Question #2: What theories of proof should be pursued?

Continued… See Part I, Part III, Part IV and Part V

a. This would be a case in which the government uses specific items or the direct method in some instances and indirect methods in other instances. For example, Jack received $ 2,000 in dividends in 2004, none of which he reported on his 2004 tax return. That is a specific item. The government’s argument is quite simple: “Got dividends? We see that you do. Were they reported on the return? It appears that they weren’t. That’s all we have to prove.” Of course, that is a bit of an exaggeration because the government must prove willfulness.

b. Fortunately for Jack, his tax liability for 2004 would be diminished by the fact that in 2004, most dividends were taxable as long-term capital gains, and not as ordinary income. The long-term capital gains rate was 15%. Therefore, Jack’s tax liability was a mere $ 300 (.15 x $ 2,000). By itself, that would not meet the standard of materiality. As a general rule, the government prefers to have a tax liability of at least $ 2,500 in a given tax year before charging an individual with tax evasion. Anything under that amount would get the government laughed out of court for expending significant resources on a prosecution involving such a paltry amount of money. Therefore, Jack’s unreported dividend income, by itself, wouldn’t pass the threshold. However, when added to the other items involved, Jack’s tax liability might exceed the threshold. The amount of tax liability arising from Jack’s unreported dividend income would be significant in light of the following: (a) the Department of Justice’s policies, (b) whether Jack resides in a circuit that demands substantiality or materiality of the amount omitted, and (c) the rest of the items involved.

c. In addition to unreported dividends, Jack received $ 40,000 in 2005 as a result of selling stock. Because this item is classified as a capital gain, it should have been reported on Schedule D of the return. However, it wasn’t. Before pursuing this item, the government must review the entire return to see if it was listed anyplace else. For example, it might have been treated as ordinary income. If so, the mere fact that it was listed on the wrong schedule is not evidence of willfulness. Instead, it suggests that the tax preparer was sloppy – in the government’s favor – on the return. Of course, Jack would much rather report this item as a capital gain on Schedule D because capital gains are taxed at a preferential rate compared to ordinary income.

d. A subtle detail about the $ 40,000 is that it is not identified as $ 40,000 of gain. Instead, the facts merely state that it’s $ 40,000 from the sale of stock. That doesn’t necessarily mean that there is unreported income. The issue is whether the $ 40,000 is gross proceeds from the sale of stock or gains from the sale of stock. Why is that relevant? Because § 61 of the IRC does not tax gross proceeds from the sale of property. Instead, it taxes gains from the sale of property.

e. Under § 1001 of the IRC, gain equals the amount realized minus the taxpayer’s basis in the property. Here, the amount realized is $ 40,000. But we do not know what Jack’s basis in the stock is. If it was $ 40,000 or more, then there would be no gain. In that case, the government would have one less item to include in the indictment.

f. Taking this a step further, if Jack’s basis in the stock was greater than $ 40,000, there would have been a loss. And at least part of that loss would have been available as a deduction on the return. Therefore, it might have offset other unreported income. Depending on what the basis is, this item could conceivably work in Jack’s favor.

g. If the government decides to pursue $ 50,000 (i.e., stolen assets) in year 2001, that too would be a specific item.

h. When all three specific items are aggregated, they don’t get the government very far. It’s probable that the largest amount of unreported income would be the unreported profits of the business. How does the government prove that?

i. One way is as a specific item. Perhaps the government could identify who Jack and Janet’s customers were and who paid them. The government could then reconstruct how many transactions were conducted along with the average cost per transaction. Business expenses could then be subtracted. However, because neither Jack nor Janet kept any books or records, that would be challenging to say the least.

j. For that reason, the Department of Justice and Criminal Investigation are likely to rely on one or more of the indirect methods for purposes of reconstructing unreported income from the business. Two threshold requirements must be satisfied before the government can use the indirect method: (1) the business’s books and records must be inadequate and (2) there must be a likely source of taxable income. Both are satisfied. Of course, the government must also prove willfulness but the larger the amount of unreported income, the more likely it is that a jury will infer willfulness.

k. Assuming that the government uses the indirect method, which one should it use?

i. The net worth method is a bad choice. Why? Because the facts do not provide enough information to calculate Jack’s opening net worth. Without a taxpayer’s opening net worth, the net worth method is useless.

ii. How about the cash expenditures method? That is also problematic.

iii. So which method should the government use? A hybrid method, combining bank deposits and cash expenditures. What Jack and Janet did with unreported profits from the business was a combination of things. First, they bought some hard assets (i.e., new home, pool, and satellite television dish). Second, they consumed money without acquiring any assets (i.e., trip to Las Vegas). And third, they produced some savings or additions to their bank account.

iv. The government need not establish opening or closing net worth. However, it must be able to negate any suggestion that the expenditures in question were funded by drawing down net worth. In other words, the expenditures must have been funded entirely by Jack and Janet skimming profits from the company.

v. To do that, the government would argue that Jack and Janet did not have any net worth before this or, if they did, it wasn’t very much. The government would rely on the couple’s prior tax returns to show that there was not enough savings that could have been liquidated in order to support the expenditures.

vi. In applying the bank deposits method, the government must be careful not to double count any methods. For example, if there were transfers between or among accounts, there should be no double counting.

In accordance with Circular 230 Disclosure