IRS and Bogus Income Issues

 

      Many people have no idea of the power of the IRS to reconstruct income.  There are many cases that uphold the IRS' right to do this.  In Cummings, Jr., 437 F2d 796, 71-1 USTC; 9192,27 AFTR2d 71-597 (5th Cir. 1971).   In Blanton, 94 TC 491 1990), the taxpayer was issued a notice of deficiency asserting unreported income in the amount received in connection with a criminal violation.  The court held for the IRS and the taxpayer was collaterally estopped from denying receipt of the funds.  Sometimes the individual wins.  In Stewart, 59 TCM 704, 90,264 P-H Memo TC (1990), the court ruled that the IRS reconstruction of drug profits was arbitrary and that the IRS failed to introduce evidence to support its income calculations.

 

      In Armstrong, 59 TCM 632, 90, 247 P-H Memo. TC (1990), the IRS reconstructed income using the bank-deposits and cash-expenditures method. The taxpayer and the IRS arrived at different determinations of income levels.  The court determined that an estimated profit margin of 40 percent was to be used to determine the cost of goods sold. 

 

      The IRS can also invent an income based on the net worth method.  In Manzoli, 904 F2d 101, 90-1 USTC; 50,290,66 ATR2d 90-5030 (1st Cir. 1990), the court upheld the IRS' determination of an income based on the net-worth increase in the assets of the individuals.  In Mazzoni, 451 F2d 197, 71-2 USTC; 9764,28 AFTR2d 71-6059 (3td Cir. 1971), the court affirmed the IRS' use of the net worth method.  In Kramer, 389 F2d 236, the IRS determined the individual's income using the net worth method.  The individual objected to the determination but the court ruled in favor of the IRS.  The IRS assessed deficiencies against an individual by using the net-worth method to reconstruct income.  The individual argued that since he had a complete set of records, the net-worth method should not have been used.  The court ruled in favor of the IRS and stated that the net-worth method will not be limited to situations where taxpayers' records are inadequate, fraud penalties were sustained.  See Ehlers, 382 F2d 58, 67-2 USTC; 9612,20 AFTR2d 5338 (8th Cir. 1997).

 

      In Steiner, 350 F2d 217, 65-2 USTC; 9550, 16 AFTR2d 5174 (7th Cir. 1965), the court upheld the net-worth method to reconstruct income even though all the transactions that were examined appeared on the taxpayer's books.

 

      The IRS can also use the bank deposits method of reconstructing income.  Many times when they use this approach, they simply claim that all deposits are income.  In Armes, 74-2 USTC Section 9543, 34 ATR2d 74-5583 (5th Cir. 1974), the Tax Court approved reconstructing a private investigator's income by means of the bank deposits and expenditures method.  In Marcello, 380 F2d 499, 19 AFTR2d 1700 (5th Cir. 1967), cert denied, 389 US 1044 (1968), the IRS reconstructed the taxpayer's income and the Tax Court held that the IRS' resort to the bank-deposit expenditure method was justified.  In Brown, 58 TCM 310, (1989), the Tax Court upheld a cash hoard argument.  The taxpayer argued that the deposits made into his bank account were not unreported income but resulted from gifts from his deceased father, a frugal lifestyle and minimal expenses.  The court held that the taxpayer's lifestyle enabled him to save a substantial amount of his wages and the father had the means of making the alleged gifts.  In Sullivan, 49 TCM 194, the Court ruled that the use of the bank-deposits method to reconstruct income as assess penalties was sustained since the taxpayer did not keep records of all income received. 

 

      Another favorite method the IRS uses to invent bogus income is the Bureau of Labor Statistics method.  In Denson, 44 TCM 275, the taxpayer refused to turn over his records so the IRS reconstructed his income using the Bureau of Labor Statistics tables. The IRS used the "higher standard of living" table and the taxpayer argued that his standard of living required reliance on the "intermediate standard of living" table.  The court ruled in the taxpayer's favor and ruled that his living standards were more applicable to an intermediate budget family. 

 

      In Wheeling, 43 TCM 1302, (1982), the court ruled that the IRS' method of reconstructing income was reasonable for a self-employed carpenter who did not file returns.  The IRS reconstructed his income based on the Bureau of Labor Statistics average for a family of four.  In Kindred, 39 TCM 490 aff'd 49 AFTR2d 82-582 (6th Cir 1982), the Court ruled that the IRS' method of reconstructing income was reasonable.  The IRS used the BLS averages for a family of five.  The taxpayer refused to comply and did not give any information to the IRS.

 

 

IRS Audit Cases

 

      The court ruled in Cardwell, 765 F2d 776, 85-2 USTC; 9528, 56 AFTR2d 85-5513 (9th Cir 1985), that fraud by IRS agents to gain consent to audit may make it invalid.  Any misrepresentation by the IRS, not only those related to prosecution, can make an audit invalid as an illegal search.

 

      The court ruled in Williams, 81-1 USTC; 9112, 47 AFTR2d 81-489 (6th Cir. 1980), that the taxpayer could assert Fifth Amendment objections only in response to specific questions or demands and that he could not take the Fifth Amendment to the audit process in general. 

 

      In Fensterwald, 553 F2d 231, 77-1 USTC; 9266, 41 AFTR2d 78-934 (DC Cir. 1977); the court ruled that the IRS must show reasons for selecting an individual for a Taxpayer Compliance Measurement Program Audit (TCMP).  This audit involves a complete review of every item on the return.  The court ruled that the IRS had to show by responding to the taxpayer's specific interrogatories, why he was chosen for a TCMP audit. 

 

      In Hicks, 62 TCM 1234, RIA TC Memo; 91,564 (1991), the court ruled that a consent form was invalid because the IRS and the taxpayers did not reach a mutual agreement when the consent form was signed. 

Failure to File Cases

 

      The IRS cannot impose both failure-to-file and fraud penalties. The IRS imposed a fraud penalty against taxpayers who repeatedly failed to file returns and was convicted of failure to file returns.  The court ruled that the fraud penalties were proper, but the IRS had to refund or credit a failure-to-file penalty that was also imposed.  Section 6653(d) prohibits the charging of both penalties.  See:  Acker, 519 F. Supp. 178, 48 AFTR2d 81-5403 (ND Ohio 1981).

 

      This case is of interest to those who have chosen to follow the suggestions in: Why No One is Required to File Tax Returns.  A taxpayer did not file a federal income tax return for 1988 until 1992 after receiving a notice of deficiency.  She did not offer evidence to prove that her failure was due to reasonable cause and not due to willful neglect.  The taxpayer argued that she was not liable for the addition to tax under Section 6651(a)(1), because adequate withholding satisfied the joint tax liability.  The IRS argued that the "amount required to be shown as tax on such return" is not reduced by withholding credits when applying the minimum addition to tax for extended failure to file.  The court ruled for the taxpayer. The court ruled that for the minimum penalty to apply, the congressional intent is that there must be an underpayment of tax.  The taxpayer did not have an underpayment of tax because the withholding credits exceeded the tax liability.

 

      The Tax Court has ruled that withholding was reduced for purposes of determining the late filing penalty. The court ruled in favor of the taxpayer and held that in computing the addition to tax, the amount of tax required to be shown on the return is reduced by the tax paid before the return was originally due.

 

      The district court has ruled that a taxpayer may protest when filing a federal tax return.  On April 15, 1992, a taxpayer filed a federal tax return for the year 1991 but he wrote the words "under protest" beneath his signature. Because of of the protest, the IRS refused to recognize that the individual had filed a return.  It treated the return as a nullity and charged the individual penalties for filing a frivolous and a late return.  The court ruled that the First Amendment protects the right of protest to any branch of government.  The words "under protest" did not alter the meaning of the jurat.  The return was filed under the penalty of perjury and it was not frivolous.  The individual properly exercised his First Amendment right to protest the IRS while still complying with the obligation to file.  The return is to be accepted as filed.  See McCormick, 94-1 USTC: 50,026, 73 AFTR2d 94-597 (EDNY 1993).