Bank Deposits Analysis: How Examiners Test Whether You Reported All Income

Your audit letter asks about your charitable deductions. The examiner asks about your bank accounts. People find this alarming. It is standard procedure, and knowing why it happens is the first step to handling it well.

Income is always on the table

The IRM is direct: "All examiners must consider gross income during the examination of all income tax returns." Minimum income probes "must be completed regardless of the type of return filed" (IRM 4.10.4.2). They are a set of analytical tests designed to determine whether income was accurately reported.

What the probes involve depends on the return:

• Nonbusiness returns. An analysis of your information returns against your return, and an interview asking about possible sources of income other than those reported and about accumulated funds, including bartering (IRM 4.10.4.2.2). A financial status analysis is required for certain office audit returns that include a Schedule C or F where gross receipts is not a classified issue.
• Individual business returns. A financial status analysis, the initial interview, a business tour, an evaluation of internal controls, reconciling the books to the return, testing gross receipts, a bank account analysis and ratio analyses (IRM 4.10.4.2.3).

The IRM adds that the minimum income probes are not subject to IRC 7602(e), the statute that limits financial status techniques. More on that below.

The T-account

The financial status analysis usually takes the form of a T-account. Sources of cash go on the left, expenditures on the right, and the totals are compared (IRM 4.10.4.2.2). Sources include reported income, loans, gifts and savings drawn down. Uses include living expenses, debt payments and asset purchases.

The examiner estimates your personal living expenses, and the IRM points to Bureau of Labor Statistics data for that (IRM 4.10.4.2.3.1). It also says Form 4822, Statement of Annual Estimated Personal and Family Expenses, may be used as a guide by the examiner, but that it is inappropriate to ask the taxpayer to complete the form independently (IRM 4.10.4.5.1.2).

If uses of cash materially exceed sources, the examiner has a question: where did the extra money come from? That question is what drives a deeper look at your accounts.

The bank account analysis

For individual business returns, the IRM says the IRS is not prohibited from asking for business and personal bank and financial account records, including statements, deposit slips, canceled checks and wire transfers, on the initial IDR or at any time (IRM 4.10.4.2.3.7). The analysis is used to identify deposits that may be taxable income, see whether expenses were paid from other sources, gauge commingling, and determine whether cash is deposited.

The steps are straightforward. The examiner totals all deposits, then backs out nontaxable funds, transfers between accounts and returned checks to arrive at "taxable deposits," and compares that to reported income. The IRM specifically tells examiners to watch for transfers, because previously unknown accounts may be identified that way.

Nonbusiness returns are treated differently. The IRM says that with regard to IRC 7602(e), examiners should not routinely ask for bank statements, canceled checks or deposit slips to examine income on nonbusiness returns. They can request documents supporting specific issues, and if there is a reasonable indication of unreported income before contact, such as a grossly imbalanced financial status analysis or an unreported Form 1099, the initial IDR may include personal banking records (IRM 4.10.4.2.2.1).

Online and app income

The IRM singles out electronic commerce. E-commerce and internet activities must be audited as part of the minimum income probes for all business returns, including limited scope audits, and the IRM says deviation from that requirement is prohibited (IRM 4.10.4.2). Expect questions about websites, online sales platforms and payment apps, and expect the examiner to compare what those platforms show with what your books show.

The examiner is not limited to what you hand over. The IRM lists internal and external sources for the financial status analysis, including FinCEN data, IRS account systems and asset and people locator services (IRM 4.10.4.2.3.1). Assume the examiner has looked at more than your return before the first meeting.

The legal limit: IRC 7602(e)

Congress put a fence around the most intrusive 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."

The IRM treats formal indirect methods, and the techniques used to develop them, as the "financial status audit techniques" that trigger 7602(e) (IRM 4.10.4.5.1.1). Ordinary examination techniques, such as testing books, analytical tests, observing and interviewing, do not trigger it. The IRM also cautions that gathering personal living expense information beyond the minimum income probes will likely trigger the limitation (IRM 4.10.4.5.1.2).

The practical takeaway: a formal bank deposits reconstruction of your income requires a reasonable indication of unreported income, and the examiner is supposed to document the reasons. If you are facing one, ask what the indication was.

Formal indirect methods

When the books cannot be relied on, IRM 4.10.4.5 describes several ways to reconstruct income:

• Bank deposits and cash expenditures. Total deposits to all accounts you maintain or control, plus cash spending, less nontaxable items.
• Source and application of funds. A cash flow comparison of money in and money out.
• Net worth. The change in your net worth plus living expenses, compared with reported income.
• Markup and unit-and-volume methods. Common for businesses with inventory or measurable output.

The IRM's definition of total deposits is broad: deposits from taxable and nontaxable sources to all business and personal accounts you maintain or control, including savings, brokerage, credit union and other financial institutions (IRM 4.10.4.5.4.3).

How to answer a bank deposits analysis

The IRM itself lists the common defenses (IRM 4.10.4.5.8). Use them.

1. The computation is wrong. The IRM notes that most challenges focus on whether individual deposits were correctly classified. Loan proceeds, gifts, inheritances and transfers between accounts are the most common, and redeposited items such as bounced checks can be double counted. Go through the examiner's schedule deposit by deposit.
2. The difference came from a nontaxable source. Document it: loan agreements and statements, gift letters with the donor's bank records, estate distribution records, insurance proceeds, sale of personal property, transfers from your own savings.
3. Cash on hand or accumulated funds. The IRM tells examiners to establish and verify cash on hand and accumulated funds during the initial interview, and warns that the after-the-fact "cash in the mattress" defense cannot be used once those amounts are established. Translation: what you say about cash at the first interview will be held against any later story. Tell the truth, and be precise.

That third point is why the initial interview matters so much. The examiner is supposed to explain the terms before asking. Make sure you understand the question before you answer it.

Prepare before the examiner does

• List every account you maintained or controlled during the year, business and personal.
• Run your own deposit analysis: total deposits, then identify transfers, loans, gifts and other nontaxable items, with documents.
• Reconcile the taxable deposits to the income on your return. If there is a gap, find out why before the IRS does.
• Assemble support for large or unusual deposits in advance.

If the analysis points to unreported income you cannot explain, stop and get advice before saying more. The field audit and office audit guides explain how these issues arise in each setting.

Deposits are not income. Unexplained deposits are a question. Answer the question with paper, and most of the scary numbers disappear.