Tax Law

Confusion in the Court of Appeals About the Indirect Method of Proof

In both criminal and civil cases, the Government sometimes uses what is called an indirect method of proof to show that a taxpayer owes additional tax. A direct method, for example, uses the return as filed and proves omitted income or improperly claimed deductions or credits. The indirect methods essentially reconstruct the taxpayer's tax picture (income, deductions, credits, taxable income) without using the return as the starting point. I explain the general theory of the use of the method in my book as follows:

In many cases, the Government may not be able to assemble proof of a tax due and owing from direct methods of proof. In those cases, the Government has developed indirect methodologies that circumstantially prove tax due and owing. The key cases blessing these indirect methodologies have arisen in the guilt determination phase in tax evasion cases where tax due and owing is an element of the offense or in parallel civil cases. These methodologies are also used also in the sentencing phase, although I am aware of no important case opinions arising from sentencing phase determinations.

All indirect methodologies are based on logic - from the facts proven can the further inference be made that there is a tax due and owing. It is the force of that logic - and that force alone - that permits the use of these methods. And, for conviction, the force of the logic must persuade beyond a reasonable doubt.

For use of an indirect method, the Government should establish that a direct method is either not available or not reliable under the circumstances. For example, the Government should show why the taxpayer's books and records are not available (taxpayer lost or destroyed them) or, if available, are not reliable (substantial provable irregularities). The indirect methodology itself may be sufficient to show that -- for example, large cash flows not reflected on the books and records establishes that they are unreliable. The Government must also establish either a "likely source" for the unreported income or that it has reasonably negated nontaxable sources of income.

Finally, I provide here only a summary of the principal indirect methods. These methods which are heavily fact dependent can be complex in their application. A good and substantially more detailed discussion of these indirect methods is contained in the CTM.

There are various ways in which the indirect methodologies attempt the reconstruction. The more commonly encountered indirect methodologies go by such labels as the "Net Worth Method" and the "Bank Deposits / Cash Expenditures Method".......

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