The IRS files thousands of tax fraud cases a year, making it the most commonly-charged offense in the Tax Code. In many of these cases, the taxpayer’s records are incomplete.  In many other cases, the taxpayer has no records whatsoever. Everybody knows that if the government has no evidence, it has no case, but that evidence does not necessarily have to be “books and records.”

The IRS has more than one way to prove tax evasion, and reconstructing the taxpayer’s income is one such tool.  By reconstructing records, the IRS can prove fraud without any records. This is why it’s critically important to consult with a qualified criminal tax attorney if you suspect the IRS is conducting a criminal investigation into your taxes.

Elements of Tax Evasion

First, let’s take a step back and look at what the IRS must prove under Internal Revenue Code 7201, because the first component of planning any trip is ascertaining the destination. There are three elements in a tax evasion case:

• Substantial Understatement of Taxes Due: There is no definition of “substantial,” and the Sixth Circuit (which includes Michigan) has essentially held that what is “substantial” is a fact question for the jury.
• Affirmative Effort to Evade Tax: The mere fact of filing a fraudulent return satisfies this element.
• Willful Evasion: Taxpayers who pay vendors other than the IRS during the period in question willfuly evade their taxes.

See how easy it is for the IRS to prove tax evasion, at least in terms of its legal elements? Moreover, under Section 7201, “any person” who files a fraudulent return can be prosecuted. That includes not only the taxpayer, but also paid tax preparers, accountants, and bookkeepers. It may apply to spouses who sign these returns as well, subject to the provisions of the innocent spouse defense.

How Does the IRS Prove Tax Evasion If There Are No Records?

As a preliminary matter, the Service must establish that the taxpayer’s records are legally insufficient. Normally, the IRS uses the record retention requirements, which rather conveniently direct taxpayers to “Keep records indefinitely if you file a fraudulent return.” If the taxpayer’s records are deficient, which is basically a foregone conclusion, the IRS can use one of several methods to reconstruct income:

• Net Worth Increase: If the taxpayer’s net worth has increased since the beginning of the first year, both the IRS and the jury generally assume that the increase came from unreported income. Of course, not all such increases come from new income, as prior cash or nontaxable income, such as an inheritance, could account for added wealth.
• Excessive Expenditure: If the taxpayer spent money like it was going out of style, it had to come from somewhere, which probably means the taxpayer probably has unreported income.
• Percentage Markup: If the taxpayer has a retail business, the IRS will sometimes examine the inventory, multiply it by a certain profit margin, and use that calculation to estimate income. The main hole in this theory is that, for various reasons, not all businesspeople obtain the same amount of profit on the same goods.

Appeals court judges nearly always defer to jury findings unless the evidence is clearly inadequate.  That means if the IRS can convince jurors that it successfully proved tax evasion (even without records), it is almost impossible convince appeals court judges otherwise.