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Although traditionally the domain of revenue agents, the task of reconstructing an individual's income also may be performed by private accounting practitioners. In fact, providing litigation support through the practice of forensic or investigative accounting can become a significant and profitable part of one's practice.
For example, one party in divorce litigation may suspect hidden sources of income or concealed assets. In such cases, an analysis of spouse's personal finances through indirect methods may be enlightening. Similarly, a plaintiff may have won a judgment against a defendant in a contract or tort action and then found it difficult to locate assets against which the judgment may be satisfied. In this case, the services of a forensic accountant could be effective in locating the defendant's concealed assets.
This article will analyze the audit techniques used by Internal Revenue examiners in an effort to identify and describe those methods that may prove useful to the private investigative accountant. Although these methods will be described from the IRS point of view, they can be adapted easily to almost any investigative assignment.
Chapter 800 of the Internal Revenue Manual, "Tax Guidelines for Internal Revenue Examiners," identifies two general approaches for determining income: the Direct (or Specific Item) Method and the various indirect methods.
DIRECT METHOD
The Service uses the Direct Method to show that specific taxable transactions either were omitted or were reported incorrectly. Thus, it is quite common for revenue agents to review real estate transactions at the county courthouse, as well as other public records. The existence of any unreported transactions would raise pertinent inquiries.
In general, the Direct Method is most useful where the taxpayer has made sales to a small number of customers. The details of each specific transaction then can be aggregated and compared with the total amount reported. Conversely, when there are many small sales to a large customer base (e.g., grocery stores, restaurants, etc.), it is too difficult and too time consuming to use the Direct Method.
INDIRECT METHODS
Revenue agents may elect to use an indirect method of determining taxable income in a variety of situations. If the taxpayer's conduct indicates the possibility of an intentional omission of income, indirect methods may be appropriate. The type of conduct or "badges...