Methods to the Madness: Calculating Tax Deficiency

In a criminal tax case, the government has the burden to show the defendant violated one of the statutes under Title 26 of the United States Code.   In meeting that burden, the government will attempt to show a tax deficiency for the tax years in question.  This deficiency will be at the center of each criminal tax case.  It is the backbone to most criminal tax defenses and the starting point for all criminal tax sentencing.

The government has various methods to show a deficient tax payment.  However, those methods are well known by attorneys who practice in this area, and most IRS-CID (Criminal Investigation Division) agents will advise the defendant’s counsel which method they are using to arrive at their final numbers.  There are two large umbrella categories for proving a tax deficiency: 1) Specific Items (Direct Method of Proof) and 2) Indirect Methods of Proof.  This article will dive into these two major areas and discuss the potential defenses, or flaws, in each system.

Specific Items (Direct Proof)

The specific items method functions exactly as it sounds.  The government looks for a specific item of income which has not been reported, or has been under reported, on the filer’s tax return.  Also included in this method are specific deductions which are fictitious or inaccurate.

If a tax payer sells $1 million dollars of stock in 2018, and shows a capital gain of $800,000, the tax payer should include this specific item of income on the tax return for that year.  If the stock was held for over one year, the $800,000 would be taxed at the long-term capital gains rate (currently 20%).  If the item was not included on the return, the government has evidence that a) a false return was filed and b) a tax deficiency of $160,000 ($800,000 X 20%) has occurred.  The same method would apply to a person who only reported $500,000 in capital gains on their return.

Another common specific item is the use of fictitious deductions or overstating valid deductions.  If a tax payer takes a deduction for $400,000 for a charitable donation, and after investigation it is learned the charitable deduction was not made (or not made in the correct tax year), the government has a specific transaction which leads to a false filing and a tax deficiency.  The tax payers’ debt to the IRS would increase absent the false or fictitious deduction.  This same theory holds true if a tax payer makes a $400,000 deduction for a charitable donation when in fact the donation was for $150,000.

The specific item method of proof is the easiest way for the government to prove elements of the indicted offense and a tax deficiency.  However, that does not mean the defendant is without a defense.  The criminal tax statutes under Title 26 require the government to prove a willful violation.  This means they must prove the defendant knew of the legal duty under the tax code, and intentionally failed to perform.  If the tax payer had an honestly held belief the tax provisions required the action that was taken, a defense to the charges exists under the logic in Cheek v. United States.  The good faith defense is covered in detail in a previous post.

The specific items method is by no means bullet proof.  The government is often prone to taking a specific item and sidestepping other legitimate deductions or business expenses which change the tax deficiency.  For instance, if a business is using a software for all incoming payments, the government may view the total software payments, compare it to the return, and assume there is a tax deficiency and false return.  However, if those software payments are used to pay for materials for the business or pay for contract labor, the software payments are not appropriately classified as income for tax purposes.  The method is too simple to paint a complete picture of the tax deficiency.  For example, if the system shows $500,000 in payments and the tax filer shows $150,000 in income for that year, the government will assume the income was understated by $350,000.  The tax filer should have itemized the deductions for the business to paint this picture clearly in their 1040 or business return, but not every tax filer is fluent in the code.  And many filers use tax preparers with little training to file their returns.  If the reality is $350,000 was put back into the business to pay contract employees, rent, marketing costs, and other valid business expenditures then the $150,000 in income is accurate.  Though the return is sloppy, it does not understate income and there is no tax deficiency for that year.  In this situation, it is unlikely DOJ will pursue criminal charges even with the return irregularities.

Indirect Methods of Proof

The indirect methods of proof require more work for the government and are more prone to false assumptions and accounting errors.  The main methods under this section are: 1) Net Worth Analysis, 2) Expenditures Method, and 3) Bank Deposits Method.  Each method has its own unique formula with potential areas of weakness for a criminal tax attorney to exploit.

Net Worth Analysis

When the tax payer does not have adequate accounting or bank records, the government will try to reconstruct earnings through establishing their net worth.  This method requires the government to determine the tax payer’s net worth at the beginning of the taxable year and subtract that number from the tax payer’s net worth at the year’s end.

This method is difficult to perform on many tax payers.  The government needs a full view of the tax payer’s financial profile to determine both the starting and ending numbers in the equation.   Further issues arise when the government attempts to prove the origins for the increase in net worth.  If the tax payer’s net worth is $5,000,000 at the start of the year and $5,350,000 at years end, the government will assume $350,000 in income over the taxable year.  However, that increase could be from a non-taxable source such as a gift or inheritance.  The government uses this method as indirect proof often alongside other facts to suggest a tax deficiency.

Expenditures Method

The expenditures method requires the government to track a tax payer’s purchase of goods and services throughout the year.  They take this number and attempt to extract the dollar value of goods and services which could have been made with resources available from a previous year or from non-taxable income.  Again, this method requires a thorough review of the assets and financial status of a tax payer.

Under this method, the government will attempt to prove an opening net worth to show the tax payer could not have used existing resources to purchase particular goods and services.  The next step is to prove the expenditure was not a result of nontaxable income sources or a proper business deduction.    For example, let’s assume a tax payer is worth $500,000 at the beginning of the year, and they purchase a yacht for $2,500,000 in June of the tax year. Unless a large income is reported in that year, the government will assume the tax filer has under reported their income.  The only missing step is to establish the money was taxable income by excluding non-taxable sources.

Banks Deposits Method

The bank deposits method is often how small business owners, and sole proprietors, determine their own tax liability at the end of the year.  This method is simple and can be very effective.  The government will construct a tax payer’s earnings by adding up all deposits into any account for the taxable year.  The agent will then attempt to parse out gifts, transfers between accounts, redeposits of cash previously withdrawn or any other non-taxable deposits.  This total number will be considered income for the year.  The government can then compare that number to the tax payer’s filings to see if there is a discrepancy.

This method can be very accurate if the government is aware of the source of each payment.  Often, the government will lump non-taxable money into the overall number based on a lack of knowledge about the origins of the payments.  It is important for anyone under investigation to hire competent counsel who can undertake this accounting and formulate accurate numbers for the government’s review.  There are times when the tax deficiency in the real numbers is so disparate from the government’s initial impression that an investigation is steered away from the criminal division.

Wrap Up – Criminal Tax Implications

It is important for counsel to obtain as much information as they can from the IRS-CID agent early in the process.  Normally, the agent will advise which method is being used, or at least provide enough information to allow counsel to figure it out.   If the agent discusses a huge purchase, there is probably a specific item or net worth analysis being done.  If the agent subpoenas bank records from the client, it is a good bet they will be reviewing bank deposits.  These methods are not exclusive.  The government may incorporate aspects of each method is building the most effective case possible.  However, a good understanding of how the IRS goes about their business is necessary in reading the tea leaves early in the case, and ultimately challenging their numbers later.

Tax loss is such a huge part of every criminal tax case.  The tax loss is crucial in determining the strength of the government’s case at trial, fine tuning the effectiveness of a defense, and pinpointing the appropriate sentence under the sentencing guidelines.  It can also be the difference between criminal litigation and steering the case back to the IRS-Civil Division.  Understanding the methods of proof is a central focus in likely the most important part of handling any criminal tax matter.

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