To prove unreported income, the government might utilize the bank deposits method, which is an indirect method.
The bank deposits method relies on circumstantial evidence to show bank deposits that do not match with the individual’s reported income.
Bank Deposits Method Generally
Bank deposits are one of the primary methods the government uses to calculate taxable income. As an indirect method, circumstantial means are utilized to approximate unreported taxable income. This method focuses on deposits made to a bank, or similar, account in a tax year.
Through this method, all deposits to an individual’s bank and similar accounts in a single year are added to arrive at gross deposits. The government will attempt to identify non-taxable amounts, such as gifts, transfers of money between accounts, repayment of loans, and cash an individual had on hand for that year. When such non-taxable amounts are identified, if any, they are subtracted from the gross deposits figure, resulting in taxable bank deposits. Added to that figure are cash expenditures, not otherwise determined to be non-taxable, which is then deemed to be the gross income figure. The gross income is reduced by applicable deductions and exemptions. The resulting figure is determined to be “corrected taxable income.” That figure is then compared to the taxable income reported by the individual on their tax return.
The government may use the bank deposits method alone, or as corroboration for another method of proof.
Proving Taxable Income through Bank Deposits
To prove unreported taxable income through the bank deposits method, the government must:
- Show an individual had a business or income producing activity,
- Show regular deposits of funds were made into an individual’s accounts, or into accounts over which he had or exercised control,
- Show a full investigation of such accounts was made to determine income versus non-income deposits, and
- Show unidentified deposits have the characteristic appearance of income.
Business or Income Producing Activity
There is a large variety of income producing activities and proving an individual engaged in income producing activity in the tax year(s) in question is relatively easy through the bank deposits method.
Income producing activity can be legal, such as:
- medical doctor,
- politician, and
- retail store owner.
Or illegal, such as:
- bribery, and
- drug dealer.
Analysis of Deposits
The foundation for the bank deposits method is that an individual engaged in an income producing activity regularly making deposits to bank accounts. The government’s investigation of the bank account(s) in question will focus on establishing a relationship between deposits and the income producing activity. The government will attempt to determine the items comprising each deposit, cash and/or check(s) and amounts, based upon bank records, third party records, and, if available, admissions by the individual to establish taxable receipts.
During their investigation, the government will review all reasonably available items, such as:
- signature cards,
- bank statements,
- deposit slips,
- deposited items,
- check stubs,
- canceled checks,
- third party payments to individual, and
- business payments to individual.
The government is not required to confirm all or even a set percentage of an individual’s deposits as income items. The government need only show that during the year in question the individual was engaged in an income producing activity, funds having the appearance of income were regularly deposited to a bank account(s), and that everything fair and reasonable was done to identify and deduct any non-income items from their determination of the total taxable income.
Bank deposit cases will contain a combination of cash and check deposits. If currency deposits exist, then checks made to cash or to the individual that are subsequently cashed and cash withdrawals must be subtracted from the total amount of deposits. Due to the possibility of redeposit, if such actions are not subtracted there is a possibility for an overstated taxable income figure.
For example: An individual earned $30,000 in a year, which was deposited into their bank account in the form of $20,000 in checks and $10,000 in cash during that same year. If the individual wrote checks to cash totaling $8,000 and redeposited the cash into the bank account in that year, the amount of deposits would appear to total $38,000. Therefore, to ensure the $8,000 is not counted twice, it should be subtracted from the total, resulting in the correct figure of $30,000. If the individual wrote checks to cash in the amount of $2,500, then only $2,500 should be subtracted because $2,500 is the total amount of cash that could be redeposited. If the individual wrote checks to cash that total $13,000, and considering only $10,000 was deposited in cash, it is possible $3,000 could be redeposited in a subsequent year, which the government will have to take into account if they are not able to determine the individual expended the $3,000 in the current year.
If there are no cash deposits made in a year, then any withdrawn cash amounts do not have to be subtracted from the total deposit amount. If any cash deposits occurred prior to any cash withdrawals, the cash withdrawal amounts will not be subtracted from the total deposits. If cash withdrawals can be traced to specific uses, such as food, clothing, et cetera, then those cash withdrawal totals will not be subtracted from the total deposit amount, even if cash comprised part of the total deposits.
Missing or Partial Bank Records
It is not always possible to obtain complete bank records for a specific year. The effect of the incomplete records depends on the type of missing records and whether the government’s investigation/analysis can fill in any gaps. Courts have held incomplete bank records sufficient where the government has shown it conducted an exhaustive search to determine sources of deposits, possible duplications, and possible deductions to arrive at a total deposits amount.
Elimination of Non-Income Items
An acceptable and complete investigation of an individual’s accounts must be conducted to determine income versus non-income deposits to support unknown excesses in deposits as currently taxable income. However, the government is not obligated to refute every possible non-income source of each deposit, but does have the burden to prove it has done its best to determine and exclude all non-income items.
Proof of Non-Income Items
If the government uncovers proof that items are non-income deposits, it must provide the direct evidence it utilized for corroboration purposes.
Good Faith Errors
Any unreported income resulting from good faith accounting errors ( i.e., a mathematical error by a bookkeeper) will not be included in unreported income totals.
Any deposits that have not been identified as either income or non-income deposits are referred to as “unidentified deposits.” If the government can show through their investigation the unidentified deposits have the characteristic appearance of current income, such as substantial circumstantial evidence to support an illegal business, the amounts will be utilized in determining income totals. It is incumbent upon the individual to overcome logical inferences from the government’s investigation in support of unidentified deposits as current income. The government is not required to invalidate all possible non-income sources of the deposits.
The strength of the evidence supporting the connection of the deposits to an income-producing activity, the completeness of the government’s analysis of deposits and investigation will determine whether unidentified deposits are accepted as current receipts.
Bank Deposits and Undeposited Currency Expenditures
In some cases, an individual who is engaged in an income producing activity makes regular deposits to their bank account, but also makes cash expenditures utilizing cash that was not deposited to their bank account. In this event, in order to include these non-deposited cash amounts in the total taxable income figure, the government must prove the unreported cash came from taxable sources and must establish a cash on-hand at the start of the tax year in question to rule out nontaxable previously amassed currency.
Amount of Cash Expenditures
There are two methods for determining cash expenditure totals. One is direct proof of cash expenditures from undeposited funds discovered during the government’s investigation. The other is an indirect method of comparing known total expenses claimed on the tax return (e.g., business expenses) against checks written for expenses. The difference resulting from this comparison is attributed to cash payment for expenses. A consideration to this theory is if the individual had cash withdrawals from their bank account(s) in sufficient amounts to cover the cash payments.
For example: An individual claims business expenses of $25,000 on their tax return. Through the government’s investigation of the individual’s bank account(s) it is determined that only $15,000 in checks was written for business expenses, and no cash withdrawals were made. Therefore, it is reasoned the individual paid $10,000 in undeposited cash for business expenses. The $10,000 is then be added to the total taxable income.
Cash On Hand
Determination of opening net worth and cash on hand is not a requirement in bank deposit cases. However, whether cash on hand determination is needed depends on the case. If the bank deposits analysis does not include currency deposits or undeposited cash expenditures, then it is not necessary to establish cash on hand amount. However, in cases that have currency deposits and undeposited cash expenditures a beginning cash on hand amount must be established unless the government can prove any pre-existing cash on hand was not the foundation of the expenditures.
The government is not required to determine an exact amount of cash on hand, it only has to prove the cash on hand amount with reasonable confidence.
The government must investigate any reasonable, timely leads provided by the individual. However, the government is not required to hunt down every imaginable lead to establish the individual’s innocence.
Use of Summary Charts and Schedules
At the close of its case, the government will usually call an expert witness to summarize the evidence and present schedules of the bank deposits analysis. The summary charts are not evidence and are not submitted to the jury.
Sample Bank Deposits Calculation
Bank Deposits plus Cash Expenditures and Specific Items Not Deposited
2010 Tax Year
|Total Bank (Brokerage) Account Deposits||$100,600.00|
|Transfers from other accounts||$1,300.00|
|Redeposits (bad checks)||$400.00|
|Proceeds from borrowing (Loans)||$1,000.00|
|Proceeds from repayment of loan||$500.00|
|Other deposits – eliminated||$1,000.00|
|Specific Items of Income – Not Deposited||$5,300.00|
|Net Profit from Business||$88,000.00|
|Exemptions (4) x $2,650||$-10,600.00|
|Corrected Taxable Income||$72,400.00|
|Taxable Income per return||-$41,000.00|
|Unreported Taxable Income||$31,400.00|
* Generally determined from tax return filed. However, if investigation establishes amounts greater than those claimed on return(s) the larger amounts are used for criminal computation purposes.