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Chapter 7 - Examination of Income Accounts and Records

Income Accounting Methods

As previously discussed, the examiner never knows what type of accounting records he or she will find; nor can he or she expect to see any type of uniformity in income accounting records among reforestation contractors. Be prepared to deal with the various income reporting methods used by the contractors. We are finding that the contractors are organized as either sole proprietorships, partnerships, or corporations. The majority of these entities maintain a calendar year accounting period. The most common types of reporting methods appear below. The group has found that the following income accounting methods have been used by contractors in this industry, but keep in mind that you may encounter other methods.

1. Bank Deposits (most common)

The contractor deposits all receipts into a business account. This method can be found in both single and double entry systems of accounting. It assumes that the contractors deposit all income received into one account and that no income checks are cashed. Normally no cash receipts journal is maintained by the contractors, and deposits are not identified as to their sources (that is, State or Federal agency, private company, or other contractors).

2. Forms 1099 Received

The contractors simply add up the Forms 1099 received and claim the total as income at the end of the year. This method assumes that all Forms 1099 were issued, received, or retained by the contractors. Often what is indicated on the Forms 1099 will be different than what was deposited in the bank.
To illustrate this point, a group member opened a 2-year examination of a prime contractor. In the first year, the contractor reported more income than in the second. The examiner found that the contractor gave the accountant Forms 1099 in the first year but not in the second. To determine the contractor's income for the first year, the accountant used the Forms 1099 since they totaled more than the bank deposit analysis. In the subsequent year, the accountant determined the contractor's income from bank deposits since the contractor reported he did not retain the Forms 1099. The examiner found that the contractor cashed income checks received from other contractors at the bank. Since the contractor did not deposit all his income, the examiner was unable to use a bank deposit analysis to determine the contractor's income.

3. Estimates

In some cases, the contractor will estimate total gross receipts for the year. Accordingly, any records available will not substantiate or corroborate the gross receipts figure per the return. The estimates are usually based on an amount that produces the desired "bottom line" figure. Not surprisingly, these estimates are almost always less than receipts verified per the examination.

Lack of Internal Control

The vast majority of reforestation contractors are small family- owned operations which lack the essential elements of internal control. This should be of particular concern to the examiner when doing the income probe, since lack of internal control usually necessitates the use of various audit techniques to verify or reconstruct income (techniques will be discussed later).

Lack of separation of duties and lines of responsibility are often major reasons for concern when evaluating internal control. Duties and responsibilities that would normally be split among employees for good internal control are often concentrated into the duties of the sole proprietor.

Lack of internal control creates the opportunity for the taxpayer to underreport income. The taxpayer/spouse has full control of the books and records, collects the income, makes the deposits, writes the checks, and negotiates checks for cash. We have found that it is not unusual for the taxpayer/spouse to cash income checks or divert income checks to other accounts (that is, savings or personal). When prime contractors work as subcontractors, we have found that they cash their income checks at the payors' banks. Fortunately, there are ways to detect income underreported by contractors. Payments issued by the State and Federal agencies are issued either by check or are wire transferred to the contractor's business account (checks over $25,000). Thus, there can be a heavy reliance on third party information from State and Federal agencies. Private companies also pay by check and are reliable third party sources, provided the examiner is able to locate all private companies for whom work was done during any given year.

Another major area of concern is transactions between contractors. Cash payments between contractors is quite common and results in little or no audit trail. Cash payments also reduce the likelihood that a Form 1099 was filed or that the contractor deposited the cash into his or her business account. A possible indicator of unreported income can be illustrated by the contractor who produces receipts for business expenses paid in cash but not previously deducted on the return.

Audit Techniques

To determine how much, if any, income has been underreported by contractors, the agent should follow a three step process.

Step 1. Identifying Income Sources

Identifying the income sources is the key in uncovering whether or not the contractor has reported all his or her income. The proper development of a unreported income case is critical to determine its potential for fraud or other penalties.
The methods for identifying income sources listed below can be used regardless of how the contractor's case was originated (that is, whether the return was selected by the Service Center, PSP, or based on information obtained from the examination of the returns of other contractors).

1. Interview of the Contractor

Your initial interview of the contractor should always be your starting point for obtaining information on income sources. Ask the contractor to give you the names of the agencies or companies for whom work was done during the period in question and about contractors for whom he or she is currently working, since services may have been performed for the same contractors in prior years. (A complete discussion of the initial interview appears in Chapter 3.)

2. Analysis of Bank Deposits

A highly recommended method for developing leads on income sources is to request a description of the source of the corresponding deposit slips (remember if the contractor does not supply you with the source of the deposit you can summons this information from the bank). This audit technique will give you names of the different payors whose checks were deposited into the contractor's business, savings, or personal accounts. Once you identify the payor, you can initiate a third party examination year. The following is an synopsis of what happened when this method was used on a reforestation contractor by a group member.

Synopsis of One Case

The bank deposit analysis turned up unidentified deposits that the taxpayer reported to be loans from relatives. To verify the taxpayer's oral testimony, the auditor requested that the taxpayer supply copies of the items deposited and the deposit slips. The auditor's analysis of the items deposited resulted in the auditor identifying six additional savings accounts and one other business account. As a result of examining the items deposited, the examiner was able to make a criminal referral for unreported income totaling over $320,000 during a 2-year period.

From the items deposited and the deposit slips, the auditor was able to secure the following information and determine that the contractor had underreported his income:

a. The names and amounts paid by Federal agencies, State agencies, private companies, other contractors or individuals (that is, loans or other non-taxable sources of income).

b. Interbank transfers and the account from which the check was drawn.

c. Whether the deposit was less cash or if the deposit was consigned to the bank and reduced by loan payments.

3. Information from Federal and State Agencies

Perhaps the easiest way of obtaining information about different contractors is by contacting the Bureau of Labor, Wage and Hour Division (BOLI) of the State of Oregon. BOLI can give some information on the jobs worked by the contractors during the period in question. In 1990, BOLI began developing a data base of contracts worked by the licensed contractors. BOLI maintains a file of contract award letters, certified payrolls, and other licensing information.

Once you have a list of the contracts or the contract locations, you can contact the State or Federal agency and secure copies of the contract solicitation packages, payment vouchers, award letters, and cancelled checks, if needed.
Information pertaining to contracts worked outside of Oregon will need to be obtained from the Federal or State agency who issued the contract. You will need to trace the Federal agency who issued the contract through checks that were deposited.

4. Information Obtained from Other Contractors

The examination of one contractor could give you leads that will help you in determining unreported income sources of other contractors. In some cases it may be easier to determine the income of a subcontractor from the records of a prime contractor then to determine the income of the prime contractor. The reason for this is that you will have access to the cancelled checks of the prime contractor. You will be able to copy the cancelled checks which will give you the check amounts, dates, and the manner in which the checks were negotiated. Compare the cancelled checks to the payee's bank deposits to determine if he or she is depositing all receipts. If the subcontractor is not in the habit of depositing all the income received, then requesting the items deposited may give you additional leads in developing unreported income. If the contractor does not maintain a checking account, you will need to use another methods to verify income. For example, Cash-T, Net Worth, or Source and Application (the IRM contains detailed instruction on each of these methods).

Step 2. Contacting Third Party Sources

After leads on contractors have been developed in Step 1, each source must be contacted to request the documentation pertaining to the payments issued. The typical documents that are maintained by the payors are:

1. Invoices issued by the contractor -- if requesting from a private company or sometimes a prime contractor.

2. Copies of the contract solicitation packages, contract award letters, payment vouchers, and copies of cancelled checks -- Federal and State agencies will be able to provide all of the above items.

3. Cancelled checks -- contractors identified by the methods listed above will have issued a check to pay their subcontractors.
Obviously, the most important pieces of information are the cancelled checks. They will evidence total payments as well as show if the checks were cashed by the payee.

The third party sources, once located, can be contacted by phone or in writing to request copies of cancelled checks, etc. When requesting third party information from other contractors, we suggest that you first contact the contractor or spouse, leave your message, and follow-up your request with a letter. This is necessary since the largest part of the industry is made up of small family-owned businesses with the contractor's spouse acting as the bookkeeper and he or she may not want to give you any information over the telephone.

When considering what information to ask for, the examiner has a choice to make, he or she can ask the contractor to make available cancelled checks, Forms 1099, or the cash disbursements journal for personal inspection, or can ask the contractor to supply copies of the needed information. When the contractor is asked to supply copies, you may receive inaccurate or incomplete information. There are a couple of reasons that the contractor may not wish to provide you with the information that you request. The first reason is that the contractor is still working with this individual and may feel a need to "protect" him or her.

Secondly, we have found that a large percentage of the contractors are related either by blood or marriage and are interested in protecting family members.
Preferably, the examiner should extract the information themselves; however, due to the problems previously mentioned, access to the records may be difficult. Judgment should be exercised by the examiner and manager in making the determination as to what type of records will be sufficient. Keep in mind that third party information should be requested from the taxpayer first. If the taxpayer does not supply the information, the third party should be contacted. If the third party does not comply with your requests, you and your manager should decide if a summons should be sent to the third party.

Step 3. Computation of the Income Understatement

The way unreported income is determined as well as the documents necessary to support that determination depend on the way income was recorded for book or tax purposes. For example, income recorded from bank deposits requires a different approach to computing unreported income than income recorded from Form 1099. Listed below are approaches for computing unreported income for each method of recordkeeping:

1. Income Recorded by Bank Deposit Method:

Method--Steps to Follow

a. Identify each check deposited in the contractor's bank account and obtain a copy of the item deposited and the corresponding deposit slip (from the contractor or through a bank summons).

b. Compare checks obtained from third parties to the checks deposited in the contractor's bank account.

c. From the deposit slips, determine if any cash was withdrawn.

d. Determine unreported income using one of the following methods:

1) Unreported Income = Gross receipts plus all undeposited cash plus "less cash" amounts determined from deposit slips.

2) Unreported Income = Total reconstructed income per exam (specifically identified business receipts) minus gross receipts per the tax return.

The reason that a different approach must be used when significant amounts of cash are deposited is simple -- large and frequent cash deposits cannot be traced to any particular income source. Therefore, when significant amounts of cash are deposited, unreported income must be computed on an aggregate basis rather than on a check-by-check basis. Where large cash amounts are deposited, deposit information is essentially ignored and income is reconstructed entirely through the use of data supplied by third party sources. Total income received from State and Federal agencies, private companies, and other contractors is compared to gross income per the return. This avoids the problem of having the contractor claim the cash deposits are "nontaxable" (that is, loans, gifts, etc.).

2. Income Recorded Through the Use of Forms 1099:

This approach is very similar to the bank deposit method where significant cash deposits were made. Here again, income is reconstructed on an aggregate basis using third party information.

Unreported Income = Total reconstructed income per exam minus gross receipts per the tax return.

Taxpayer's Explanation of Unreported Income

It is very important to solicit the taxpayer's explanation for unreported income. The most common explanation for a discrepancy is the cash expense defense: "Yes, I didn't report all my income but I also didn't report all my expenses because they were paid in cash." The defense suggests that the unreported checks were cashed and used to pay expenses, usually cash wages, creating a "wash." This is not usually a problem since the burden is on the taxpayer to show these expenses were incurred and paid. Also, it creates a "no-win" situation for the contractor since any substantiated cash wages creates an employment tax liability that may be greater than the income tax liability. Criminal penalties may be applicable in either case.
Other assorted defenses such as blaming the bookkeeper are offered by contractors. However, the important point to remember is that the explanation should be solicited, analyzed for reasonableness, followed up (if necessary), and properly documented. It should be emphasized that once a taxpayer offers an explanation, the examiner must attempt to refute it or the income adjustment will be jeopardized. A final conclusion should be clearly stated and the methodology documented in the examiner's workpapers. This will be invaluable for tax and penalty considerations once the case leaves the examiner's hands, agreed or unagreed.