When the IRS decides to investigate a taxpayer with a criminal tax investigation, it is because they believe that subject taxpayer is either under-reporting their income, overstating their deductions or not reporting certain income at all. In order for the IRS to prove its case and ultimately force a taxpayer to pay their full taxes plus interest and penalties on the misstated taxes, the IRS uses specific methods to analyze the situation. In order to prove a case, the IRS uses either direct or indirect methods of proof. What does that mean? A lot more than you might guess.
To begin with, when the IRS decides to use direct proof/specific items to determine if tax fraud occurred they basically focus on specific transactions to prove their case rather than trying to reconstruct a taxpayer’s entire financial picture. The key objective is for the IRS to prove that a taxpayer earned more money than is reported on their tax returns. They might also try to prove that deductions, expenses, or credits are overstated or nonexistent. They’ll try and get this information by speaking to the taxpayer’s employees, accountant, ex-wife, or anyone else who might have direct knowledge of the issue at hand.
There are four basic steps that the IRS follows to develop a tax fraud case:
- They must prove the relevant amounts are taxable income to the taxpayer
- They must prove the income was received by the taxpayer
- They must prove the income was not reported
- They must prove the taxpayer was personally involved in the failure to report the income
If the IRS decides they want to invest more time and energy in a case, they employ indirect methods of proof and essentially build up a picture of a taxpayer’s finances as a whole. The key here is that rather than looking to charge someone for a specific act or issue, they look for an overwhelming series of practices. This is how they ultimately caught Al Capone.
Their first stop in this area is by developing a picture of a taxpayer’s net worth. They look at all assets at the beginning of a given year, then look at assets at the end of the year and if they can prove that the person’s net worth improved over the year but was not reflected on the filed tax returns, they may win their case of tax fraud or tax evasion.
The next method they employ is what is called the bank deposit method. In this case they carefully (using a microscope pretty much) go over a taxpayer’s bank accounts and get a sense of what money flows in and out, where it comes from and so on. So if they see about $100,000 come into an account over a year, but the taxpayer only claims $40,000 in income, they’re going to be asking some very pointed questions to determine if you committed tax evasion and if they have a tax fraud case against you.
Finally, the use the expenditures method. Here, they develop a picture of a taxpayer’s spending habits over the year in terms of regular things like gas, food, and so on; not obvious big ticket items. They’re looking for people who take in large sums of money, but then spend it out to live without declaring it as income. Say a taxpayer makes $30,000 on business deal, takes the payment in cash and then spends the next six months using it to pay for everyday items. If you look at the previous six months, the spending patterns, credit card bills, bank deposits and withdrawals will be very different and may be a sign of tax fraud.
The bottom line is that the IRS is very good at finding out if you are hiding something. They have lots of experience, lots of tools and very sophisticated methods at their disposal. If you feel you may have made an honest mistake, this is a good time to talk to your criminal tax lawyer.