World War II was far from over in the autumn of 1944, but with Allied armies closing in from three sides, total victory was probably off the table for the Nazis absent some spectacular reversal of fortune for one side or the other. That was about the time German officials began destroying records, specifically about the Holocaust. When the Nuremburg war crimes trials began, prosecutors relied on George Stevens’ short film about the liberation of Dachau, at least in part, to detail the horrors of Nazi wartime atrocities.

Apropos of nothing, before the war, fifteen-time Academy Award winner George Stevens mostly helmed light-hearted comedies, like Swing Time (with Fred Astaire and Ginger Rogers) and Vivacious Lady (Ginger Rogers and Jimmy Stuart). But the war changed him and he never went back to comedies, instead making films like Giant, The Diary of Anne Frank, and The Greatest Story Ever Told from the late 1940s to the end of his career.

The lack of evidence at Nuremburg illustrates a common issue in many kinds of criminal cases, viz, a lack of damning evidence. In these instances, the government sometimes must decide whether to throw up its hands and quit, take its chances with the available evidence, or reconstruct evidence as best it can. I’ll give you three guesses which approach the IRS uses if financial records are unavailable in tax fraud cases, and the first two guesses don’t count.

Adequacy of Taxpayer Records

If the financial data that the taxpayer provides is inadequate, untrustworthy, or altogether absent, the IRS can reconstruct the data pursuant to the Internal Revenue Code. The best way to avoid this unpleasantness is to retain all records until the ten-year statute of limitations on collections matters expires. Taxpayers should prioritize expense records, especially travel and gift expenses, because expenses are harder to establish than income and the Service routinely scrutinizes business expenses.

Since the law changed in 1998, the IRS has had the burden of proof to establish that the taxpayer’s records are so shoddy, for whatever reason, that they must be reconstructed. However, for that burden shift to kick in, the taxpayer must have some credible evidence pertaining to tax deductions, cooperate with all IRS requests, and comply with substantiation and recordkeeping requirements.

Income Reconstruction Methods

If the Tax Court determines that the taxpayer’s records are inadequate, the IRS can use almost anything to reconstruct them, including the taxpayer’s prior returns and available income/expense data. Rather disturbingly, the Service can also use statements from disgruntled ex-employees, possibly overblown newspaper stories, and information provided by reward-seeking individuals. There are several overall methods:

• Cash Expenditures and Bank Deposits: The T-men compare the total amount of bank deposits and business expenses to the figures in the return. This method is rather straightforward and easy to understand; however, it is not very useful for business (such as small legal and medical offices) that have lots of cash transactions.
• Funds Sources and Applications: Agents analyze cash flow for a given period, and then compare that analysis to known data to fill in the gaps. If the cash flow is higher than the reported income, the Service adjusts the income figure upwards. This method usually has lots of moving parts and is therefore subject to breakdown.
• Mark-On: If the taxpayer operates a service business, the Service often compares the subject pizzeria to other pizzerias in the area to calculate income. There are some holes in the markup method, specifically with regard to theft losses, unsold inventory, and other business variables.
• Volume Measurement: The IRS often takes a similar approach if the target is a retail business, like an auto parts store, that has a known sales volume and known unit prices. Perhaps the most glaring deficiency with this method is that not all customers pay the same amount for an air filter, given things like volume discounts, promotional events, and price wars.

To mitigate all these objections, at least in part, the Service sometimes relies on third-party business statistical providers, like BizStats. Taxpayers can use these resources as well, and it’s usually a good idea to do so, to help ensure that claimed expenses at least pass the straight-face test (your lawyer will know what this is if you can’t figure it out).

Taxpayers have the right to monitor the income reconstruction process, so they are in a better position to make objections in court.

Expense Reconstruction

Most agents prefer the income-reconstruction methods as opposed to expense reconstruction, due to the limits of the Cohan rule. This Second Circuit decision basically allows individual taxpayers to reconstruct their expenses based on their best estimates. The IRS grudgingly codified this rule, while still allowing auditors to request additional supporting information, such as a Form 4822 Statement of Annual Estimated Personal and Family Expenses. That way, if the taxpayers’ estimates turn out to be grossly inaccurate, they lied on two forms instead of just one.

The important thing to remember is that, in most cases, the IRS must show that not only are some records missing, but also that the missing records render the tax calculations utterly unreliable. And, assuming that there are no Hollywood directors embedded in your office, that is not an easy burden to meet.