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Methods to reconstruct income

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The use of indirect methods to reconstruct income by the IRS is limited by Code Sec. 7602(e), which prohibits financial status or economic reality techniques to determine the existence of unreported income unless there is another reasonable indication of unreported income. Forensic accountants can however use these procedures to help determine if a suspect is living beyond their known income and the analysis can be entered into evidence. It is often necessary to obtain a subpoena in order to get a suspect to provide a copy of their tax returns, When reviewing non-business returns, it is necessary to question the suspect about possible sources of income other than what is reported on the tax return. If there is no other information in the file indicating potential unreported income, the minimum income probe is met. However, for individuals who are self-employed and file a Schedule C or F with their Form 1040, an analysis can be made from the information provided on the tax return to determine if the income reported on the tax return is sufficient to support the individual's lifestyle. When conducting a lifestyle audit particular attention should be paid to credit card charges, mortgage interest expenses, business expenses, assets acquired throughout the year, investment accounts, and bank account balances.

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This is very true. Basically, a lifestyle audit can also be seen as a reality audit. This type of an audit answers questions like, "Can this person or family really survive, given the circumstances?" This is best proven by example. There is a family of three, including a small child. Only one spouse is employed, the other has been looking for work. The working person has a Schedule C business, and claimed a profit of $4,000. The child attended a preschool, to which the parents paid $900 (which can be found by examination of the tax return - Form 2441). Is this realistic? On a profit of $4,000, where ...

Solution Summary

This solution explains the indirect method commonly used by the IRS to reconstruct a business or a taxpayer's income.