The below information is the Internal Revenue Service explanation of the Net Worth Method of Proof, with details on how the calculations are done. This page on the IRS website is the source of the information.

9.5.9.5  (11-05-2004)
Net Worth Method of Proof

  1. An investigation utilizing the net worth method of proof differs from a specific item method in that direct comparisons of income, expenses, and credits can not be made. The net worth method of proof utilizes evidence of income applications such as asset accumulation, liability reduction, expenditures, and other financial data to indirectly establish correct taxable income.
  2. An accounting is made showing how funds generated from income were applied by identifying increases to net assets and various expenditures.
  3. After making adjustments for exemptions, itemized deductions, nontaxable income, and nondeductible losses, the courts permit the IRS to infer, indirectly, that the remainder is taxable income.
  4. By comparing this to taxable income reported on the subject’s return, if a return was actually filed an understatement of taxable income can be determined.
  5. The net worth method is a very effective way of proving taxable income in criminal income tax investigations. The formula for calculating the subject’s correct taxable income can be broken down into four steps:
  • The special agent must first calculate the change in a subject’s net worth (assets less liabilities). This is done by determining the subject’s net worth at the beginning and end of a period of time (a taxable year or years) and then subtracting the beginning period’s net worth figure from the ending period’s net worth figure. This computation will yield a change in net worth (either an increase or decrease in net worth).
  • The amount of this change in net worth is then adjusted for personal living expenses, nondeductible losses, and nontaxable items to arrive at a corrected adjusted gross income figure.
  • The corrected adjusted gross income figure is then adjusted for itemized deductions or the standard deduction amount, and then for exemptions, to arrive at a corrected taxable income figure.
  • Finally, by comparing the corrected taxable income figure with the taxable income reported on the tax return, the special agent can determine whether the subject failed to report any taxable income.

9.5.9.5.1  (11-05-2004)
Authority for Net Worth Method

  1. There is no statutory provision defining the net worth method and specifically authorizing its use by the Commissioner. However, every judicial circuit has endorsed the net worth method of proof and the Supreme Court has approved its use in a number of investigations. The following is a listing of some of the more prominent of those investigations:
  1. Holland v. United States, 348 US 121 (1954)
  2. Friedberg v. United States, 348 US 142 (1954)
  3. Smith v. United States, 348 US 147 (1954)
  4. United States v. Calderon, 348 US 160 (1954)
  5. Massei v. United States, 355 US 595 (1958)
  6. United States v. Johnson, 319 US 503 (1943)
  • These investigations outline the broad principles governing the prosecution and review of investigations based on the net worth method of proving income.

9.5.9.5.1.1  (11-05-2004)
Legal Requirements to Establish a Prima Facie Net Worth Investigation

  1. The Supreme Court, while firmly approving the net worth method of proof, cautioned, in Holland v. United States, 348 US 121, 125 (1954), that ” it is so fraught with danger for the innocent that the courts must closely scrutinize its use.”
  2. The Supreme Court set forth three requirements that the government must satisfy prior to using the net worth method of proof:
  1. establish an opening net worth with reasonable certainty
  2. negate reasonable explanations by the subject inconsistent with guilt
  3. establish that the net worth increase is attributable to currently taxable income – Id. at 132 – 137.
  • Net worth increases are determined by establishing a net worth at the beginning of a given year and then comparing this beginning net worth with the net worth at the end of the year. The opening net worth is the point from which net worth increases are measured. While every effort should be made to identify all of the assets and liabilities of the subject at the starting point, the government does not have to establish the opening net worth with mathematical certainty.
  • Without a doubt, determining how much cash an individual has “on hand” at the beginning or end of a year is an extremely difficult task. To require mathematical certainty would eliminate the possibility of using the net worth method of proof.
  • The thoroughness of the investigation is crucial in determining whether the government has established the subject ’s opening net worth with reasonable certainty. When the government chooses to proceed against a subject using the net worth method of proof, ” the government assumes special responsibility of thoroughness and particularity in its investigation and presentation.” United States v. Hall, 650 F. 2d 994, 999 (9th Cir. 1981).
  • Success in overcoming attacks on the legal sufficiency of the evidence supporting an opening net worth is directly related to the extent and thoroughness of the investigation. Although not a model, the Mastropieri investigation does furnish an excellent example of a number of steps that must be taken to establish an opening net worth. US v Mastropieri, 685 F. 2d 776, 779 (1982). For example, in Mastropieri:
    • The special agent canvassed 47 banks, 71 brokerage firms, and 13 lending institutions. In addition, the special agent searched the local property records of Bronx, Nassau, Queens, Kings, and Suffolk counties for the years during the investigation and prior to 1967.
    • The special agent checked records of the IRS and the county clerk and interviewed unnamed friends and relatives of the subject.

9.5.9.5.2  (11-05-2004)
When to Use the Net Worth Method

  1. The net worth method of proof is most often used when one or more of the following conditions exist:
  1. the subject maintains no books and records
  2. books and records are not available
  3. books and records are inadequate
  4. subject withholds books and records
  • The fact that the subject’s books and records accurately reflect the figures on the return does not prevent the use of the net worth method of proof. The government can look beyond the self-serving declarations in the subject’s books and records and use any evidence available to refute the accuracy thereof.
  • In addition to being used as a primary method of proving taxable income in civil and criminal income tax investigations, the net worth method can be used:
  1. to corroborate other methods of proving income
  2. to verify accuracy of reported taxable income

9.5.9.5.3  (11-05-2004)
Method of Accounting

  1. The net worth method of proof is not limited by the subject’s method of accounting. The net worth statement may reflect the subject’s corrected taxable income by whichever method of accounting (cash, accrual, etc.) is appropriate. Reflecting a certain accounting method in the net worth computation is accomplished by including certain accounts in the net worth statement and omitting others. For instance, to compute the income of a physician on the cash basis, patient accounts receivable and business accounts payable at the beginning and end of each year would be omitted. If the physician used the accrual method of accounting, these accounts would be included in the net worth computation.
  2. In preparing a net worth statement or summary for use in a criminal investigation, special agents should ensure that:
  1. The subject’s method of accounting is used.
  2. The cost of assets and actual amounts of liabilities are used and that values other than cost, i.e., market value or reproduction value, are not considered in the net worth computation.
  3. Estimated nondeductible expenditures are eliminated from the net worth computation, unless the subject agrees to the estimated amount or it is proper to include some minimum estimated personal living expense figures.
  4. Generally accepted accounting principles are followed.
  5. Technical adjustments that increase income are eliminated, e.g., unintentional errors or omissions relating to capitalized expenses, depreciation, revaluation of the basis of property, and changing inventory basis, or doubtful items such as unidentifiable commingled funds.

9.5.9.5.4  (11-05-2004)
Overview of the Net Worth Method of Proof Formula

  1. The net worth formula expanded:
Assets:
Cash on hand
Cash in accounts
Checking
Savings
Brokerage
Securities
Vehicles (motor homes, airplanes, motorcycles, etc.)
Business equipment
Real estate investments
Personal items
Negotiable instruments
Subtract: Liabilities and Accumulated Depreciation
Loans
Notes
Accounts payable
Credit card balances
Mortgages
Accumulated depreciation
Equals: Net Worth
Subtract: Prior Year’s Net Worth
Equals: Increase (Decrease) in Net Worth
Add:Adjustments for Personal Expenditures and Nondeductible Losses
Note:Personal living expenses (including payments that may later be allowed as itemized deductions or adjustments to arrive at adjusted gross income)
Federal income taxes paid
Life insurance premiums
Nondeductible portion of capital losses
Gifts of property made by subject
Losses on the sale of personal assets
Subtract: Adjustments for Nontaxable Items
Federal tax refunds
Gifts and inheritances received by subject
Veteran ’s benefits
Nontaxable portion of pensions and annuities
Tax-exempt interest
Capital loss carryover
Net operating loss carryover
Honest mathematical and bookkeeping errors
IRA and Keogh Plan payments
Other nontaxable income
Equals: Corrected Adjusted Gross Income
Subtract: Allowable Itemized Deductions or Standard Deductions
Personal exemptions
Equals:Corrected Taxable Income
Subtract: Reported Taxable Income
Equals: Unreportable Taxable Income
  1. In determining the value of assets, all assets in the computation are entered at cost or other tax basis. Fluctuations in fair market value are of no consequence in determining taxable income. Paper gains or losses resulting from changes in fair market value of assets are not taxable or deductible until said gain or loss is realized.

9.5.9.5.5  (11-05-2004)
Establishing the Starting Point

  1. The key to a successful net worth investigation is establishing a reliable beginning net worth (opening net worth) which includes all of the assets and liabilities on hand. It is this starting point from which all future increases or decreases will be calculated. This starting point is normally referred to as the base year. In a net worth computation, it is extremely important to firmly establish a beginning net worth (starting point or base year) with the best evidence available.
  2. In calculating annual net worth, be aware that an inverse relationship exists between one year and the next. If the subject ’s opening net worth is understated, there is a resulting overstatement of the increase in net worth for the following year. Conversely, if the subject’s opening net worth is overstated, there would be a resulting understatement of the increase in net worth for the following year.
  3. The first step to establishing a firm starting point is to determine the date (opening or base year) best suited for the investigation. The interview with the subject will strengthen the starting point. While questioning the subject, the special agent should attempt to develop all information relating to the subject’s assets and liabilities for the years involved. The subject should be questioned about the value of any item which cannot be determined from available books and records, e.g., cash on hand as of a particular date, personal living expenses, assets held in the names of others, gifts, inheritances, loans, and other nontaxable sources of income.
  4. The establishment of cash on hand is critical. The inability to establish a firm and accurate amount of cash on hand can be fatal to the investigation. Uncertainty about the amount of cash on hand is a common defense in net worth investigations. It will be easier to refute this defense if the special agent has established a firm beginning and an ending cash on hand amount is established. Cash on hand is almost always proved by circumstantial evidence.
  5. The best source of information in establishing an accurate cash on hand figure may be obtained from the subject during an interview. The special agent may not always have the opportunity to interview the subject in every investigation. However, when the opportunity does exists, the special agent should attempt to establish the beginning and ending cash on hand. In determining a firm cash on hand figure, the following subsections offer insight into possible techniques to employ during a subject interview.
  6. During the subject interview, the subject should be questioned in detail about cash on hand. The questioning should be preceded with an explanation of what constitutes cash on hand and elicit the subject ’s answer as to cash on hand. Cash on hand is coin and currency (bills, Federal Reserve notes, etc.) in the subject’s possession, i.e., on the subject’s person, in the subject’s residence, or other place, in nominee hands, or in a safe-deposit box. It does not include any money the subject has on deposit in any account with any type of financial institution.
  7. The special agent should use caution in using terms such as cash because people often refer to money on deposit in banks as cash on hand. The special agent should be specific and explain that he/she is referring to undeposited coin and currency in all locations.
  8. Most people have difficulty recalling specific dates and amounts, especially when several dates are involved, and they extend back for a number of years. Direct questions, such as “How much cash on hand did you have on December 31, ____” will frequently be answered with “I don’t know” or “I can’t remember that far back” . In such investigations, the special agent should persist in questioning about whether the subject had a depository for coins or currency and/or whether the subject placed any coins or currency in the possession of another person. The special agent should obtain a description of the depository. If the depository is a safe-deposit box or home safe, the special agent should relate the questions to when and where the box was rented or purchased. The special agent should obtain a description of the depository and a description of the funds (their denomination and quantity) to determine whether it was possible to have such a sum of money in that particular depository.
  9. The special agent may determine the amount of cash on hand by asking questions about the maximum amount of cash that the subject could possibly have had at any particular time. For example, such questions as, “Did you ever have more than $100 in cash on hand? More than $5,000? More than $10,000?,” may result in admissions that can establish the total amount of cash on hand at a particular date.
  10. Discussing the accumulation and purpose of the cash on hand may establish the minimum and maximum amount on a particular date. Determining the ultimate disposition of this cash on hand can provide a lead to a specific amount of cash on hand on a particular date. For example, a statement like “I used all my cash on hand to pay for my house in 1994” indicates how much cash the subject had on the date of payment. It also provides a cut-off date for cash on hand, since the subject evidently had no more cash after using all the cash on hand to pay for the house. The special agent should question the subject further to elicit an admission that the subject did not have any additional cash on hand as of the specified date.
  11. The special agent’s questioning should be directed toward developing:
  1. the maximum amount of cash on hand (undeposited currency and coin) claimed at the starting point and at the end of each year under investigation
  2. the amount of cash on hand at the date of the interview (This data is sometimes useful in computing cash on hand for earlier years.)
  3. how was the cash on hand accumulated and from what sources
  4. where the cash was kept
  5. who knew about the cash
  6. whether anyone ever counted the cash
  7. when, where and for what was any cash spent
  8. whether any record is available with respect to the alleged cash on hand
  9. the denominations of the cash on hand
  10. was the cash shown on any net worth or personal financial statements
  11. ask to see the cash on hand
  • In addition to questioning the subject about cash on hand, also:
  1. question the subject about prior years’ earnings
  2. obtain prior years’ tax returns to determine if no return was filed or if the returns indicate little or no income in prior years
  3. determine if the subject had financial difficulties prior to the starting point, e.g., compromises of overdue debts by the subject; foreclosure procedures against the subject; collection actions against the subject, etc.
  4. obtain copies of financial and or net worth statements
  5. question the subject as to the contents of any safe-deposit boxes
  6. question the subject concerning all taxable and nontaxable sources of income
  7. obtain loan records
  8. determine consistent use of checking and savings accounts
  9. determine if there are recurring overdrafts on non-sufficient funds (NSF) charges or other bank penalties
  10. determine the minimum payments on any credit card balances
  11. determine if there was ever a divorce and division of assets
  • In addition to interviewing the subject, the following investigative steps should be taken when establishing a firm starting point in a net worth investigation:
  1. The special agent should interview the subject ’s spouse, relatives, and close associates to determine if the subject received loans, gifts, or inheritances in prior years. The interview of the subject’s spouse should include cash on hand and sources of taxable and nontaxable income so that the subject cannot claim the increases resulted from funds the spouse received.
  2. The special agent should canvass banks and stockbrokers to determine whether the subject has or had any accounts that could be a source of funds, or whether he/she submitted any financial statements to the financial institution. When reviewing bank records, the special agent should determine whether the subject has ever had checks returned for insufficient funds.
  3. The special agent should examine financial statements presented for credit or other purposes at a time prior to or during the periods under investigation. The special agent can obtain these types of documents from banks, loan companies, bonding companies, and the other operating divisions of the IRS (offers in compromise and financial statements).
  4. The special agent should check the following records for potential assets, liabilities, and sources of funds:
real estate records to determine if the subject owns or has owned property that could be a source of funds
bankruptcy, foreclosure, and repossession record (If the subject filed for bankruptcy, this could be used as a starting point for net worth)
divorce records
social security records for prior earnings and receipt of any funds from social security
welfare records
probation records
  1. The special agent should determine the subject ’s borrowing habits, especially borrowing at high interest rates.
  2. The special agent should analyze available Federal and state tax returns. Tax returns can be obtained from the IRS, the state where the subject resided, the subject’s accountant and/or return preparer, or financial institutions where the subject has applied for and/or obtained loans.
  3. In the event the special agent is unable to firmly establish a starting point through the above-described steps, the special agent may have to rely upon an indirect approach to establishing a starting point. This can be accomplished by using a Source and Application of Funds computation.

9.5.9.5.5.1  (11-05-2004)
An Indirect Approach for Establishing a Starting Point

  1. Another method of establishing a starting point for cash on hand is to analyze the subject’s available finances for the years leading up to the starting point. Such a “source and application of funds” approach can also be used to bridge the years to the starting point from some point in time when cash on hand has been firmly established. The following is an example of how a source and application of funds computation can be used to establish a firm starting point in a net worth investigation.
  1. The subject filed bankruptcy in 1993. Immediately following the bankruptcy, the subject did not have any assets or liabilities. The starting point for the investigation is December 31, 1996, the prosecution years are 1997 and 1998. For the purposes of using the source and application of funds computation in determining a firm starting point (cash on hand figure on December 31, 1996), the years 1993 through 1996 would be treated as one unit.
  • First, the special agent must determine the total amount of funds available (taxable and nontaxable) during 1993 through 1996. From this amount, he/she will subtract the subject’s personal expenditures for the period. This will yield the maximum amount of funds available for the subject’s net worth at the beginning of 1997.
  • Second, the special agent subtracts the subject ’s beginning net worth figure (the amount the investigation revealed as of December 31, 1996, without the cash on hand figure) from the total funds available for net worth. This will account for non-personal living expenditure payments by reflecting the payments made to increase assets and decrease liabilities.
  • Funds used to purchase assets disposed of prior to the starting point can be included as funds applied, if their disposition is traced and the funds from the disposition are accounted for as funds available. The advantage of using this method is that the beginning net worth can be used as funds applied. If the subject has a large beginning net worth, it may be possible to overcome the subject’s reported income for prior years and show that he/she could not have had cash on hand at the starting point. This can also be used to establish a maximum possible cash on hand figure. It is important that the subject be given credit for all sources of funds available (both taxable and nontaxable) in the period for which the source and application method is used.
  • When using the one unit source and application of funds method to establish a firm starting point, the beginning net worth must be adjusted for any asset purchased and completely paid for prior to the source and application years. This is necessary because no funds were applied during the source and application period to purchase the asset. This point is illustrated in the following example:
  1. The subject purchased and paid off a residence 10 years prior to the starting point. The cost of the residence $20,000, is included in the beginning net worth. The source and application of funds only covers a period of six years prior to the starting point. The beginning net worth must be adjusted by subtracting the cost of the residence because the residence was purchased with funds acquired by the subject prior to the years included in the computation. This is illustrated as follows:
Funds available (1991–1996)

$105,000

Less: Funds applied to personal living expenses

-50,000

Equals: Maximum funds available for an increase in net worth

55,000

Beginning net worth per investigation

$72,000

Less: Cost of residence purchased prior to 1991

-20,000

Funds applied by the subject to acquire the adjusted beginning net worth

$52,000

Maximum funds available for an increase in net worth

$55,000

Less: Funds applied by the subject to acquire the adjusted beginning net worth

-52,000

Equals: Maximum possible cash on hand at starting point 12/31/1996

$ 3,000

  1. This method can be used to establish cash on hand at the starting point if the subject does not cooperate during the investigation, or to corroborate the subject’s admission of cash on hand. A source and application of funds cannot be used in every investigation but, in certain instances, can be a valuable tool in determining possible cash on hand.

9.5.9.5.8.1  (11-05-2004)
Adjustments to Net Worth

  1. After the special agent has established a firm starting point and identified the amount of cash on hand, the next step is to calculate the subject’s change in net worth for the prosecution years. Once the change (increase or decrease) in the subject ’s net worth has been determined, the special agent makes adjustments to that figure and arrives at the subject’s corrected adjusted gross income. Perhaps the most difficult phase in calculating a subject’s corrected taxable income is identifying, documenting, and correctly applying the adjustments to the subject ’s change in net worth for the nondeductible and nontaxable items. These adjustments are necessary in arriving at the subject ’s corrected adjusted gross income figure from the calculated increase or decrease in net worth. The following paragraphs will identify common adjustments to the calculated increase or decrease in a subject ’s net worth.
  2. The following are examples of adjustments for personal expenditures and nondeductible items which are added to the subject ’s change (increase or decrease) in net worth:
    1. personal living expenses
    2. Federal tax payments
    3. nondeductible portion of capital loss
    4. losses on sale of personal assets
    5. gifts made
    6. life insurance premiums
  3. The following are examples of adjustments for nontaxable items which are subtracted from a subject’s change (increase or decrease) in net worth:
    1. for capital gain transactions see the appropriate instructions and forms for statutory inclusions and exclusions
    2. gifts received
    3. inheritances
    4. nontaxable pensions
    5. veterans benefits
    6. non-taxable portion of social security income
    7. tax exempt interest
    8. proceeds from life insurance
    9. disability income received (USC §104–§106)
    10. errors in subject’s records (in his favor) which relate to honest mathematical and bookkeeping errors found in the subject ’s books and records, and which tend to account for part of the understated income
    11. gains on the sale of a personal residence (depending upon the date of the sale, the gain could be entirely non-taxable) pursuant to the applicable law concerning these transactions and to the extent of whatever non-taxable gain the subject may have received
    12. net operating loss carry-back and carry-forward
    13. allowed capital loss carry-over
    14. Federal income tax refunds
  4. No adjustment is necessary to net worth increase or decrease for:
    1. net short-term capital gain
    2. deductible portion of net short-term capital loss
    3. excess of net short-term capital gain over net long-term capital loss

3 Comments

  1. […] Net Worth Method – This indirect method of proving income looks at the accumulation of assets, the reduction of liabilities, expenditures, and other financial information to establish the target’s income. A starting point must be identified and the assets and liabilities must be valued at that point. Then the analysis attempts to estimate expenditures, increases to assets, and decreases to liabilities, either through documentation of actual figures or reasonable estimates of known items. […]

  2. […] of the case? It appears to be based on a lifestyle analysis, which the feds are more apt to call the net worth method of proof.  As happens in many cases involving financial crimes such as drug dealing, money laundering, and […]

  3. sjn 04/16/2015 at 3:25 am - Reply

    This blog is very helpful for a study case that is presented in my accounting course, Fraud Examination.

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