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Laura W. Morgan
Family Law Consulting

You know the opposing client is hiding income. It might be income that doesn't show up on tax forms. See Hidden Income. How do you prove it? Analogize your task of finding hidden income or assets of a parent with that of finding a drug lord. By doing so, you will see that the indirect methods of discovering such income used by the Internal Revenue Service and other state and federal government agencies will also be very helpful in your specific case. See Use of Indirect Methods to Prove Income, 16 Fair$hare No. 10 at 2 (Oct. 1996). The methods are as follows.

A. Sources and Application of Funds Computations

In essence, is flagged if all known applications of funds (i.e., money spent/expenses) significantly exceed the known sources of those funds. In other words, if one's expenses are $20,000 per month but the only known sources of income amount to $10,000 per month then there must be hidden income. All sources and uses of cash flow must be considered, whether originating from taxable income, loans, gifts, exchanges between bank accounts or other sources.

B. Percentage Mark-Up Analysis

This method is commonly used by state agencies to compute or verify sales tax liabilities. The IRS has also used this approach to test gross receipts by extrapolation from purchase records. The mark up (margin) in a business is the amount added to the cost of an item for sale. Average mark ups can be determined through interrogatory or deposition. This computation can be enhanced by corroboration of industry averages and bank deposits.

C. Net Worth Expenditures Methods of Proof

These methods require establishing assets and liabilities at fixed points in time. Income is measured by the degree to which net worth has increased during the period. First, determine the value of the assets as of a set date (i.e., date of marriage or five years prior to date of separation). The assets consist of cash and cash equivalents such as brokerage accounts, mutual funds, government bonds, accounts and notes receivable. Fixed assets, such as buildings, machinery and equipment, must be incorporated in the computation at cost. Second, determine the liabilities as of the set date. These include notes and accounts payable, and mortgage liabilities. Leads to banks and loans from family members should be investigated so that the net worth computation does not mistakenly consider receipts from these sources as income. Third, determine the net worth which is “what you have less what you owe.” For example, if the beginning net worth is $25,000 and the ending net worth is $145,000, assume the $120,000 increase represents income.

There may be certain items that are not defined as assets but should be added to the net worth increases since they represent funds which may have been created by income. They could be vacation travel, weekend cottage rentals and gifts. Non-income items such as gifts or inheritances may actually reduce the income in this methodology so you must take these into consideration so as to attempt to obtain the most accurate and realistic income calculation.

In sanctioning the net worth approach, if an individual has more wealth at the end of a period than at the beginning of the period, and non-income items such as inheritances, gifts and loans, do not explain the increase, then the increase is a valid approximation of income earned during the period. The essential elements of a case using the net worth method are as follows:

1. A beginning net worth must be established with reasonable certainty.

2. Net worth at the end of the period must be established with equal certainty. The difference between beginning and ending net worth represents the net worth increase, and, as noted, can be considered income.

3. A likely source of income from which the net worth increase originated must be established. Alternatively, the existence of nontaxable sources of income must be negated.

4. Reasonable expectations, inconsistent with guilt, offered by the defendant to explain the net worth increase must be negated.

D. The Bank Deposits Method of Proof

This method involves summing up all deposits and credits to all known bank accounts of the subject. Adjustments are made to reflect exchanges between bank; non-income deposits such as loans and gifts; sales of capital assets; checks issued to cash which may have been available for redeposit; and cash on hand at the beginning of the period. If certain precautions are taken, total deposits can be considered to represent income.

Deposits to all financial accounts should be included. One should consider savings accounts, mutual fund accounts, and the like. They can be treated separately since they may be inactive so long as there is a proper accounting of transfers from these accounts. The transfers do not represent income. Other non-income items are checks issued to cash, bad checks redeposited, loans and gifts.

The essential elements to prove income using the bank deposit method are:

1. Establishing that the subject was engaged in a business or income- producing activity;

2. Periodic and regular deposits of funds were made into the account(s);

3. An adequate investigation of the substance of the accounts was made to distinguish between income and non-income deposits;

4. Deposits that have not been identified during the investigative process nonetheless have the inherent appearance of income;

5. Currency expenditures that are added to the resultant bank deposit computation must have originated outside the bank account(s) that are being used in the computation.

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