The IRS almost always checks for unreported income when it audits an income tax return. The IRS does this by analyzing the deposits made in the taxpayer’s bank accounts. But what if a deposit was not taxable, as in the case of an amount received for a third party and paid out to a third party? The court recently addressed this in Azam v. Commissioner, T.C. Memo. 2018-72, which provides an opportunity to consider the question.
Facts & Procedural History
The facts and procedural history in the case are not unusual. The taxpayer’s income tax returns were audited by the IRS. The IRS conducted a bank deposit analysis and identified deposits in excess of those reported on their income tax returns. The IRS adjusted the taxpayer’s income accordingly, which eventually led to the tax court case.
About the IRS’s Bank Deposit Analysis
The IRS’s bank deposit analysis is an indirect method for determining the amount of income the taxpayer received. The word “indirect” refers to the fact that it is not direct evidence. Direct evidence would be conclusive; whereas, indirect evidence is secondary. It is subjective. It is an estimate. It is not always accurate.
The courts have generally accepts the IRS’s bank deposit analysis when the following factors are present:
- The taxpayer was engaged in an income-producing business, activity, or profession.
- The taxpayer made periodic deposits of funds into his/her bank accounts, or into nominee bank accounts over which he/she exercised control.
- The deposits into the above referenced accounts reflect current year income and an adequate investigation of deposits was made by the IRS to negate the possibility that deposits arose from nontaxable sources.
- The unidentified deposits have an inherent appearance of income.
Once accepted, the burden is on the taxpayer to prove that the analysis is incorrect.
So how does the IRS conduct a bank deposit analysis? Simple. The IRS’s bank deposit analysis starts by identifying all relevant bank accounts, identifying all deposits into those accounts, and eliminating any deposits that are not taxable. These non-taxable deposits include transfers, loans, etc.
Transfers In and Out
This brings us to transfers in and out, as in the Azam case. In Azam, the taxpayer had received rents for a third party and, once they were received, distributed those rents to the owner of the building.
You may be wondering why the taxpayer would do this? It is not stated in the case, but having seen this issue time and time again, it is likely that there was a legal reason why the taxpayer was receiving the rental income. This may include immigration issues, divorce or family issues, etc.
With transfers in and out, it is up to the taxpayer to convince the IRS agent to remove the transfers. The taxpayer may have to have the third party show up or provide an affidavit to confirm the facts. The IRS agent can then check the IRS’s records to ensure that the third party picked up and reported the income on their tax returns. If the third party did not report the income, the IRS agent will likely insist on including the income for the taxpayer.
The Court’s Take on Transfers In and Out
So what do the courts say about this type of in-and-out transfer? The Azam case provides a good example. The court sided with the IRS as the taxpayer was not able to produce the third party or any real evidence, other than their own testimony, to establish the transfers out.
Had the taxpayer been able to get the third party to testify in court, the court may have reached a different decision.
This is the general rule. Property held by another is a bailment or constructive trust. These amounts are generally not taxable to the recipient. But as a practical matter, they may be taxable to the recipient if the recipient is audited by the IRS and cannot prove that the funds are non-taxable during the course of the audit.