When conducting an audit involving income tax returns, the IRS will almost always check for unreported income. The IRS has specific procedures for conducting this type of income verification.
This often involves a bank deposit analysis by the IRS agent. This type of analysis can be used to identify unreported income, but it can also result in nontaxable deposits being subject to income tax.
Disputes involving the IRS’s bank deposit analysis are common. We have touched on several of these disputes on this blog (such as this article on advances to third parties and this article on IRS use of third-party information), but we have not ever addressed the bank deposit method head-on. The recent Haghnazarzadeh v. Commissioner, No. 21-71390 (9th Cir. 2022), case provides an opportunity to do so.
Facts & Procedural History
This case involved an IRS audit that was later reviewed by the U.S. Tax Court. The taxpayers represented themselves at the trial.
Prior to the court case, the IRS auditor performed a bank deposit analysis and believed that there were some taxable deposits that were not reported on the taxpayers’ income tax returns for 2011 and 2012. This included $4,854,849 for the 2011 tax year and $1,868,212 for the 2012 tax year.
It appears that the tax court case was continued a few times, as the U.S. Tax Court issued its pretrial order several times. The pretrial order required the parties to submit a pretrial memorandum to the court and disclose any witnesses they intend to call at trial. The taxpayers did not comply with this requirement.
The U.S. Tax Court concluded that there was insufficient evidence showing that the unreported income was, well, unreported income. It also excluded the taxpayers’ accountant from testifying in the case. Presumably, the accountant would have been able to explain why the deposits into the bank account were not taxable.
About Unreported Income
IRS auditors are trained to perform income probes. This is the very first step in most small business audits.
There are three primary methods the IRS uses to identify unreported income:
- Lifestyle Method. The IRS may compare a taxpayer’s lifestyle with their reported income to determine if there is any unreported income.
- Networth Method. This method involves calculating an individual’s net worth at the beginning of a tax year and comparing it to the net worth at the end of the tax year. The difference between these two amounts is then used to estimate the individual’s income for the tax year.
- Bank Deposit Method. This method starts with the taxpayer’s bank and financial statements. The IRS agent adds up the deposits. This amount is compared to the amount of income reported on the applicable tax returns to see if the income is all reported.
The first two methods require more work and are easier challenged by taxpayers, so IRS agents tend to use the bank deposit method.
With the bank deposit method, the challenge is excluding non-taxable items. This can include transfers between accounts and then loans, rebates or refunds, gifts, etc. It can also include funds received as an intermediary conduit. The IRS agents will typically exclude transfers between accounts in performing this analysis, but they do not usually exclude loans, rebates or refunds, gifts, etc. as the IRS agent does not have sufficient information to do so. It is usually up to the taxpayer to go through the IRS’s analysis and identify these items.
This can be a complex task as the IRS agent may not provide a copy of the analysis unless requested and the analysis may be cryptic and difficult to understand. Additionally, the taxpayer may not have sufficient time to review the analysis before the audit is closed.
Who Has the Burden on Unreported Income
To understand unreported income, one has to start with the burden of establishing that there is unreported income.
Generally, taxpayers report their income and, if pulled for an audit, the IRS can propose to adjust the income. The IRS issues a notice of deficiency and, assuming the IRS actually did a minimally proper audit, the determination set out in the notice is presumed to be correct.
Not all numbers listed in the IRS’s notice are a “determination,” however. The courts have said that the IRS picking up income as reported on a Form 1099 by a third party and including it as income is not a “determination.” This is often referred to as a “naked assessment.” Naked assessments are not afforded a presumption of correctness if the taxpayer establishes that the assessment is arbitrary and erroneous. The burden shifts to the IRS to prove the correct amount of taxes owed.
Even absent third-party information, the burden may shift back to the IRS if the taxpayer presents credible evidence. This is provided for in Sec. 7491. This means that if the taxpayer meets the conditions set forth in the statute, the IRS would have to prove that the taxpayer’s position is incorrect, rather than the taxpayer having to prove that the IRS’s position is incorrect. To qualify for the burden shift under Section 7491, the taxpayer must have cooperated with the IRS in providing evidence and must have maintained all required records.
Unreported Income in This Case
This brings us back to this case. In the current case, the IRS performed a bank deposit analysis and the taxpayers’ attorney identified several items that were non-taxable. It does not appear that the case involved the IRS relying on third-party records to identify income.
At trial, the taxpayers did not present records. As such, they were not able to shift the burden back to the IRS under Sec. 7491.
It also appears that the taxpayers were not able to challenge the method the IRS used to perform the bank deposit analysis. This may have been due to their accountant being precluded from testifying at trial. The court case does not address this, but the accountant may have had an expert report that could have been admitted into evidence. While not ideal, this could might have been admissible as impeachment evidence even if it was not disclosed in the taxpayers’ pretrial memo.
The appeal filed by the taxpayers in this case is understandable. The income recognized by the IRS may very well have been nontaxable. They are probably 100% certain that the IRS is imposing tax when it should not. And given this case, the IRS got away with it.
This case emphasizes the significance of adhering to pre-trial directives and, particularly in cases of substantiation, having the necessary witnesses and records ready to be presented as evidence prior to the trial and disclosed in advance (most of these requirements are addressed in this overview of the tax court process). Cases like this may require substantial time and effort to prepare for trial. This case serves as a cautionary tale of the potential repercussions of failing to prepare for trial.