Summary:
Internal Revenue Service uses various methods to determine taxable income.

When a taxpayer's records are inadequate, the Internal Revenue Service computes income.

Sometimes it uses information from a taxpayer or taxpayer's records like in these four cases:

• For a service station's gross income, the IRS reviewed supply records. To the amount paid for supplies, it added a profit margin, like seven cents to each gallon of gasoline and pumped up the station's income.
  
• The IRS raided five houses used in an illegal gambling operation. It considered betting slips and tallies from three days' activities as average in estimating income for the ten months the lottery operated.
  
• A mortuary operator listed data like date of death and charges for various items like caskets in a memorandum book. To prepare the tax return, he used a ledger. But the two books didn't match. The agency used the memorandum book and buried the ledger.
  
• Two IRS special agents, posing as an engaged couple, interviewed a photographer. He said he had photographed weddings for 11 years. He said he did 28 to 30 a year charging $250 to $750. Later in court, the photographer said his remarks were puffery; he didn't take pictures for profit. The court had a negative opinion. It said the photographer could change his mind in a flash: He always said what was in his best interest at the time, first to the special agents and then in court. The judge accepted the agent's computations based on numbers from their interview.
  

As much leeway as the courts give the IRS in computing income, they sometimes balk:

• The agency learned about an alleged illegal drug dealer from an informant. Based on his testimony, the alleged dealer's organization sold 500 bags of heroin daily at $50 per bag over 61 days. The court refused to accept the IRS computation based on what the informant said. The court noted he jumped bail on narcotics charges after testifying.
  

• The IRS said Marietta Stewart's income for five years totaled more than $350,000.
  

The Fresno, Calif., resident said this can't be correct because she barely had enough money to live on. During her marriage, she lived modestly, receiving little money from her husband. For years before his conviction as a drug dealer, she requested financial assistance from her church for herself and her six children.

Using a formula, the IRS estimated his drug income over five years at $757,652. His income, in a community property state like California, is considered half hers. So the agency said she owed taxes on $378,826.

The judge ruled for Stewart:

"The absence of adequate records does not give the IRS carte blanche for imposing draconian absolutes." It has wide discretion in its computations, the judge said, but this was unreasonable.

Comments: Once the agency estimates income, the taxpayer must prove its numbers are wrong or the taxpayer has an adequate bookkeeping system. To prevent the problem, keep records supporting each item of taxable income and deductible expense. Also keep records of nontaxable income--an inheritance, a gift or the receipt of borrowed money--so you can prove it shouldn't be on your return. Save a copy of that promissory note supporting the loan and a copy of the thank-you letter to Aunt Martha.

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