Botching An IRS Bank Deposit Analysis

 

What caught my eye was the taxpayer’s name. I am not sure how to pronounce it, and I am not going to try.

I skimmed the case. As cases go, it is virtually skeletal at only 6 pages long.

There is something happening here.

Let’s look at Haghnazarzadeh v Commissioner.

The IRS wanted taxes, penalties and interest of $2,424,100 and $1,152,786 for years 2011 and 2012, respectively.

Sounds like somebody is a heavy hitter.

Here is the Court:

“… the only remaining issue is whether certain deposits into petitioners’ nine bank accounts are ordinary income or nontaxable deposits.”

For the years at issue, Mr H was in the real estate business in California. Together, Mr and Mrs H had more bank accounts than there are days of the week. The IRS did a bank deposit analysis and determined there was unreported income of $4,854,84 and $1,868,212.

Got it.

Here is the set-up:

(1) The tax Code requires one to have records to substantiate their taxable income. For most of us, that is easy to do. We have a W-2, maybe an interest statement from the bank or a brokers’ statement from Fidelity. This does not have to be rocket science.

This may change, however, if one is in business. It depends. Say that you have a side gig reviewing articles before publication in a professional journal. What expenses do you have? I suspect that just depositing the money to your bank account might constitute adequate recordkeeping.

Say you have a transportation company, with a vehicle fleet and workforce. You are now in need of something substantial to track everything, perhaps QuickBooks or Sage, for example. 

(2) Let’s take a moment about being in business, especially as a side gig.

Many if not most tax practitioners will advise a separate bank account for the gig. All gig deposits should go into and all business expenses should be paid from the gig account. What about taking a draw? Transfer the money from the gig account to a personal account. You can see what we are doing: keep the gig account clean, traceable.

  (3) Bad things can happen if you need records and do not keep any.

We know the usual examples: you claim a deduction and the IRS says: prove it. Don’t prove it and the IRS disallows the deduction.

The tax Code allows the IRS to use reasonable means to determine someone’s income when the records are not there.  

(4) One of those methods is the bank deposit analysis.

It is just what it sounds like. The IRS will look at all your deposits, eliminating those that are just transfers from other accounts. If you agree that what is left over is taxable, the exercise is done. If you disagree, then you have to provide substantiation to the IRS that a deposit is not taxable income.

The substantiation can vary. Let’s say that you took a cash advance on a credit card. You would show the credit card statement – with the advance showing – as proof that the deposit is not taxable.

Let’s say that your parents gifted you money. A statement or letter from your parents to that effect might suffice, especially if followed-up with a copy of their cancelled check.

You might be wondering why you would deposit everything if you are going to be flogged you with this type of analysis. There are several reasons. The first is that it is just good financial and business practice, and you should do it as a responsible steward of money. Second, you are not going to wind up here as default by the IRS. Keep records; avoid this outcome. A third reason is that the absence of bank accounts – or minimal use of the same – might be construed as an indicator of fraud. Go there, and you may have leaped from being perceived as a lousy recordkeeper to something more sinister.

Back to the H’s.

They have to show something to the IRS to prove that the $4.8 million and $1.8 million does not represent taxable income.

Mr H swings:

For 2011 he mentioned deposits of $1,556,000 $130,000, and $60,000 for account number 8023 and $1,390,000, $875,000, and $327,000 for account number 4683”

All right! Show your cards, H.

Why would I need to do that? asks Mr H.

Because ……. that is the way it works, H-man. Trust but verify.

Not for me, harumphs Mr H.

Here is the Court:

Petitioner husband did not present evidence substantiating his claim that any of these deposits should be treated as nontaxable.”

Maybe somebody does not understand the American tax system.

Or maybe there is something sinister after all.

What it is isn't exactly clear.

COMMENT: This was a pro se case. As we have discussed before, pro se generally means that the taxpayer was not represented by a tax professional. Technically, that is not correct, as someone could retain a CPA and the decision still remain pro se. With all that hedge talk, I believe that the H’s were truly pro se. No competent tax advisor would make a mistake this egregious.  

Our case (again) was Haghnazarzadeh v Commissioner, T.C. Memo 2021-47.