Specific Items Method of Proving Income
To prove unreported income, the government could use the specific items method, which is a direct method.
The specific items method focuses on specific financial transactions to support unreported or underreported income. In contrast the indirect methods rely on circumstantial evidence to show increases in net worth, bank deposits, or cash expenditures that do not match with the individual’s reported income.
Specific Items Method
The specific items method centers on direct evidence of income received by an individual in a tax year, which can include records and/or testimony by third parties as to money paid to the individual for goods or services. The goal of the specific items method is to show an individual earned more income than he or she reported on his or her tax return, or the individual included overstated or nonexistent deductions, credits, or credits on the tax return.
There are four common theories in specific items cases:
1. total amount of income received is more than amount reported;
2. items of income were not reported,
3. a business or other source of income was not reported, and
4. deductions or expenses that were false or overstated.
Proof in Specific Items Cases
There are four steps to establishing a specific items case of unreported or underreported income:
1. Showing the underreported/unreported amounts are taxable income to the individual,
2. Showing the income was received by the individual,
3. Showing the income was not reported, and
4. Showing the individual’s personal involvement in the failure to report the income.
In unreported/underreported income cases the individual received more income than he or she reported on his or her return and/or the individual did not report all items of income on the return.
To establish the underreported or unreported income, the government may use an individual’s admissions, witness testimony, books and records, information returns, and bank records. Testimony of office staff, including bookkeeper, office manager, secretary, return preparer, or accountant may be used to prove:
- receipt/deposit of income procedures,
- whether anyone was given any specific instructions to hide income,
- whether complete information was provided to prepare returns, and
- if any admissions/statements were made about avoiding taxes.
The government may also use client testimony to establish total amounts paid, versus what was reported on the tax return.
Witness testimony to support unreported/underreported income is not always feasible, such as in situations where customers number in the thousands. In such cases, the government will look to the books and records of the business and/or information returns.
Unreported income may include legal sources, such as:
- Capital gains or taxable interest,
- Commission checks,
- Rental income,
- Business income, and
- Income diverted from business.
Or illegal sources:
- Graft payments,
- Extortion, and
Failure to Report Business or Source of Income
The specific items method can be utilized when an individual receives and does not report income from a business during a tax year to show the individual either filed a false return or failed to file the required return. Failure to attach Schedule C is considered a false statement, not an omission.
The government must show the individual operated a business and the business had sufficient gross income to warrant the filing of an income tax return. Gross income is determined through total receipts reduced by cost of goods sold and other costs.
Should the government uncover exculpatory information during its investigation of the case, it must consider any such deductions or offsets when calculating the unreported/underreported income amount.
If the government arrives at a gross income figure that is sufficient to require the filing of an income tax return, it is the burden of the individual to establish offsetting expenses or deductions to disprove the government’s gross income figure. In specific items cases the government does not have the burden to follow reasonable leads, as is required in indirect method cases.
If an individual comes up with offsetting costs or expenses, the government has the burden of establishing whether or not the expenses were allowable or insufficient to reduce the gross income level below the filing requirement.
In the case of filing a false return, evidence as to offsetting costs and expenses would not go to materiality, but to lack of intent.
Overstated Deductions or Expenses
Cases of overstated deductions or expenses fall within two categories: the individual/entity was not entitled to the deduction/expense or the deduction/expense was overstated.
For example: An individual causes their personal expenses to be paid for by the company and then causes those personal expenses to be improperly deducted as business expenses on the corporate tax return. The result is an understatement of taxable income on both the corporate and personal return.
Examples of overstated deductions include:
- Overstated costs for business supplies/expenses,
- Improper deduction of foreign subsidiary expenses,
- Capital expenditures improperly deducted as operating expenses,
- False partnership deductions, and
- Corporate dividends falsely expensed as commissions.
Return preparers comprise a large category of specific items cases involving false deductions/expenses. These claimed deductions or expenses may be completely false, such as fictitious dependents and often include false child care credits, Schedule C business expenses, and charitable deductions.
The government will search for admissions made by an individual as to their income, such as statements to a spouse, friends, or co-workers about avoiding taxes on income, et cetera. Additionally, the individual may leave a paper trail of admissions through financial statements to lenders, credit card applications, loans applications, et cetera. The government will also use admissions made on “dummy” returns, delinquently filed returns, and timely filed returns.
Returns submitted to a lender in support of a credit application, but not submitted to the IRS, also known as dummy returns, may be used by the government to support willfulness.
A delinquently filed return can be used as an admission by an individual, only if the government corroborates the information contained on the return by independent evidence.
Timely Filed Returns
Where an individual has timely filed his or her tax return, the government can take the income amount reported thereon as an admission to the total income received in that year. Similarly, any deductions and expenses claimed on a timely filed return are admissions that support a prima facie case. These constitute pre-offense admissions and do not require corroboration.
Method of Accounting
The government must utilize the same method of accounting as the defendant to determine the taxable income for each year, whether it be cash, accrual, or some hybrid. The defendant cannot change their accounting method for the year(s) under indictment for trial purposes.
Multiple Methods of Proof
The specific items method of proving unreported/underreported income may be substantiated by indirect proof, such as net worth, bank deposits, or expenditures methods or a combination thereof. Additionally, the government may utilize specific items for one tax year(s) and indirect proof for another tax year(s) in the same indictment.