How Can the IRS Auditor Adjust My Income?
For the IRS to say that your income is more than you reported on your tax return, the IRS is first required to determine your tax liability. This starts by determining what your taxable income is.
Once the IRS makes a determination on audit and issues a notice of deficiency, the IRS’s determination is presumed to be correct. This is even true in the case of constructive dividends, i.e., payments from a closely held C corporation that were not actually paid to the shareholder-owner.
The notice of deficiency requirement is set out in Sec. 6212. Section 6212 just says that the notice has to notify you, the taxpayer, of the tax due, the type of tax and period involved, and the ability to bring suit to contest the assessment by filing a tax court petition.
The notice has to be sent to your last known address.
The courts have made it clear that the IRS’s determination will only be upheld if the IRS has some evidence supporting its determination. The Portillo v. Commissioner, 932 F.2d 1128 (5th Cir. 1991) case is a good example of this and well worth reading if you find yourself in this situation.
So how does the IRS determine what your income is?
IRS Methods for Determining Taxable Income
There are several methods the IRS uses to determine your income.
The IRS may use the cash method, percentage markup method, and unit and volume method for determining your income. These methods are not as common as the bank deposit analysis method and the net worth method, however.
The two primary methods are the bank deposit method and the net worth method, so we’ll focus on those.
The Bank Deposit Method
The bank deposit method focuses on your bank and other financial statements. The IRS agent will add up all deposits and eliminate any transfers between accounts. The assumption is that any deposit that is not a transfer is taxable income.
With the bank deposit method, the IRS agent will propose an adjustment by increasing your taxable income. It is then up to you to show which items are not taxable. Items that are not taxable include gifts, loans, inheritances, etc. You may also be holding funds that belong to another person and these amounts may need to be excluded.
The Net Worth Method
The net worth method focuses on your standard of living. The IRS agent will take your reasonable living and other expenses. Based on these expenses, the IRS agent will assume that your income was sufficient to pay these expenses.
With the net worth method, the IRS will propose an adjustment by increasing your taxable income. It is then up to you to show that the IRS’s method was not reasonable.
The courts have sanctioned the use of the net worth method. The courts have also not upheld the IRS’s determinations using the net worth method in various cases.
This is particularly true if the IRS did not account for cash on hand. The net worth method is generally not reliable if you are spending cash on hand.
The IRS also looks for any unreported items that would not show up on your bank records. Employer-provided fringe benefits are an example. The IRS usually discovers these items by checking information returns filed by third parties.
Help With IRS Audit Adjustments
We are experienced tax attorneys in Houston, Texas. We help clients with IRS adjustments.
If the IRS has audited your return and proposed adjustments to income, we want to hear from you.
Call us at (713) 909-4906 or schedule an appointment with our tax attorneys to discuss your IRS audit.
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