One of the first thing an IRS examiner will do is to verify that all taxable income is reported on a tax return. One of the methods used is to examine the taxpayer's bank account(s). The examiner will request all bank statements for the year under audit via the information document request (IDR).
The examiner will then prepare a spreadsheet of all deposits made and arrive at a total. He or she will then calculate all income reported on the tax return and arrive at a total.
If there are any discrepancies such as the total bank deposits are greater than the income stated on the tax return, an adjustment could be made to the tax return as an addition to income, if there is no proper response such as a loan was obtained, a gift from a relative, and so on.
Make sure to prepare for the "Bank Deposit Analysis" before the audit!
Example:
John and Mary Doe's 2008 tax return, "Form 1040" is under audit. John is self employed as a gardner and Mary is a secretary at the local high school. John reported $50,000 as gross receipts on his Schedule "C". Mary's take home pay after deductions for the entire year was $18,000.
We would assume that John and Mary deposit all of the income received in their bank account arriving at 50,000+18,000= $68,000 of total deposits.
Here is an example of the report presented to the IRS examiner:
John and Mary Doe
2008 - 1040
Income
Per Return: 68,000
Per Audit: 73,000
Adjustment: $0
Issue: Was all income reported on taxpayer's 1040 for tax year 2008 per IRC Section 61?
Facts: John and Mary filed a joint return in 2008. John is self employed as a gardner and reported $50,000 in gross receipts on his schedule "C" of the 1040 tax return.
Mary is employed as a secretary and her take home pay for the year was $18,000. Both Mary and John received $68,000 for the year. John and Mary use only one bank account.
Deposits Per Bank Statements
January |
5667 |
February |
5667 |
March |
5667 |
April |
5667 |
May |
5667 |
June |
5667 |
July |
5667 |
August |
5667 |
September |
5667 |
October |
5667 |
November |
5667 |
December |
10,667 |
|
|
Total: |
73,004 |
Taxpayers have a discrepancy of 73,000-68,000 = $5000
Rule of Law: IRC Section 61 states that "Except as otherwise provided in this subtitle, gross income means all income from whatever source derived, including (but not limited to) the following items...........Estate or a trust |
Argument: Taxpayers state that the $5,000 of unreported income on their return was a gift from Mary's mother.
Taxpayers presented the actual cancelled check from Mary's mother bank account and a statement from her stating it was a gift.
Conclusion: The additional $5,000 deposited doesn't have to be included on the tax return and no adjustments are made.
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The previous example is what I call an "IFRAC". Issues, Facts, Rule of Law, Arguments, and Conclusion. Practice it. It is very important especially if you and the examiner don't agree and you appeal the examiner's decision. The only thing that will be missing would be under arguments and that is "Government Argues" as you'll study under "IRS Appeals".
Important Issue
Aside from the bank deposit analysis mentioned above, examiners of tax returns would probe for what we call "Economic Reality". Let us assume that John and Mary reported $68,000 on the tax return but their mortgage payments for the year were $70,000. How did they live? They had car payments, insurance, food, supplies, and so on. Make sure to examine the tax return before the audit for economic reality and find answers before the audit!!!! The answer could be as simple as a past inheritance or a loan.