Legal Definitions - cash-expenditure method

The cash-expenditure method is a technique used by the Internal Revenue Service (IRS) to determine a taxpayer's actual income, particularly when their reported income appears to be unusually low compared to their lifestyle or known spending. This method involves comparing the total amount of money an individual or business spends on goods, services, and investments during a specific period with the income they officially reported for that same period.

If the total expenditures significantly exceed the reported income, the IRS may conclude that the difference represents unreported taxable income. This method is often employed when a taxpayer's financial records are incomplete, unreliable, or when there's a suspicion that income is being hidden.

Here are some examples of how the cash-expenditure method might be applied:

• Lavish Lifestyle vs. Reported Income: Imagine an individual who reports an annual salary of $50,000 but is known to regularly drive luxury vehicles, take multiple expensive international vacations each year, and has recently purchased a high-end boat with a substantial cash payment. The IRS might use the cash-expenditure method to investigate. They would calculate the total cost of these significant expenditures (car payments, travel, boat purchase). If these expenses far exceed the reported $50,000 income, the IRS would treat the unexplained difference as unreported taxable income, subject to taxes and potential penalties.

• Small Business Owner with Unexplained Wealth: Consider a small business owner who consistently reports very modest profits, sometimes even losses, on their business tax returns. However, this owner recently made a large down payment on a new, upscale home and is observed making frequent large cash purchases for personal items. The IRS could apply the cash-expenditure method by examining the owner's personal spending and asset acquisitions (like the home down payment). If these personal expenditures cannot be reasonably explained by the reported business profits or other legitimate income sources, the IRS would attribute the unexplained spending to unreported business income.

• Undisclosed Income Source: Suppose an individual reports no formal employment income or business profits for several years. Despite this, investigators discover that this person has paid off a significant mortgage balance in cash and has made several large, undocumented investments in real estate. The IRS would likely employ the cash-expenditure method. They would sum up the mortgage payoff and the real estate investments. Since no income was reported, any substantial expenditures would be considered unreported income. This method is particularly useful when the source of income is suspected to be from activities where traditional income records are absent or intentionally concealed.