This lesson provides an in-depth examination of indirect methods used to reconstruct income when a taxpayer’s records are inadequate or unreliable, including the Source and Application of Funds Method, Bank Deposits Method, Markup Method, and Net Worth Method.
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Source and Application of Funds Method (T-Account Method): Analysis of a taxpayer’s cash flows and comparison of all known expenditures with all known receipts. Net increases and decreases in assets and liabilities are taken into account along with non-deductible expenditures and non-taxable receipts. The excess of expenditures over reported and non-taxable income is unreported taxable income .
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Bank Deposits and Cash Expenditures Method: Computes income by showing what happened to a taxpayer’s funds. Based on the theory that if a taxpayer receives money, it can either be deposited or spent. If the method indicates understatement, it may be due to either unreporting of gross receipts, overstating expenses, or a combination of both .
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Markup Method: Reconstructs income based on using percentages or ratios considered typical for the business under examination. Analysis of sales and/or cost of sales and application of appropriate percentage of markups to arrive at gross receipts. Percentages can be obtained from analysis of declared items, official government statistical bodies, or industry publications. Most effective when applied to businesses whose inventory is regulated or purchases can be readily broken down in groups with the same percentage of markup .
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Unit and Volume Method: Gross receipts may be determined or verified by applying sales price to the volume of business done. The number of units or volume of business might be determined from the taxpayer’s books or third-party sources. Effectively applied in businesses such as carryout pizza, coin-operated laundromats, and mortuaries .
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Net Worth Method: Based on theory that increases in a taxpayer’s net worth during a taxable year, adjusted for non-deductible expenditures and non-taxable income, must result from taxable income. Requires complete reconstruction of the taxpayer’s financial history, accounting for all assets, liabilities, non-deductible expenditures, and non-taxable sources of funds. Purpose is to determine whether the taxpayer is purchasing assets, reducing liabilities, or making expenditures with funds not reported as taxable income .