The net worth method is an indirect balance sheet approach to estimating an individual's true income. To use the net worth method it is necessary to calculate the individual's net worth at the beginning and ending of the period in question. Starting with taxable income the methodology requires the addition of nondeductible living expenses that increase net worth.
If there is a difference between the income reported on the individual's tax returns and the increase in net worth calculated for the year, it is necessary to attempt to account for these differences by reviewing nontaxable income, gifts, and unexplained differences. Any unexplained difference may be an approximation of the amount of a theft, unreported income, or hidden income. This can also be used to help identify individuals who are laundering money.
The net worth method is very effective in certain key areas. The IRS utilizes a net worth audit, most often used when tax evasion or fraud is suspected, and is one of the most effective means of discovering hidden income. This method is basically most useful when the taxpayer lacks appropriate documentation, or when records cease to exist, for whatever ...
This solution explains the net worth method and how income is estimated by the IRS using this method. This solution also explains differences in reportable 1040 income, and how these elements tie-in to tax evasion, money laundering, and other forms of fraud.