Every year, I get a few emails or calls in December from some of my clients. The message is always the same.
They received a large check in December and they want to know if they should wait to deposit it in January. These clients are cash basis taxpayers. They have usually had a good year and they think that by simply depositing this large check in January, they will save on taxes. Outside of a larger discussion of whether or not they have constructively received the income, I point to IRS reconstructing income guidelines.
The first time I ever represented a client for an audit ended up being a crash course on how the IRS reconstructs income. My client owned a topless bar. This was before credit cards were used for most payments. His club was cash only; there was an admission that patrons paid cash and there was a three-drink minimum. My client received cash and would pay his workers nightly in cash. He would then deposit the remaining cash into the bank and call that income. The IRS revenue agent, or RA, had a field day with this. The income was reconstructed by the average number of patrons in a day and the average cost of a drink. In the end, the RA found $568,000 worth of income that was never claimed over two years.
I appealed the RA’s finding, but IRS Appeals knew they had my client. There were literally hundreds of Tax Court cases where the Service reconstructed income based on this method. When Appeals weighed the “hazards of litigation,” it was determined they would be willing to go to Tax Court.
Later in my career, I represented another client who did large events for corporate clients. I didn’t prepare his returns and the person who did selected the cash method of accounting. The client would receive large deposits in December for events that were to happen in the first three months of the year. He held the deposits until early January and then deposited the funds.
After explaining to the client he had constructively received the income in the prior year, and in order to defer claiming the income his tax preparer should have selected the accrual method, he argued with me. He stated he didn’t deposit the money until January and his accountant told him he was on the cash method of accounting. He went on to say that his preparer said that he recognized income when it was deposited.
I pointed to the Information Document Request, where the RA was requesting his bank statements for not only the year in question, but also January of the following year. I explained that the reason the RA wanted the January statement was to see if my client “kited” his income. I went on to say it was obvious that he had received the money in December because there was a large deposit made on January 3 of the following year.
Just as I had predicted, the RA counted the large deposit in the year in question. However, it didn’t stop there; the Service opened up the rest of the tax years that were still open to see if the kiting of income occurred in those years as well.
When a taxpayer’s accounting method does not clearly reflect income, IRC§ 446(b) gives the IRS authority to compute taxable income using an alternate method. This section allows the Service to use reasonable means to determine income when accounting records do not support the income and deductions a taxpayer reports. If there is a reasonable indication of unreported income, the IRS can use an indirect method to reconstruct it. The available methods, which are listed in the Internal Revenue Manual, have been validated in various court cases.
Helvering v. Taylor, 293 US 507, 513, and Anastasato v. Commissioner, 794 F2d 884, 887, it was established that the IRS deficiency determinations of income are presumed correct. The taxpayer has the burden of proof when contesting those determinations in Tax Court.
The clients that send me those emails or call me in December will hear the same thing from me. It doesn’t matter if you deposit the check now or in January. It is still income in the year received.
Craig W. Smalley, MST, EA, is the founder and CEO of CWSEAPA, LLP, and Tax Crisis Center, LLC.