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Proving Income

To prove unreported income, the government will utilize one or more of the following methods: specific items, net worth, expenditures/cash, or bank records.

Expenditures Method

Through the expenditures method, the government will look for spending that exceeds an individual’s reported taxable income in a specific tax year. If the expenditures exceed reported taxable income in a tax year, the excess is suspected to be unreported income. The expenditures method is utilized in cases where an individual spends money on consumables (items that do not increase net worth), such as travel, entertainment, food, drink, hobbies, et cetera, but not on assets (items that increase net worth), such as stocks and real estate.

Requirements of Proof

General requirements for proving an expenditures case are:

  1. The government must show an opening net worth for the specific tax year.
  2. The government must show the expenditures were not deductible.
  3. The government must show a likely source of income from which the expenditures were made, or disprove non-taxable sources of income.
  4. The government must investigate all reasonable leads as to the source of the income.

Cash Method

A variation on the expenditures method is the cash method. This method focuses on an individual’s cash expenditures, against their known cash sources, including cash on hand, for a specific tax year. If cash expenditures exceed the individual’s known cash sources, the excess is suspected to be unreported income.

Opening Net Worth

In an expenditures case, the government is not required to present a formal net worth statement; they need only show an opening net worth with reasonable certainty. In calculating an opening net worth, the government must consider an individual’s cash on hand at the start of the taxable period and/or the possibility of the sale of assets, such as liquidation of a retirement account, on hand for cash during the taxable period.

Another consideration for the government is to determine if the individual utilized previously accumulated funds, also known as a cash hoard, to make the expenditures in question.

Deductible Expenses

The government must show the expenditures in question were not deductible to the individual/entity. Allowable deductions, which are set forth under internal revenue laws, vary and are determined on an individual by individual, business by business basis.

Likely Source of Income

The government must prove the likely source of taxable income or disprove that expenditures (or increases in net worth) were made through non-taxable sources of income.

  • Possible sources of non-taxable income include:
  • Proceeds from a loan,
  • Disability insurance payments,
  • Monetary gifts,
  • Life insurance payouts,
  • Sale of principal residence, and
  • Inheritance.

Investigation into Possible Income Sources

While the government is expected to perform an investigation into income sources, they are not expected to conduct an exhaustive search.