Income tax returns filed by taxpayers are often incorrect. Sometimes they are wrong due to simple mistakes, accidents, carelessness, confusion, or misunderstandings of the law. Sometimes they are wrong due to gross negligence or reckless negligence of the law. And sometimes they are wrong because the taxpayer intentionally and knowingly pretended they were wrong in order to intentionally pay less income taxes. Whatever the reason, when incorrect returns are identified, they must be corrected, either immediately or after the conclusion of any criminal process that may be initiated.
When tax inspectors or investigators confront taxpayers to ask why the income tax return is incorrect and seek their cooperation to rectify it, the taxpayer will cooperate or not. When the taxpayer cooperates, it is much easier to determine how much actual income the taxpayer earned, or what expenses are actually allowed by law, to arrive at the correct amount of tax. Cooperative taxpayers can provide their books and records or other documents, and assist the inspector or investigator as they try to determine how much additional income tax the taxpayer must pay.
When taxpayers do not cooperate, the inspector or investigator may face a serious dilemma. How can they determine how much additional income tax the taxpayer must pay, if any? They must resort to other methods to obtain the information necessary to calculate the true tax owed by the taxpayer.
During a criminal tax investigation, the investigator must identify the amount of income that is not reported on the income tax return, and also identify any expenses that are on the income tax return that are not allowed by law to be include in the statement. . Generally, it is not possible to be exact when determining the amount of income, nor is it necessary to identify the exact amount of unreported income. The undeclared amount must be substantial, relative to the reported amount, if any. Small cases, in which lesser amounts of income are not reported, are not the type of cases that the tax investigator should identify and investigate. The tax investigator must always be alert to important cases using the criteria, in order to identify and document the amount of income that is not reported, or to identify expenses not allowed by law that have been deducted on the tax return, the investigator you must identify and gather evidence. This is not an easy task. When taxpayers don’t cooperate, it becomes a very difficult task.
In the world of financial investigation, there are methods and techniques available for the investigator to recalculate or reconstruct the true income and expenses of the taxpayer, even without their cooperation, or even without their books and records. In fact, as the tax investigator enters the world of criminal justice, where the taxpayer commits fraud and thus could face incarceration, the taxpayers are more likely to cooperate less. Therefore, the tax investigator must be adept at using available techniques to recalculate or reconstruct a taxpayer’s income and expenses.
However, before these methods are explained, the researcher must fully understand what an income tax return represents and how it relates to the taxpayer’s ledgers, commonly called books and records. The next section explains how the daily business activities of buying and selling relate to an income tax return. While this section may seem elementary or basic, a review of the nature of an income tax return will clarify the use of the Specific Transaction Method to Reconstruct Income, the most common and effective method available to reconstruct a taxpayer’s income. when the taxpayer does not cooperate.
The Income Tax Law requires that income tax returns filed by taxpayers contain a summary of all financial transactions in which the taxpayer participated during the tax year. The summary must include all transactions in which the taxpayer incurred an expense or other deduction permitted by law through a disbursement or expenditure of funds. It must also include all transactions in which the taxpayer received or earned money from the sale of a product or service.
In general, when the total of all transactions for which funds were received exceeds the total of all transactions for which funds were spent, the taxpayer has a net profit, which is the amount on which the tax is based. When the total of all transactions for which funds were spent exceeds the total of all transactions for which funds were received, the taxpayer has incurred a net loss and no tax is required.
Of course, each specific expense must be allowed by law to be included on the income tax return, and each specific receipt of funds must be taxed under the law to be required to be reported on the income tax return. the rent. Incurred expenses that are not allowed by tax laws must still be reported in the taxpayer’s books and records, but should not be included on the income tax return. Similarly, the receipt of funds that are not classified as taxable funds must be reported in the company’s books and records, but not included in the income tax return.
Also, depending on the profit and expense accrual method, some items of expense can be included in the income tax return even though no actual expense has been incurred, and some items can be included as income, even though no funds have actually been received. .
If the taxpayer participates in specific financial transactions during the year that should be included in the summary of expenses and receipts, but they are not, then the income tax return is incorrect.
For example, if the taxpayer participates in a financial transaction in which he sells a product or service but does not report the receipt as gross income or gross income, then the income tax return is incorrect. Similarly, if a taxpayer includes on their income tax return a financial transaction in which funds were spent on a product or service that they are not allowed to deduct under tax law, the return is also incorrect.
The income tax return is required by law to include all specific financial transactions related to the determination of a profit or loss. When certain specific transactions are not included, the tax investigator must be able to identify which specific transactions were not included and try to gather evidence of the source and the amounts to be included. Identifying the specific transactions that were not reported correctly is known as the Specific Transaction Method.
Other methods to recalculate or reconstruct a taxpayer’s true net profit or loss are based on the sum total or aggregate of all the transactions the taxpayer made during the year. These methods do not identify specific buy and sell transactions. Instead, the net profit is calculated or reconstructed based on the total of all expenses incurred or the total of all funds deposited in bank accounts.
One of these methods is known as the Net Worth Method. This method measures increases in a taxpayer’s net worth between years. Net worth is the amount of assets that a taxpayer has accumulated that exceed the amount of liabilities that he has accumulated. Increases in net worth are the result of the taxpayer spending money to increase the amount of assets he has or to reduce the amount of debt he has. In addition, a taxpayer’s expenses that do not have lasting value or that do not increase assets, such as expenses for expensive airline tickets for personal vacations, are identified and added to their increase in net worth.
The increase in equity from one year to the next is compared to the amount of income reported on your income tax return. Increases in excess of the amount of reported income can be attributed to the taxpayer not reporting all their income, because no one can spend more than they earn. The excess is charged to the taxpayer as undeclared income. Of course, adjustments must be made, as described in the text that follows, for loans, gifts, inheritances, and other sources of funds that are not taxable.
Another method is known as the bank deposit method. This method compares the total amount of funds deposited in all bank accounts during the year with the gross income reported by the taxpayer on their income tax return. Bank deposits that exceed gross income are charged to the taxpayer as undeclared income. Again, certain adjustments must be made and other requirements must be met before the excess can be called undeclared income.
The specific transaction method is the most widely used and the easiest to understand method.
However, all three methods have a common thread. All three require the tax investigator to follow the flow of money, from one person to another. This is accomplished by following the paper trail left by financial transactions. When products are sold, goods are bought to be consumed in the course of business, or when services are provided, often on the basis of a contract, there are usually records that reflect the nature of the transaction, particularly if the quantities are large. Such records include purchase orders, sales receipts, inventory lists, invoices, deposit slips, bank statements, etc. By following the money, tax investigators will come across people who can become witnesses who will ultimately produce the evidence the investigator needs to document their case and establish that the taxpayer committed a crime under the Income Tax Law. .
Smaller companies may not keep books and records, increasing the difficulty of addressing non-compliance. There are other methods available to address these types of taxpayers. A common method is to impose an annual license fee on small businesses, rather than requiring an income tax return. This method greatly reduces the administrative burden required to collect a small amount of income tax.