollar income items (e.g., Form 1099-MISC amounts greater than $100,000), examiners, in consultation with their manager, should use their professional judgment in deciding whether it makes good business sense (given the circumstances) to verify IRP information. This discussion should be documented in the workpapers.

If an indirect method is used, the use of statistical data must be tailored to the individual taxpayer.

If an indirect method reveals an understatement of income in excess of $10,000 and the case is a no show, the examiner will take the following steps:

In no show/no response cases the Service has no legal requirement to estimate expenses, including cost of goods sold. If the examiner has actual taxpayer information regarding expenses, then taxpayer specific information (not industry averages) should be used to determine expenses.

If the sale of securities is an issue and in cases where the taxpayer has not substantiated stock basis, the Service has no legal requirement to obtain basis information from third party sources, despite the fact that the proceeds of stock sales are included in income.

Penalties, such as negligence, will not be asserted solely due to the taxpayer’s failure to appear for an audit or respond to an inquiry or notice. However, the facts and circumstances from the return and the case file may warrant assertion of the accuracy-related penalty attributable to negligence.

See IRM 20.1.5.7.1, Negligence, and IRM 20.1.5.8.2, Substantial Understatement, paragraph 5. The examiner should document actions and decisions using Form 9984, Examining Officer's Activity Record.

Determining whether a taxpayer uses the Internet can be done during any phase of the examination. However, if it can be identified, the website should be reviewed during the pre-contact stage.

Examination issues for e-businesses are published on MySB/SE Issues and Procedures Module. Select Electronic Business from the drop down menu for "Filter by Program Area." Internet activity provides techniques on finding websites, analyzing and saving websites, the tax treatment of domain names, and finding the owner of a website using "whois" tools. Online Sales provides sample document requests and interview questions with explanations. Interview questions should be tailored to the taxpayer and appropriate follow up questions asked. Items to consider:

In every case, examiners should search for an Internet presence using a search engine such as Google. Examiners should also ask the taxpayer about Internet use. Effective web searching provides tips on using the advanced search features of popular search engines to narrow results. Internet use and e-commerce activities provide examples of appropriate open ended questions.

If a website is discovered, viewing it can provide insight into the taxpayer's activities. Reviewing a taxpayer's website is a complement to touring the physical business site; e.g., to gather information helpful to understanding the business activities.

To see how the website looked in the year under audit, search the Internet Archive at http://www.archive.org. The search feature is call the "Wayback Machine." The Examiner will be provided with a historical copy of all available archived copies of the website.

Use http://www.linkpopularity.com to identify websites with hyperlinks that are linked to the taxpayer's website. Linkpopularity.com is a metasearch website that uses the reverse link feature to find websites that have hyperlinks pointing to a website.

Evidence of an unreported e-business activity can be found by reconciling credit card payments, as a taxpayer may consolidate all credit card or payment vouchers when submitting them to the e-payment provider.

When reviewing a website, consider the following questions:

Further inquiry will be needed to determine how the website is supported; i.e., whether the website is hosted by a third party or maintained on the taxpayer's own web servers, the location of the web servers, what equipment or computers are used, who has access to the servers, what records are maintained, and when the website was placed in service.

To document the case file, save the website or make hard copies of the website pages. Documenting the website content before the taxpayer limits access may be important to the development of, or providing evidence for, an unreported income issue.

The taxpayer should be interviewed regarding Internet use for e-commerce activities. For individual business returns, the taxpayer should be asked about both personal and business use. Payments made over the Internet need to be considered as part of the minimum income probes.

Exhibit 4.10.4-7 is a list of interview questions specific to Internet and website use.

This section provides an overview of common sources of taxable income generated by e-commerce activities and associated audit techniques.

The Uniform Electronic Transaction Act (UETA) defines electronic records as a record created, generated, sent, communicated, received, or stored by electronic means. The UETA is suggested legislation that the National Conference of Commissioners on Uniform State Laws, in 1999, drafted and recommended be adopted by all states. More information about the UETA can be found at http://www.uniformlaws.org/Act.aspx?title=Electronic Transactions Act.

Rev. Rul. 71-20, 1971 -1 C.B. 392, establishes that all machine-sensible data media used for recording, consolidating, and summarizing accounting transactions and records within a taxpayer's Automatic Data processing (ADP) system are records within the meaning of IRC 6001 and Treas. Reg. 1.6001-1, and are required to be retained so long as the contents may become material in the administration of any internal revenue law.

Rev. Proc. 98-25, 1998-1 C.B. 689, specifies the basic requirements that the Service considers essential when a taxpayer maintains records within an ADP.

Rev. Proc. 98-25 provides an exemption for small business taxpayers with assets of less than $10 million at the end of its taxable year in complying with the record retention requirements of Rev. Rul. 71-20 and Rev. Proc. 98-25. For purposes of meeting that exemption, a controlled group of corporations (as defined in IRC 1563) is considered to be one corporation and all assets of all members of the group are aggregated. Also, a small business taxpayer will not meet the exemption provided in Rev. Proc. 98-25 if any of the following three conditions exist:

An "ADP System" consists of an accounting and/or financial system (and subsystems) that processes all or part of a taxpayer's transactions, records, or data by other than manual methods. It includes, but is not limited to, a mainframe computer, stand-alone or networked microcomputer system, Data Base Management System (DBMS), and a system that uses or incorporates Electronic Data Interchange (EDI) technology or an electronic storage system. Key requirements include:

Understanding the reliability of electronic books and records is critical to evaluating internal controls, reconciling the books and records to the tax return, and obtaining records. The following attributes of electronic records need to be considered when evaluating the reliability of electronic books and records:

Rev. Proc. 97-22, 1997-1 C.B. 652, provides guidance to taxpayers that maintain books and records by using an electronic storage system that either images their hardcopy (paper) books and records or transfers their computerized books and records to an electronic storage media, such as an optical disk, which allows books and records to be viewed or reproduced without the use of the original program. Key requirements include

A taxpayer is not in compliance with the recordkeeping requirements under IRC 6001 (and associated regulations) if the taxpayer's electronic storage system fails to meet the requirements of Rev. Proc. 97-22, and a Notice of Inadequate Records pursuant to Treas. Reg. 1.6001-1(d) should be issued. See IRM 4.10.8.16, Inadequate Records Notices: Overview, for complete discussion of Notices of Inadequate Records.

Banks and other financial institutions that previously maintained account information such as signature cards, loan applications, and account activity in hard copy may now do so electronically. There are online banks that only do business on the Internet. Taxpayers can maintain accounts with banks across the country or even overseas, rather than with banks in close proximity to the their physical location.

The Internet has resulted in new third party record keepers whose information may be of help in resolving tax issues. These new third party record keepers may be able to supply information regarding website ownership, related websites owned by the taxpayer, location of the business, contact information, and the taxpayer's bank accounts. Examples include:

Formal indirect methods and the techniques used to support their development are collectively known as "financial status audit techniques" and trigger IRC 7602(e), which states that "the Secretary shall not use financial status or economic reality examination techniques to determine the existence of unreported income of any taxpayer unless the Secretary has a reasonable indication that there is a likelihood of such unreported income."

"Financial Status Audit Technique" was defined as the use of formal indirect methods in the Government Accounting Offices's report, "More Criteria Needed on IRS' Use of Financial Status Audit Techniques," GAO/GGD-98-38.

"Examination techniques" include examining and testing the taxpayer's books and records, analytical tests, observing, and interviewing the taxpayer. None of these techniques are unique to the use of a formal indirect method and do not trigger the limitation of IRC 7602(e).

Examiners should adjust PLE based on information received during the interview and update the T-Account during the audit process. In developing the PLE for the T-Account, examiners should only use the PLE information that was made available through the minimum income probes.

Obtaining PLE information beyond the minimum income probes will likely trigger the limitation of IRC 7602(e). If there are indications of unreported income and you need to go beyond the minimum income probes, use a Financial Status Audit Technique and document your files with the reasons to support your use of the indirect method.

Form 4822, Statement of Annual Estimated Personal and Family Expenses, may be used as a guide by the examiner for determining the taxpayer's personal living expenses. The form lists the typical expenses incurred by most individuals. It is inappropriate to ask the taxpayer to complete the form independently.

Care should be taken to avoid duplicating amounts when modifying estimates for actual costs.

In certain cases, as described below, income may be reconstructed using Bureau of Labor Statistics (BLS) data or comparable statistics from a reliable source. The analysis is completed using the tables for annual expenses, not income, because determining the expenses represents a better reflection of the actual costs to maintain a household.

The BLS data can be accessed at www.bls.gov, select "Inflation and Consumer Spending." Tables specific to year, region within the United States, and individual expenses are available.

Statistical data cannot be used as a substitute for reconciling the taxpayer's books and records. If the taxpayer provides information, or information becomes available, which shows that income in a specific amount was earned, statistical data cannot be used to increase income to the national average.

In court proceedings involving individuals, IRC 7491(b) may shift the burden of proof. IRC 7491(b) provides that the Service will have the burden of proof for any item of income where income is reconstructed using only BLS data or other comparable statistical information on unrelated taxpayers.

The use of a formal indirect method to make the actual determination of tax liability should be considered when the factual development of the case leads the examiner to the conclusion that the taxpayer's tax return and supporting books and records do not accurately reflect the total taxable income received and the examiner has established a reasonable likelihood of unreported income.

The following list, which is not intended to be all inclusive, identifies circumstances that, individually or in combination, would support the use of a formal indirect method.

The selection of a formal indirect method is critical to effectively and efficiently determine the tax liability. For example, although the Bank Deposits and Cash Expenditures Method and the Source and Application of Funds Method are frequently used, they are not the most effective methods if cash is not deposited and/or the cash outlays cannot be determined unless voluntarily disclosed by the taxpayer. Realistically, it may be difficult to identify significant personal acquisitions or expenditure that the taxpayer has deliberately camouflaged. These weaknesses can be overcome by using a formal indirect method based on the taxpayer's business activities to make the actual determination of tax liability; i.e., the Markup Method or Unit and Volume Method.

The following factors should be considered when selecting a formal indirect method:

The reasons why the examination of income was expanded to include the use of a formal indirect method to make the actual determination of tax liability should be documented in the workpapers, as well as why a specific method was selected. Notations on the lead sheet is not sufficient. The documentation should include a narrative explaining how the evidence in the file establishes the likelihood of unreported income, and justifying the use of a formal indirect method. The documentation should include:

Document likely sources of taxable income. It is not essential to pinpoint the specific source, but only to indicate the possibility of, or the opportunity for, likely sources of taxable income. To the extent that the possible source(s) can be identified, the more credible the results of a formal indirect method will be. Possible sources can be demonstrated by:

The documentation should be prepared concurrent to the decision; i.e., before using a formal indirect method to make the actual determination of tax liability.

Group manager approval is not required when initiating the use of a formal indirect method, except for the Net Worth Method (see IRM 4.10.4.6.7.2 (2)).

The use of the Source and Application of Funds Method of proof in establishing unreported income received the Supreme Court’s approval in United States v. Johnson, 319 U.S. 503 (1943). In addition to proving the taxpayer owned gambling establishments whose winnings were unreported, it was proven that in three of the years involved, the taxpayer’s personal expenditures exceeded his current income plus his declared accumulated funds.

This method is based on the theory that any excess expense items (applications) over income items (sources) represent an understatement of taxable income.

The Source and Application of Funds Method is recommended in the following situations:

Sources of funds are the various ways the taxpayer acquires money during the year. Decreases in assets and increases in liabilities generate funds. Funds also come from taxable and nontaxable sources of income. Unreported sources of income even though known, are not listed in this computation since the purpose is to determine the amount of any unreported income. Specific items of income are denoted separately. Examples of sources of funds include:

Application of funds are ways the taxpayer used (or expended) money during the year. Examples of applications of funds include:

See Exhibit 4.10.4-10 for an example.

Since the results of this method are on a cash basis, adjustments must be made for an accrual basis taxpayer. Accounts receivable at the beginning of the period examined are shown on the debit side, as they are presumed to be collected during the period. Ending accounts receivables are a credit adjustment, required to effect a non-cash increase in income.

Accounts payable are shown as adjustments in the reverse order of accounts receivables. Beginning accounts payable are a credit adjustment having the result of increasing income and transferring a current period cash expenditure to the prior period in which it was incurred and deductible under the accrual method. Conversely, ending accounts payable balances are a debit adjustment having the effect of reducing income to result in a non-cash reduction of income.

See Exhibit 4.10.4-10.

The classic bank deposits case is Gleckman v. United States, 80 F.2d 394 (8th Cir. 1935). The court held that standing alone bank deposits and large items of receipts do not prove additional tax due. On the other hand, if it is shown that these amounts can be associated with a business or income-producing activity, then the income is taxable. Since the Gleckman case, the Bank Deposits Method has received consistent judicial approval.

The Gleckman case, and the cases that followed, taught that in order to use the Bank Deposits and Cash Expenditures Method in determining income, it must be shown that:

The Bank Deposits and Cash Expenditures Method should not be the automatic choice when selecting a formal indirect method. For example, cash intensive businesses, where significant amounts of gross receipts are not deposited and numerous cash outlays occur, do not lend themselves to this method.

If the Bank Deposits and Cash Expenditures Method is the method of choice, the entire analysis must be completed; shortened versions that do not account for business and personal cash expenditures are insufficient.

The Bank Deposits and Cash Expenditures Method is recommended when:

The advantages of the Bank Deposits and Cash Expenditures Method include:

Total deposits include amounts deposited from both taxable and nontaxable sources to all bank accounts (both business and personal) maintained or controlled by the taxpayer, as well as deposits made to accounts in savings and loan companies, investment trusts, brokerage houses, credit unions, and other financial institutions.

Gross receipts represents the total or gross taxable receipts of the taxpayer during the year from all sources, not reduced by returned sales and allowances, cost of goods sold, basis, or expenses. gross receipts, or gross business receipts, can be determined by computing the sum of the three items listed below and deducting nontaxable and/or nonbusiness receipts, duplicated deposits, etc.

Gross receipts includes, but is not limited to the following:

Gross receipts does not include nontaxable income, such as, but not limited to, gifts, inheritances, loan proceeds, transfers between accounts, checks to cash redeposited, tax exempt interest, insurance proceeds, and federal tax refunds.

Are there any unusual or extraneous deposits which appear unlikely to have resulted from reported sources of income?

Are there any loan proceeds, collection of loans, or extraneous items reflected in deposits? In the analysis of bank deposits, the examiner should identify all items of this nature. This is a necessary step before comparing receipts to deposits.

Are there transfers between bank accounts or redeposits?

Are there personal or nonbusiness bank accounts?

Are the deposits in personal and business accounts, as adjusted, during short periods of time, accounted for by the records?

The Bank Deposits and Cash Expenditures Method is used to determine gross receipts from all sources; i.e., it is not limited to consideration of business receipts and it is not necessary to audit or verify expenses deducted on the return. The basic formula for computing the understatement of taxable income is outlined here. An example is shown in Exhibit 4.10.4-9, The Bank Deposits and Cash Expenditures Method. Also, see the example of computation of gross receipts below:

The Bank Deposits and Cash Expenditures Method does not account for non-cash expenses claimed on the tax return that do not represent a current outlay of funds. Examples include depreciation, depletion, bad debts, and inventory. Therefore, these expenses should be separately considered and specific item adjustments made if necessary. For example, if the bank deposit computation revealed an adjustment of $5,000 and depreciation claimed was found to be overstated in the amount of $1,000, there would be two adjustments:

In United States v. Fior D'Italia, Inc., 536 U.S. 238 (2002), the majority held that IRC 446(b) does not limit authority to use aggregate estimation of income taxes (unreported tip income).

In Barragan v. Commissioner, T.C.M. 1993-92, the Service properly determined gross receipts from a gas station based on the supplier's delivery records and the retail prices per an independent market survey. Similarly, in Stafford v. Commissioner, T.C.M. 1992-637, the Service properly determined gross receipts from gas stations based on Bureau of Labor Statistics data.

In Nichols v. Commissioner, T.C.M. 1983-242, the Service was upheld in applying an established tip rate to the taxpayer's gross receipts to determine unreported tip income.

In Webb v. Commissioner, 394 F.2d 366, 371-372 (5th Cir. 1966), aff'g T.C.M. 1966-81, the government determined Webb's income from liquor sales using the Markup Method.

It was held in the Estate of Bernstein v. Commissioner, T.C.M. 1956-260, that the inability to use other "formal" indirect methods is not prerequisite for using a percentage method.

In the case of Yorkville Live Poultry Co. v. Commissioner, 18 BTA 47 (1929), the Board of Tax Appeals approved a net income computation based upon four percent of the net sales where no books were available.

The Markup Method is recommended in the following situations:

This method is effective for industries such as liquor stores, taverns, gasoline retailers, restaurants, and jewelry stores.

Examiners should address the following issues when applying the Markup Method:

The gross profit to sales ratio indicates the average markup on products. The calculation divides the gross profit margin (sales less cost of goods sold) by total sales:

Example: A taxpayer sells two products, A and B, and reports $140,000 in gross sales. The costs for product A are $50,000 and the costs for product B are $80,000. The costs are verified with the third party supplier and adjusted for opening and closing inventory.

Using the cost of sales to gross receipts ratio is a variation of the gross profit margin to sales ratio. It also is a comparison of costs to sales.

In Salami v. Commissioner, T.C.M. 1997-347, the court held that a cab driver's gross income could be determined using claimed gas expenses, price per gallon, miles per gallon, occupancy rates, etc. Same for the cab driver in Irby v. Commissioner, T.C.M. 1981-399.

In Maltese v. Commissioner, T.C.M. 1988-322, the Service was upheld in determining gross income by determining the number of pizza crusts per 100 pounds of flour times the average price per pizza.

In Stanoch v. Commissioner, T.C.M. 1959-132, the Service established gross receipts for a tavern by allowing a specific measurement of liquor per drink and a percentage for spillage.

The Unit and Volume Method is recommended for making the actual determination of tax liability when:

Examiners should be aware of the following when considering the Unit and Volume Method:

This example is for a coin operated laundry, where the known unit is the amount of water needed for each unit of sale (load of laundry). Per the utility bills, the taxpayer consumed 3,000,000 gallons of water.

The price per dryer load is $1.50. Based on observations on different days of the week, the examiner determines that customers' use of dryers is 75% of their wash loads. The price per dryer load is $1.50. Therefore, the gross receipts for dryer use is .75(109,259) x $1.50 = $122,916.

Summarize the gross receipts for all the services and compare to the gross receipts reported on the tax return.

The Net Worth Method is a very old method of determining income. See United States v. Frost, 25 F.Cas. 1221 (N.D. Ill. 1869). The first criminal case involving the Net Worth Method was United States v. Beard, 222 F.2d 84 (4th Cir. 1955), which involved delinquent returns.

The use of the Net Worth Method of proof has been approved by the Supreme Court in: Holland v. United States, 348 U.S. 121 (1954). Holland set forth the following requirements that the government must meet when using the Net Worth Method:

The Net Worth Method is generally recommended in the following situations:

The Net Worth Method should be used only if:

The fact that the taxpayer’s books and records accurately reflect the figures on a return does not prevent the use of the Net Worth Method of proof. The government can still look beyond the "self-serving declarations" in a taxpayer’s books and records and use any evidence available to determine whether the books accurately reflect the taxpayer's financial history.

While the Net Worth Method was originally used against taxpayers whose principal source of income was from an illegal activity, it is now regularly recommended in fraud cases, especially where significant changes in net worth have occurred and other methods of proof are insufficient.

In addition to being used as a primary means of proving taxable income so that an actual determination of tax liability can be made, the Net Worth Method is relied upon to corroborate other methods of proof and test the accuracy of reported taxable income.

The formula for computing income using the Net Worth Method is as follows:

A complete discussion of the computation for the Net Worth Method and associated audit techniques is included in IRM 9.5.9.5.4 through IRM 9.5.9.5.9.

An example of the Net Worth Method can be found at Exhibit 9.5.9-1, Net Worth Statement.

Bank Deposits and Cash Expenditures Method — Most challenges to the accuracy of this method focus on the nature of the individual deposits in the account(s). The taxpayer may claim that the deposits consist of taxable and nontaxable items that were not correctly classified by the examiner. Deposits of loan proceeds, gifts and inheritances, as well as transfers from other accounts are some of the most common claims. Redeposits of items, such as insufficient funds checks, may also cause inaccuracy if counted twice. The examiner should carefully review the analysis and attempt to identify the source and character of each deposit before presenting results as an understatement of taxable income.

Source and Application of Funds Method — Challenges are made to the adjustments for the accrual method of accounting and the handling of loan transactions; i.e., loan payments are an application of funds. Also, the taxpayer may claim that purchases, labor costs, materials and supplies, and other current period costs associated with inventory are an application of funds rather than the cost of goods sold.

Markup Method — The main challenges to this method are to show that the computation relies upon improper percentages, improper cost of sales, or that the examiner’s computation fails to give adequate consideration to significant items such as spillage, breakage, or theft losses. These issues should be addressed and quantified during the initial interview. Since the method relies on a comparison of a situation similar to that under examination, defenses could be formulated based on dissimilarities in several areas such as type of merchandise handled, size of the operation, locality, time period covered, or general merchandising policy.

The taxpayer may attempt to refute the findings of the examiner’s formal indirect method by claiming the unexplained difference is actually caused by the receipt of nontaxable sources of funds.

If it can be shown that all nontaxable sources of income have been considered, then it can be concluded that the only likely source remaining is a taxable one. Examiners need to show that increases in taxable income arose from a likely taxable source. This can be demonstrated by specific omissions, showing the taxpayer’s business had the capacity to generate more sales, or comparisons over time. To the extent that the possible source can be identified, the more acceptable the computation will be.

The taxpayer may attempt to refute the findings of the examiner’s formal indirect method by claiming the unexplained difference is actually caused by the use of nontaxable funds accumulated in prior years.

Since cash-on-hand and accumulated funds are important fundamental aspects of the examination of income and the formal indirect methods, examiners should establish the amount and verify the taxpayer’s statements of cash accumulations during the initial interview. This is necessary because:

In order to avoid any misunderstanding by the taxpayer, it is important that the meaning of cash-on-hand and accumulated funds be explained prior to answering any inquiry. Taxpayers must understand the term cash-on-hand means any undeposited currency and coins used for normal business transactions. Accumulated funds refers to cash accumulated by the taxpayer and is not associated with normal business practices and/or transactions with customers. The funds may have been taxed in prior years, originate from nontaxable sources, or may represent taxable income in the year under audit. Once the terms are understood, the examiner should inquire as to the existence of any cash-on-hand and accumulated funds. See Exhibit 4.10.4-1, Interview Questions Addressing Accumulated Funds.

If a taxpayer attempts to avoid answering questions concerning cash, examiners should try to pinpoint amounts by starting with an estimate such as "over or under $10,000" and narrowing the range until the taxpayer agrees with a general amount.

A commitment should be sought concerning whether an individual had any large accumulations of cash during the tax period under audit. Examiners should ask the taxpayer to make an affirmative statement regarding the existence or nonexistence of cash-on-hand and accumulated funds.

If taxpayers allege that they have what appears to be an inordinate amount of cash, the examiner should further inquire to establish:

Information regarding cash-on-hand and accumulated funds is necessary to establish the consistency and reliability of the taxpayer’s statement. Usually no direct corroborating evidence is available, but statements made about the source and use of the funds can be verified. Look for inconsistencies. For example:

A taxpayer’s explanation for cash-on-hand or accumulated funds may change during an examination. The examiner should document the information as it is received. The documentation should include when and where the information was received, who was present, what was said, and when the documentation was prepared; i.e., contemporaneously to the event.

The following procedures must be followed to protect SARs and SAR data: