Legal Definitions - net-worth method

The net-worth method is a technique used by the Internal Revenue Service (IRS) to estimate a taxpayer'staxable income when their financial records are incomplete, inaccurate, or entirely absent. Instead of relying on traditional accounting books, the IRS reconstructs the taxpayer's income by analyzing the change in their overall financial position from the beginning to the end of a specific tax year.

Here's how it generally works:

• First, the IRS calculates the taxpayer's net worth (total assets minus total liabilities) at the start of the year.
• Then, they calculate the taxpayer's net worth at the end of the year.
• The increase in net worth during the year is considered a starting point for estimating income.
• Finally, this increase is adjusted to account for any money received that isn't taxable (like gifts, inheritances, or loans) and any personal expenses paid that are not tax-deductible. The resulting figure is an estimate of the taxpayer's gross income for tax purposes.

This method is often employed in situations where taxpayers fail to maintain proper records, or when there's suspicion of unreported income.

Here are some examples of when the net-worth method might be applied:

• Small Business Owner with Poor Record-Keeping: Imagine a freelance consultant who primarily deals in cash payments and doesn't meticulously track all income and expenses, often mixing personal and business funds. During an audit, the IRS finds their records insufficient to verify the reported income. The IRS might then use the net-worth method. They would determine the consultant's assets (e.g., bank accounts, property, business equipment) and liabilities (e.g., loans, credit card debt) at the beginning and end of the year. If the consultant's net worth significantly increased, and they cannot provide legitimate non-taxable sources for that increase (like a documented inheritance), the IRS would estimate their unreported business income using this method.

• Individual with Unexplained Wealth: Consider an individual who reports a modest income from a declared job, but over several years, they acquire significant assets such as a luxury vehicle, a new boat, and make a substantial down payment on an expensive home. These acquisitions far exceed what their reported income could reasonably support. The IRS could apply the net-worth method to investigate potential undeclared income. They would calculate the individual's net worth at the beginning and end of the period in question. If the substantial increase in assets cannot be explained by reported income, documented gifts, or loans, the IRS would infer that the individual earned unreported taxable income to fund these acquisitions.

• Cash-Intensive Business with Discrepancies: A small restaurant owner operates largely on cash transactions and keeps very basic, sometimes incomplete, records of daily sales and expenses. During an audit, the IRS notices that the restaurant's reported income seems unusually low compared to its apparent business activity (e.g., high foot traffic, large inventory purchases) or the owner's visible lifestyle. The IRS might then resort to the net-worth method. They would assess the owner's personal and business assets (e.g., bank balances, real estate, equipment) and liabilities. A substantial increase in the owner's net worth that isn't justified by the reported income or other non-taxable sources would lead the IRS to estimate additional taxable income.