| Income tax returns filed by taxpayers are often | | | | return. Similarly, the receipt of funds that are not |
| incorrect. Sometimes they are incorrect due to simple | | | | classified as funds subject to tax, should be reported in |
| mistakes, accidents, oversight, confusion, or | | | | the books and records of the business, but not |
| misunderstanding of the law. Sometimes they incorrect | | | | included on the income tax return. |
| due to gross negligence or reckless disregard of the | | | | In addition, under the accrual method of accounting for |
| law. And, sometimes they are incorrect because the | | | | expenses and earnings, some expense items may be |
| taxpayer willfully and knowingly intended them to be | | | | included on the income tax return even though no |
| incorrect in order to purposely pay less income tax. No | | | | actual expenditure was made, and some items may |
| matter what the reason, when incorrect returns are | | | | be included as income, even though no funds were |
| identified, they must be corrected, either immediately, or | | | | actually received. |
| after the conclusion of any criminal proceedings that | | | | If the taxpayer engages in specific financial |
| might be undertaken. | | | | transactions during the year that are required to be |
| When tax inspectors or investigators confront | | | | included within the summary of expenditures and |
| taxpayers to inquire why the income tax return is | | | | receipts, but are not, then the income tax return is |
| incorrect and seek their cooperation to rectify it, the | | | | incorrect. |
| taxpayer will either be cooperative or not. When the | | | | For example, if the taxpayer engages in a financial |
| taxpayer cooperates, it becomes much easier to | | | | transaction where he sells a product or service but |
| determine how much true income the taxpayer | | | | does not report the receipt as gross income or gross |
| earned, or which expenditures are truly allowable under | | | | revenue, then the income tax return is incorrect. |
| the law, in order to arrive at the correct amount of tax. | | | | Similarly, if a taxpayer includes on his income tax return |
| Cooperative taxpayers may provide their books and | | | | a financial transaction where funds were expended on |
| records or other documents, and assist the inspector | | | | a product or service that is not allowed to be |
| or investigator as he attempts to determine how much | | | | deducted under the tax law, the return is also incorrect. |
| additional income tax the taxpayer should pay. | | | | The income tax return is required by law to include all |
| When taxpayers do not cooperate, the inspector, or | | | | specific financial transactions related to determining a |
| investigator, can be confronted with a serious dilemma. | | | | profit of loss. When certain, specific transaction are not |
| How can they determine how much additional income | | | | included, the tax investigator must be able to identify |
| tax the taxpayer should pay, if any. They must resort | | | | which specific transactions were not included, and |
| to other methods to obtain the information necessary | | | | seek to gather evidence of the source and amounts |
| to calculate the true tax due from the taxpayer. | | | | required to be included. Identifying which specific |
| During a tax criminal investigation, the investigator is | | | | transactions were not properly reported is known as |
| required to identify the amount of income that is not | | | | the Specific Transaction Method. |
| reported on the income tax return, and also identify | | | | Other methods of re-calculating or reconstructing a |
| any expenditures that are on the income tax return | | | | taxpayer's true net profit or loss are based on the |
| that are not allowed by law to be included on the | | | | sum total, or aggregate of all transactions the |
| return. It is usually not possible to be exact in | | | | taxpayer engaged in during the year. These methods |
| determining the amount of income, nor is it necessary | | | | do not identify specific transactions of buying and |
| to identify the exact amount of unreported income. | | | | selling. Instead, the net profit is calculated or |
| The amount not reported must be substantial, in | | | | reconstructed based on the total of all expenditures |
| relation to the amount reported, if any. Small cases, | | | | made, or the total of all funds deposited into bank |
| where minor amounts of income are not reported, are | | | | accounts. |
| not the type of cases the tax investigator should | | | | One such method is known as the Net worth Method. |
| identify and investigate. The tax investigator should | | | | This method measures the increases in a taxpayer's |
| always be alert to major cases using the criteria, in | | | | net worth between years. Net worth is the amount of |
| order to identify and document the amount of income | | | | assets a taxpayer has accumulated that exceed the |
| that is not reported, or to identify expenditures not | | | | amount of liabilities he has accumulated. Increases in |
| allowed by law that have been deducted on the tax | | | | net worth are the result of the taxpayer spending |
| return, the investigator must identify and gather | | | | money to increase the amount of assets he has, or to |
| evidence. This is not an easy task. When taxpayers | | | | reduce the amount of debt he has. In addition, a |
| do not cooperate, it becomes a very difficult task. | | | | taxpayer's expenditures that have no lasting value, or |
| In the world of financial investigation, there are methods | | | | do not increase assets, such as expenditures for |
| and techniques available for the investigator to actually | | | | costly airline tickets for personal vacations, are |
| re-calculate or reconstruct the taxpayer's true income | | | | identified and added to his increase in net worth. |
| and expenses, even without his cooperation, or even | | | | The increase in net worth from one year to another is |
| without his books and records. In fact, as the tax | | | | compared to the amount of income reported on the |
| investigator enters the world of criminal justice, where | | | | income tax return. Increases greater than the amount |
| taxpayer engages in fraud, and could therefore could | | | | of income reported can be attributable to the taxpayer |
| face imprisonment, it is highly likely that taxpayers will | | | | failing to report all his income, because no one can |
| cooperate less. Therefore, the tax investigator must | | | | spend more than he earns. The excess is charged to |
| become skilled in the use of the techniques available to | | | | the taxpayer as unreported income. Of course, |
| re-calculate or reconstruct a taxpayer's income and | | | | adjustments must be made, as described in the text |
| expenses. | | | | that follows, for loans, gifts, inheritances, and other |
| However, before these methods are explained, the | | | | sources of funds that are not taxable. |
| investigator must fully understand what an income tax | | | | Another method is known as the Bank Deposit |
| return represents, and how it relates to the taxpayer's | | | | Method. This method compares the total amount of |
| books of account, commonly called books and | | | | funds deposited into all bank accounts during the year |
| records. The section that follows explains how the | | | | with the gross receipts reported by the taxpayer on |
| daily business activities of buying and selling relate to | | | | his income tax return. Bank deposits that exceed |
| an income tax return. Although this section may | | | | gross receipts are charged to the taxpayer as |
| appear to be elementary or basic, a review of the | | | | unreported income. Again, certain adjustments must be |
| nature of an income tax return will clarify the use of | | | | made, and other requirements must be met before the |
| the Specific Transaction Method of Reconstructing | | | | excess can be called unreported income. |
| Income, the most common and effective method | | | | The Specific Transaction Method is the most |
| available to reconstruct a taxpayer's income, when the | | | | commonly used method and the most easily |
| taxpayer does not cooperate. | | | | understood. |
| Income tax returns filed by taxpayers are required by | | | | All three methods, however, have one common |
| the Income Tax Law to contain a summary of all | | | | thread. All three require the tax investigator to follow |
| financial transactions the taxpayer engaged in during | | | | the flow of money, from one person to another. This is |
| the tax year. The summary should include all | | | | accomplished by following the paper trail that financial |
| transactions where the taxpayer incurred an expense | | | | transactions leave. When products are sold, goods are |
| or other deduction allowed by law through an outlay or | | | | purchased to be consumed in the course of business, |
| expenditure of funds. It should also include all | | | | or when services are provided, often based on a |
| transactions where the taxpayer received or | | | | contract, records generally exist that reflect the nature |
| otherwise earned money from selling a product or | | | | of the transaction, particularly if the amounts are large. |
| service. | | | | Such records include purchase orders, sales receipts, |
| In general, when the total of all transactions where | | | | inventory lists, invoices, deposit slips, bank statements, |
| funds were received exceed the total of all | | | | etc. By following the money, the tax investigators will |
| transactions where funds were expended, the | | | | encounter individuals who can become witnesses who |
| taxpayer has a net profit, which is the amount upon | | | | will ultimately produce the evidence the investigator |
| which the tax is based. When the total of all | | | | needs to document his case and establish the |
| transactions where funds were expended exceed the | | | | taxpayer committed a crime under the Income Tax |
| total of all transactions where funds were received, | | | | Law. |
| the taxpayer has incurred a net loss, and no tax is | | | | Smaller businesses may not maintain books and |
| required to be paid. | | | | records, which would increase the difficulty of |
| Of course, each specific expenditure must be | | | | addressing non-compliance. Other methods are |
| allowable under the law in order to be included on the | | | | available to address these types of taxpayers. One |
| income tax return, and each specific receipt of funds | | | | common method is to impose an annual license fee on |
| must be taxable under the law in order to be required | | | | small businesses, instead of requiring an income tax |
| to be reported on the income tax return. Expenditures | | | | return. Such a method greatly reduces the |
| incurred that are not allowable under the tax laws | | | | administrative burden necessary to collect a small sum |
| should still be reported in the taxpayer's books and | | | | of income tax. |
| records, but must not be included on the income tax | | | | |