Key Takeaways The IRS uses indirect income reconstruction methods when it believes a business has underreported income and direct records are unavailable or unreliable The five primary methods are bank deposits, net worth, markup, cash T analysis, and source and application of funds Each method has specific vulnerabilities that an experienced tax professional can exploit to reduce or eliminate proposed adjustments Detailed record-keeping is the best defense against income reconstruction, but defenses exist even when records are incomplete Professional IRS audit defense representation is essential in income reconstruction cases due to their complexity Why the IRS Uses Income Reconstruction The IRS turns to income reconstruction when it has reason to believe that a business's reported income does not reflect its true economic activity. This suspicion may arise from specific indicators uncovered during an audit, from third-party reports that contradict the taxpayer's returns, or from patterns in the taxpayer's financial behavior that suggest unreported income. Cash-intensive businesses — restaurants, bars, car washes, construction companies, and retail stores — face the highest risk of income reconstruction because cash transactions are inherently more difficult to trace than electronic payments. The stakes in income reconstruction cases are enormous. The IRS's calculations frequently result in income figures that far exceed the taxpayer's actual income, leading to proposed assessments that can threaten the survival of the business. In the most extreme cases, income reconstruction findings can trigger referrals to the IRS Investigation division for potential prosecution of tax evasion. For these reasons, income reconstruction cases require the most experienced and specialized tax controversy representation available. What Is IRS Income Reconstruction? Income reconstruction is the process by which the IRS estimates a taxpayer's true income using indirect methods when the IRS believes that the taxpayer's books and records do not accurately reflect actual income. The IRS has...