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Forensic Accounting – Hidden Secrets On Your Tax Return

Painting A Lifestyle Picture Through The Income Tax Returns

Forensic AccountingDuring the course of a fraud investigation, one of the most important financial documents that a forensic accountant can obtain is a tax return. These documents paint a financial lifestyle picture  for the investigator.  This article will focus on the numerous and varied types of information and leads that can be gleaned from a thorough analysis of Federal 1040 Individual Income Tax Returns.

Obtaining tax returns can be a challenge or relatively easy depending on the type of case in which the investigator is involved. In civil cases, the most direct method of acquiring tax returns is through a Request for Production of Documents or Subpoena. In criminal cases however, it may be necessary to acquire tax returns incident to the execution of a search warrant, a Grand Jury or Administrative Subpoena or an Ex Parte Order. Tax returns for the period under investigation should be acquired and analyzed.

The financial investigator should make the judgment call as to the time period analyzed and extenuating circumstances may result in the review of fewer or a greater number of years. In most civil cases, the last five years of tax returns are reviewed unless there are specific allegations of asset dissipation, misappropriation of funds or perhaps inherited funds need to be traced. In criminal fraud cases, all years in question are requested, analyzed and included in the forensic accountant’s report.

Once the income tax returns are in the hands of the forensic accountant, analytical procedures commence and the fountain of financial information begins to flow. The most obvious information provided is specific income and expense figures. The investigator now has the subject’s own representations as to the amount of money earned and tax related expenditures on a yearly basis. This is important since it is very difficult for the subject to dispute his own representations without admitting to tax evasion. If a net worth calculation or some other alternative method of proof is being used in proving the case, tax returns supply an excellent starting point to obtain many subsequent figures for those schedules.

The actual analysis of tax returns is a multi—part process. Beginning with Form 1040, the investigator is afforded and overview of the complete returns and may be furnished with the such pertinent facts as:

The subject’s current and prior addresses are important because the investigator may not have prior knowledge of said addresses and a public record search should supply the answers to the disposition of the real property. Was the property sold or is it still owned by the subject? What happened to the proceeds from the sale? Can those proceeds be traced into another asset?

The subject’s social security number (SSN) is contained on the tax return and if necessary can be verified through public records. The prefix of the SSN can be traced to the state of issue to determine parents’ names, maiden names, prior addresses, etc. Those names often times are used by subjects as aliases and nominee names in business dealings and to effectively hide assets.

The tax return reveals the marital status and if divorced, the name of the ex-spouse and their SSN. It isn’t hard to imagine the abundance of information a spurned ex-spouse can provide.

The names of DBA’s (doing business as) of any businesses in which the subject has an ownership interest. Additional information in that category may include business addresses, type of business, Employer Identification Number (EIN), etc. The EIN, like the SSN, will reveal the state in which it was issued and appropriate follow-up, such as Secretary of State inquiries, can then be performed.

Sources of income will be evident by just glancing at the 1040. The name of the employer may be contained on a supplemental schedule or a copy of the w-2. Other sources of income may be revealed including pension, alimony received, unemployment compensation, Social Security benefits, IRA or other retirement fund distributions, tax refunds, gambling winnings, interest and dividends, capital gains, rental or royalty income, and farm income.

Expenditures evidenced on the 1040 would include contributions to an IRA, Keogh, SEP or SIMPLE plans, alimony payments, moving expenses, and taxes paid. All these “known” sources and expenditures of funds are important in completing the subject’s financial picture.

Lastly, if a paid preparer was used, the 1040 reveals the individual and firms names, address and identifiers of the preparer. This is important should the investigator need to subpoena additional financial documentation.

SCHEDULE A:Itemized Deductions reveal known and previously undisclosed sources of expenditures, which may be of importance depending on type of case and exactly what the investigator is looking for. Areas found to be the most important include:

Real Estate Taxes– these can be tied to known parcels of real property or lead the investigator to hidden parcels. Perhaps a database real property search is necessary to determine the location of unknown parcels.

Personal Property Taxes– Even though the Department of Motor Vehicles (DMV) in the majority of states no longer provide ownership information through their offices, it is available in many states through database companies. Alternatively, it should be relatively easy to determine if the property taxes paid on motor vehicles relate to the subject’s known auto. If additional personal property taxes are evident, the investigator may want to run aircraft registration and watercraft records to confirm or eliminate those possibilities.

Interest– Home mortgage interest will reflect the amount of interest paid by the subject on the non-rental real property both to financial institutions and individuals. If the amount of interest paid is small compared to the value of the home, it may indicate a large down payment, and inheritance of property, or excess principal payments.

Investment Interest– Amounts included in this section represent deductible interest expense on investments in the subjects name. This is where an investigator may find evidence of assets held in offshore accounts or businesses.

Miscellaneous Deductions– This section will reflect fees paid for safety deposit boxes, tax preparation fees, and unreimbursed employees expenses. There should also be a deduction for gambling losses, if gambling winnings are included on the 1040. No one is going to claim 100% of their winnings without attempting to claim the wagers they placed to acquire those winnings.

SCHEDULE B: Interest and Dividend Income details where the individual has invested money and provides the investigator with previously unknown leads for possible follow-up.

Interest form seller-financed mortgages- the payer’s name, address and SSN should be listed here along with the amount of interest paid to the subject. This represents a source of funds the investigator may not have previously known about and should be verified.

Interest and dividend income from financial institutions, brokerage firms, partnership or Sub-S corporations, public stock ownership, etc., will also be listed in this section. All sources of funds should be investigated and subpoenas issued to determine the balance and activity in the account.

Income from foreign accounts or trusts will be evidenced in Part III of this form as will the name of the foreign country. Depending on the foreign country and their privacy laws, this information may or may not be verifiable. Verification procedures on this information may be difficult, if not impossible.

SCHEDULE C: Profit or Loss from Business provides the investigator with a source of legitimate income and leads to possible assets and associates. The investigator should be familiar with type of industry being reported to assure a thorough understanding of the information contained on this form. If the investigator is unfamiliar with the industry, they should conduct research into the industry and other businesses to assure an adequate analysis of this form.

The name and address of the business needs to be verified for additional real and personal property owned by the subject or in the DBA name.

The investigator should be aware that large cash flow businesses, i.e. bars and small restaurants, consulting firms, laundry mats, etc., offer good cover for money laundering operations.

Excessive legal/professional fees may indicate a less than arms length relationship with the attorney or accountant. This should be noted when requesting documents from the accountant.

Sub-contractor expenses should be verified through the 1099s and independent verifications.

Perform reasonableness tests on the cost, performance and liquidity ratios. In this instance, knowledge of the industry is imperative.

Business records including the General Ledger, General Journal, cash receipts, cash disbursements, bank statements, cancelled checks, and business tax returns should be acquired and analyzed.

SCHEDULE D: Capital Gains and Losses will provide the investigator with lump sum income and expenditures amounts from the purchase and sale of investments. The total cost of an investment needs to be considered in the year of purchase and the total proceeds received in the year of sale should be included as a source of income formulating the financial picture or in an alternative method of proof calculation. The name of the investment will also be revealed on this schedule and Amy provides the investigator with additional leads for subpoena.

SCHEDULE E: supplemental Income and Loss may provide the investigator with new information regarding income or losses from rental properties, royalties, partnerships, S Corporations, estates and trusts. This information includes: rental property in other states, names and Employer Identification Numbers for business affiliations, estates and trusts. Be aware that the income or loss amounts from partnerships or S-Corporations are non-cash adjustments to the tax return and do not constitute actual losses or spend able cash and therefore should not be considered in the financial picture. Ownership interest and benefits derived from these business affiliations should be investigated.

Financial investigated results are only as complete as the documents and the information analyzed during the course of the investigation. If a financial investigator is fortunate enough to acquire tax returns on the subject of the investigation, the resulting assistance and leads provided may prove immeasurable.

If you have any questions or require further info please call 718-531-1105 or send an email.

This web site and these articles are not tax or legal advice and are not intended as tax or legal advice.  They are intended to provide only general, non-specific legal information and are not intended to cover all the issues related to the topic discussed.  The specific facts that apply to your matter may make the outcome different than would be anticipated by you.  This web site and these articles are based on United States law.  You should consult with an accountant or lawyer familiar with the issues. This web site and the articles contained on this web site are not solicitations.


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Ronald Semaria
Semaria Consulting
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