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Net-Worth Method Used to Support Fraud Determination Against Surf Shop Owners.
(Parker Tax Publishing November 24, 2014)

The Tax Court upheld the IRS's use of the "net worth and personal expenditures" method (net-worth method) of income reconstruction; finding a family running a chain of surf and skateboard shops was liable for taxes on underreported income and civil fraud penalties. Worth v. Comm'r, T.C. Memo 2014-232 (11/13/14).

The Worth family, Donald, Marie, and their son, Frank, operated a chain of seven surf and skateboard shops across California, called White Sands. Frank was responsible for about half of the stores and Donald and Marie operated the other half. Marie also managed the books and prepared tax returns. As manager of the heavily cash-based business, Frank had the authority to write checks on certain White Sands bank accounts, wrote checks or used cash to pay vendors for merchandise as it came in, and wrote checks to reimburse himself for business expenses he paid. Frank also supervised inventory and receipts from store branches. There were no formal ownership arrangements; however, Donald and Frank held themselves out as joint owners, and Frank testified in previous cases that he was a part-owner. Frank reported income from the business on his Form 1040 Schedule C and never received a Form W-2 from White Sands.

Banking irregularities lead the IRS and state authorities to institute a criminal investigation into the business, resulting in Frank pleading guilty to willfully making and subscribing to a false return for 2000, and Donald and Marie pleading the same for 1998-2000. All three admitted to knowingly and willfully understating the business' gross receipts to decrease tax liability.

The IRS determined deficiencies for Donald and Marie and for Frank based on unreported income using the net-worth method, because the lack of complete and reliable records precluded using the simpler bank-deposit method. The IRS has great latitude in reconstructing a taxpayer's income, and the reconstruction need only be reasonable in light of all surrounding facts and circumstances. The net-worth approach is a permissible method that seeks an approximation, rather than a precise determination, of the taxpayer's gross income.

OBSERVATION: Under the net-worth method, the IRS reconstructs a taxpayer's income by determining net-worth at the beginning and end of each year in issue. The net worth increase (or decrease) for each year is then adjusted by adding nondeductible expenses (such as everyday living costs) and subtracting receipts from nontaxable sources (such as gifts, inheritances, and loans).

An increase in net worth for a given year creates an inference of additional gross income for that year, provided that the IRS:

(1) establishes the taxpayer's opening net worth with reasonable certainty and

(2) either shows a likely source of unreported income or negates possible nontaxable sources. Brooks v. Commissioner, 82 T.C. 413 (1984).

The primary issue before the Tax Court was whether the Worths failed to report income for 1998-2000 as determined by the IRS using the net-worth method of reconstructing income.

The court determined that the net-worth method was computed correctly and that the family was liable for the deficiencies. The court reasoned that the Worths failed to maintain accurate books or records from which tax liabilities could be computed and did not present any affirmative case to rebut the IRS's arguments.

The court rejected the Worths' arguments that the IRS agent was not a qualified expert, thus making her testimony inadmissible, finding that that the IRS agent was not testifying as an expert, but permissibly providing factual information as to how the audit was conducted and how net-worth was calculated. Moreover, the IRS audit properly investigated and accounted for alleged cash-hoards as well as other alleged loans from Donald and Marie to Frank, which could have lowered the taxpayers' AGI. Lastly, the court determined that based on the IRS audit, criminal investigation, and admissions, Frank was a 50 percent owner of White Sands during the years at issue and thus half of the assets of White Sands was properly allocated to him for purposes of the net-worth analysis.

The Tax Court ultimately upheld the IRS's deficiencies and determined the family members were liable for the civil fraud penalty because of the understatements of income, false statements, lack of credible testimony, insufficient records, and attempts to conceal income by structuring bank deposits to fall under the reporting limit required for banks.

For a discussion of the IRS's examination authority, see Parker Tax ¶ 263,110. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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