A common assumption goes like this: if there are no records of the income, the government cannot prove the income. It is wrong, and the IRS has been proving otherwise for decades.
When books are missing, incomplete, or unreliable, IRS Criminal Investigation uses indirect methods of proof. Instead of tracing each dollar of income, agents reconstruct it from what a person owned, deposited, and spent. Courts have approved these methods, with safeguards.
This guide explains the methods as the CI manual describes them in IRM 9.5.9, and the Supreme Court's guidance in Holland v. United States. It is general information about how the government builds cases, not advice on any case.
Direct versus indirect
IRM 9.5.9.2.1 says the specific item method, which proves particular items of unreported income or false deductions, is "the most preferred." It fits schemes involving understatement of income, overstatement of expenses, and fraudulent claims for credits or exemptions.
When specific items cannot be traced, IRM 9.5.9.2.2 describes indirect methods. The special agent gathers evidence to determine what income should have been reported and compares it with the return. The manual says courts have upheld the net worth, expenditures, bank deposits, and cash methods "on the theory that proof of unexpended funds or assets may establish a prima facie understatement of income which requires a defendant to overcome the logical inference drawn therefrom." The percentage markup method and the unit and volume method are also described, with the manual cautioning that percentage markup should be used only on a limited basis.
The net worth method
The idea is simple. Measure what a person was worth at the start of a year and at the end. Add nondeductible spending. If the increase is substantially more than reported income, the government argues the difference is unreported income.
IRM 9.5.9.5.4 sets out the formula: assets, including cash on hand, bank and brokerage accounts, vehicles, real estate, and other property, minus liabilities, equals net worth. Subtract the prior year's net worth to get the increase, then add adjustments for personal living expenses and other nondeductible items.
The Supreme Court approved the method in Holland v. United States, 348 U.S. 121. The Court described the typical prosecution: the government establishes an opening net worth, proves increases over later years, adds nondeductible expenditures, and claims any excess over reported income is unreported taxable income.
The Holland safeguards
Holland approved the method and, in the same breath, warned that "it is so fraught with danger for the innocent that the courts must closely scrutinize its use." The CI manual quotes that warning in IRM 9.5.9.5.1.1 and lists three requirements drawn from the opinion:
- Establish an opening net worth with reasonable certainty. The starting point has to be right, because every later increase is measured from it. The government does not need mathematical certainty, but the investigation has to be thorough.
- Negate reasonable explanations inconsistent with guilt. Holland said the government's proof depends on "its effective negation of reasonable explanations by the taxpayer inconsistent with guilt," and that leads furnished by the taxpayer that are "reasonably susceptible of being checked" should be investigated. When the government fails to investigate such leads, the Court said, "the trial judge may consider them as true."
- Show the increase came from currently taxable income. The Court said proof of a likely taxable source, such as a business shown to be capable of producing the income, is sufficient. The government does not have to negate every possible nontaxable source when no relevant leads are offered.
Holland also catalogued risks in the method, including that a taxpayer "may be entirely honest and yet unable to recount his financial history," and that summary charts "have a way of acquiring an existence of their own."
The cash on hand problem
The classic defense in a net worth case is a cash hoard: money saved years earlier that explains the later increase. Holland called it a "favorite defense" and noted the difficulty on both sides.
The CI manual addresses it head on. IRM 9.5.9.5.9.2 says agents should anticipate this defense, establish cash on hand at the starting point and throughout the prosecution years, and that "admissions by the subject are most effective to determine the cash on hand amount and should be obtained during the initial interview or early in the investigation."
Read that again with the first special agent visit in mind. A casual answer about how much cash you had years ago can become the foundation of the government's computation. That is one more reason to let counsel decide whether to answer any questions. See special agents at your door.
The bank deposits method
The bank deposits method starts with total deposits to all accounts, including nominee accounts, adds cash spending, and subtracts deposits that are not income, such as transfers between accounts, loan proceeds, gifts, and inheritances. IRM 9.5.9.7.4 lays out the full formula.
IRM 9.5.9.7.1.1 lists the evidentiary facts used to establish a prima facie bank deposits case, including that the subject was engaged in an income-producing business or activity, made periodic deposits into accounts the subject controlled, and that an adequate investigation was made to negate the possibility that deposits came from nontaxable sources. The manual also notes that "unidentified deposits have an inherent appearance of income."
The common defenses, according to IRM 9.5.9.7.6, include that deposits reflect funds accumulated in prior years, non-income items, income from other years, or duplications of income already counted.
The expenditures method
The expenditures method focuses on spending rather than assets. If a person spent more than reported income and other known sources could support, the excess suggests unreported income. The CI manual covers it in IRM 9.5.9.6. Under IRM 9.5.9.6.2, it is used when a subject's net worth does not substantially increase during the period, or when significant extravagant living expenditures are apparent, such as spending on travel, vacations, and gifts rather than on stocks or real estate.
Why the government often uses more than one method
The CI manual encourages corroboration. IRM 9.5.9.6.2 says a special agent submitting a prosecution report based on the expenditures method should also submit proof using the net worth method, because the two require the same investigative steps and showing both "substantially strengthens the prosecution recommendation." The trial attorney then decides which method best presents the case to a jury.
A civil limit worth knowing
In civil examinations, the Code limits the use of these techniques. IRC 7602(e) says the IRS "shall not use financial status or economic reality examination techniques to determine the existence of unreported income of any taxpayer unless the Secretary has a reasonable indication that there is a likelihood of such unreported income." Whether that reasonable indication existed can be a fair question in a civil case.
Why indirect cases are treated as complex
The Justice Department treats these cases with extra care. Under JM 6-4.212, a referral is designated complex when the IRS used an indirect method of proof, which means a full prosecution memorandum and senior review before charges are authorized. See how the Justice Department reviews criminal tax cases.
What this means for you
If you are worried that your income could be reconstructed from your bank statements, your property records, and your spending, you are thinking the way an investigator does. The answer is not to explain it away to an agent. Your explanations, whatever they are, need to be accurate and documented, and they should be developed with counsel before anyone presents them. If you are not yet under examination, read about the Voluntary Disclosure Practice and its timing rules.
Holland also addressed jury instructions. The Court said charges in net worth cases should be especially clear, including a summary of the nature of the method, the assumptions on which it rests, and the inferences available both for and against the accused.
Frequently asked questions
Can the IRS prove income without my records?
Yes. The CI manual describes indirect methods, including net worth, expenditures, and bank deposits, and says courts have upheld them as establishing a prima facie understatement of income that the defendant must then overcome with an explanation.
What did Holland v. United States require for net worth cases?
The Supreme Court required an opening net worth established with reasonable certainty, investigation of reasonable leads furnished by the taxpayer, and evidence that net worth increases came from currently taxable income, while warning that courts must closely scrutinize the method.
Are all bank deposits treated as income?
No. The bank deposits formula subtracts non-income items such as transfers between accounts, loan proceeds, gifts, and inheritances. But the CI manual notes that unidentified deposits have an inherent appearance of income.
Can the IRS use lifestyle audits in a civil exam?
IRC 7602(e) bars financial status or economic reality examination techniques to find unreported income unless the IRS has a reasonable indication that there is a likelihood of unreported income.
General information only, not legal advice. Reading this page does not create an attorney-client relationship. Laws and IRS procedures change; the sources cited were reviewed on the date shown above.