Most US citizens understand the concept of criminal law that
provides a person is innocent until proven guilty. However, many fail to grasp
that the same is not true in tax court. To the contrary, in general, the IRS
commissioner’s determinations are presumed to be correct and the taxpayer bears
the burden of proving that the positions are erroneous.
The IRS is allowed to reconstruct income using various
manners including the commonly used method of bank account analysis. The IRS reconstruction
of income is simply required to be reasonable in light of the surrounding facts
and circumstances. As established by case law, all bank deposits constitute
evidence of income and as such the IRS can simply assert that all deposits made
to bank accounts are taxable income. If deposits represent loans, contributions
from the owner of a business or transfers between accounts; it is the responsibility
of the taxpayer to prove this fact. The Tax Court will not reconcile accounts
to match transfers nor attempt to gather evidence to support the source of
funds to an account. The substantiation must be efficiently and concisely
supported by documentation provided by the taxpayer.
Furthermore, Tax Court Rule 142(a) states that deductions are
a matter of “legislative grace” and the taxpayer therefore must prove that they
are eligible for the deduction and also substantiate the deduction claimed with
appropriate receipts and documentation. If the taxpayer is unable or unwilling
to prove eligibility or substantiate the deduction, it will be denied.
Business income and expenses reported on Schedule C are
increasingly scrutinized by the IRS. Ordinary and necessary expenses incurred
in a trade or business are normally deductible. However, taxpayers should note
that banks statements or tables of expenses generated from bank statements are
not considered sufficient evidence of eligibility for deduction. The court
asserts that the tables do nothing more than summarize purchases and therefore
do not prove that they were ordinary and necessary business costs as opposed to
personal or other non-deductible business expenditures. In addition, a memo notation in a check is not
necessarily enough to substantiate a payment as a legitimate business expense
if it could also be presumed a personal expense.
The IRS may impose a 20% accuracy-related penalty when there
is a substantial understatement of tax. Substantial understatement is considered
to exist when it exceeds 10% of the tax required to be shown on the return
(unless the understatement is less than $5,000). The penalty will not be
imposed on any portion of the understatement which resulted due to reasonable
cause and in good faith. To establish reasonable cause and good faith, the most
important factor is the extent of effort the taxpayer has taken to arrive at
the correct tax liability.
Therefore, careful record keeping and documentation are imperative.
Moreover, business and personal expenditures should be maintained independently
through separate bank accounts and credit cards. For more information on how to
document and defend your tax position, contact a tax advisor.
