During the course of a tax audit, the agent will add up all bank deposits, back out identifiable non-tax items (such as account transfers) and compare that total to the gross income reported on the tax return. The excess of deposits over reported income is deemed to be unreported taxable income unless proven otherwise. Frequently, taxpayers find themselves trying to explain undocumented deposits. A loan from a friend, a gift from a relative, and other clearly nontaxable deposits will be included in the taxpayer’s income unless proof of what the deposit is can be provided.
The most recent case, Cherry vs. Commissioner (TC Memo 2013-3), the taxpayer offered oral testimony as to the nature of various bank deposits. The court rejected this, citing Nicholas vs. Commissioner (70 TC 1057), a 1978 case in which the court ruled that absent documentary evidence that various deposits were from nontaxable sources, the deposits were income.
The lesson is that taxpayers need to keep books and records under the assumption that the IRS will audit their return. Whether the taxpayer is an individual, business, trust, or nonprofit, the rules are the same. Proper documentation is key in avoiding paying tax on what should be nontaxable income.