Underreported income refers to the difference between the amount of income that a person or business reports to the Internal Revenue Service (IRS) and the amount that they actually earned. The IRS uses various methods to detect underreported income and establish the correct amount of tax liability. One of the main methods used by the IRS to establish underreported income is the direct method, which involves reviewing the taxpayer's financial records and comparing their transactions to what was reported on their tax return(s). If records are missing or incomplete, the IRS may use indirect methods to estimate the taxpayer's income. Indirect methods used by the IRS include the bank deposit method, net worth method, expenditures method, and percentage markup method. The bank deposit method assumes that all unexplained deposits to a taxpayer's bank account(s) during a certain period of time are considered taxable income, while the net worth method calculates taxable income by determining the net worth of the taxpayer at the start and end of a period and subtracting the end-of-period net worth from the start-of-period net worth. The percentage markup method involves determining the gross profit margin of a business and then applying that percentage to the cost of goods sold to determine taxable income, while the expenditures method relies on the theory that if a taxpayer's expenditures during a certain period exceed their reported income, the expenditures represent unreported income. In situations where indirect methods are used to determine tax liability, the burden of proof is usually on the taxpayer. The IRS must make a “determination” as to the correct tax liability and cannot solely rely on third-party reports. For example, in Portillo v. Commissioner, the court ruled that the IRS failed to establish a clear relationship between the determination and the taxpayer and rejected the IRS's assessment as it was only based on a Form 1099 without additional effort to verify the taxpayer's denial. In conclusion, underreported income is a serious issue that the IRS takes seriously, and it is important for taxpayers to accurately report all of their income to avoid penalties and fines. The IRS uses a variety of methods to establish underreported income, and it is important for taxpayers to understand these methods to ensure that they are in compliance with tax laws and regulations.

1. Kreig Mitchell JD LLM
IRS Methods for Identifying
Underreported Income

2. Kreig Mitchell JD LLM
Krieg D. Mitchell is an attorney based in Houston,
Texas. He has extensive experience in the tax field,
having worked as an attorney and appeals officer for
the IRS, as well as in the tax departments of two
Fortune 500 companies, a Big Four accounting firm,
and a tax consulting firm. He has also managed a tax
law firm.
Kreig D. Mitchell
https://mitchelltaxlaw.com

3. Underreported Income
The term “underreported income” is an income tax concept.
It refers to the difference between the amount of income a person or business
reports to the IRS and the amount they actually earned.
The IRS use various methods to detect underreported income.

4. Methods for Establishing Underreported Income
The IRS has two types of methods for identifying underreported income:
1. Direct method
2. Indirect method
The direct method involves reviewing the taxpayer's financial records and
comparing their transactions to what was reported on their tax return(s).
Indirect methods are often used when records are missing or incomplete. They are
methods to estimate income.

5. Indirect Methods for Establishing Income
Indirect methods the IRS uses for identifying unreported income involve gathering
evidence and estimating the amount of unreported income.
The most common indirect methods the IRS uses include the following methods:
1. Bank deposit
2. Net worth
3. Expenditures
4. Percentage markup
The bank deposit analysis is the most common method used by the IRS.
The percentage markup method is usually used in conjunction with other methods.

6. The Bank Deposit Method
The bank deposit method assumes that all unexplained deposits to a taxpayer's
bank account(s) during a certain period of time are considered taxable income.
From this starting point deposits that are known to be non-taxable (such as gifts,
transfers between accounts, etc.) are subtracted.
The accuracy of this method is highly dependent on the thoroughness of the IRS's
investigation, whether they identify all of the bank accounts, and the method they
use to exclude non-taxable deposits.

7. The Net Worth Method
The net worth method calculates taxable income by determining the net worth of
the taxpayer at the start and end of the period, subtracting the end-of-period net
worth from the start-of-period net worth, and adding any nondeductible expenditures
made during the period.
This calculation also takes into account any income or asset receipts from
nontaxable sources, such as gifts.
The accuracy of this method is highly dependent on the thoroughness of the IRS's
investigation and the method they use to allocate income among the years in the
period.

8. The Percentage Markup Method
The percentage markup method involves determining the gross profit margin of a
business and then applying that percentage to the cost of goods sold to determine
the taxable income.
This method is based on the premise that a reasonable profit margin should exist in
any business, and the IRS calculates taxable income by estimating the profit margin
and applying it to the cost of goods sold.
The accuracy of this method is highly dependent on the thoroughness of the IRS's
investigation, how the percentage is determined, and how the costs the percentage
is applied to are identified.

9. The Expenditures Method
The expenditures method relies on the theory that if a taxpayer's expenditures during a certain
period exceed their reported income, and the source of the funds used for the expenditures is
unknown, the expenditures represent unreported income.
This method starts with an evaluation of a taxpayer's net worth at the beginning of a period. If, by
the end of the period, their expenditures have exceeded the amount they reported as income and
their net worth is the same or has a known explanation for any difference, it may be concluded
that their tax return shows less income than they actually received.
The accuracy of this method is highly dependent on the thoroughness of the IRS's investigation,
how the net worth and expenditures are determined, and how nontaxable items are identified.

10. The Burden of Persuasion & Proof
Indirect methods for determining tax liability are often unreliable and are only
permitted if the taxpayer's records are insufficient to make a fair assessment.
In such cases, an indirect method can be used only if it provides a convincing and
reasonable estimate of the taxpayer's liability based on the specific circumstances.
If the IRS fails to properly conduct the analysis using a methodology that is not
suitable for the taxpayer, the court may reject it entirely or rule in favor of the
taxpayer, despite the fact that the burden of proof is usually on the taxpayer.

11. The IRS Has to Make a “Determination”
The IRS generally has the burden for underreported income; however, it can
usually meet this burden by performing an analysis and issuing a notice of
deficiency based on the analysis.
In Scar v. Commissioner, 814 F.2d 1363 (9th Cir. 1987), the court invalidated an
IRS notice of deficiency that disallowed a tax shelter loss as the IRS had issued
the notice without the benefit of the taxpayer's individual income tax return, the
IRS referred to the wrong tax shelter in the notice, and informed the taxpayer that
the IRS did not have the taxpayer's return. The court held that the IRS must make
a "determination" as to the correct tax liability which implies that the return has
been examined, where one has been filed.

12. IRS Cannot Solely Rely on Third Party Reports
In Portillo v. Commissioner, 932 F.2d 1128 (5th Cir. 1991), the taxpayer was
issued a Form 1099 by a third party that overreported the amount of income paid
to the taxpayer. The taxpayer denied receiving income beyond the amount
indicated on the checks received. The court found that the determination made by
the IRS was not credible as the IRS only relied on a Form 1099 without making
any additional effort to verify the taxpayer's denial. The court ruled that the IRS
failed to establish a clear relationship between the determination and the taxpayer
and such a “naked assessment” is not afforded a presumption of being correct.

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