UNREPORTED
INCOME AND HIDDEN ASSETS
 Unreported income and hidden assets are often alleged in
divorce proceedings, with the spouse who is not running
the business claiming that unreported income should increase
both the spousal support award and the valuation of the
family business.
In civil litigation, it is often a
partner or shareholder that is alleging that someone
in his business is hiding income.
The process of finding and proving unreported income or
hidden assets is often one of the most difficult assignments
of a forensic professional, and the costs must be weighed
carefully against the potential benefits.
However, in some cases, the process is much easier than
one might think, as the following case histories illustrate.
Unreported Beer Sales
A large restaurant sold Southern food and beer, with the
beer being sold in a prominent part of the restaurant. The
beer sales were a major part of the business. The owner
reported approximately $50,000 of annual income from the
business, and yet he and his wife drove expensive cars,
their children attended private schools, and he was buying
significant amounts of real estate.
Records of the local beer distributors were subpoenaed.
Those records detailed exactly how much beer, and what types
of beer (kegs, bottles, etc.) were sold to the restaurant
during the prior two years. A member of our firm went to
the restaurant, ordered a drink at the bar, and took note
of all of the prices of the beer by type (Bud, Miller, regular,
light, etc) and size (8 oz, 12 oz, etc).
The amount of beer purchased per the subpoenaed records
of the beer distributor was then priced out.
For example, if 1,000 cases of Miller ten-ounce light were
purchased each year, and each case held 24 bottles, and
that item would sell in his restaurant for $2.00, then
the sales for that item would amount to $48,000 per year.
After pricing out each item of the purchased beer, we arrived
at an expected total sales for the year. (Inventory was
assumed to have remained constant at the beginning and the
end of the year, and we adjusted the current prices to reflect
probable lower prices for the prior year.)
We then compared this computed total sales of beer with
what was reported on the books, and found that the reported
sales was around five hundred thousand dollars lower than
our computed amount.
As a result, at trial the court found that the gross income
available for support was vastly higher than what was
reported on the tax returns, and the value of the business
was much higher due to the higher level of income and profits
that were previously not identified.
The Hidden Factory
We were asked to value a certain California manufacturing
company. The document production was going very slowly,
and then we were provided with approximately thirty boxes
of documents at the opposing attorney's office. As
expected, many of the boxes contained useless information,
and we went through those quickly.
However, one box contained miscellaneous files, including
correspondence between the company and its patent attorney.
The file contained a letter from the company's patent attorney
pointing out that the trademark of a particular unrelated
Florida company was similar to a trademark of a product
made "in the Atlanta facility".
Until then, there had been no mention of an Atlanta facility
and nobody was aware of any business location besides
the California facility. We notified counsel, and soon enough,
full details of the "hidden factory" were produced.
Home Improvements
A manufacturer of personal products made massive improvements
to his home, so that the additions were larger and more
costly than the original structure. Extensive landscaping
was also done, including the transplanting of large trees.
An analysis of the personal banking records showed that
the remodeling was not paid from personal funds.
The business records were then analyzed, and it was noted
that there were many corporate payments to home remodeling
contractors and landscapers, but the supporting invoices
all indicated that the work was done at the company. Even
the massive landscaping invoices showed that the work was
done at the company's office, which was located in an industrial
park that had virtually no landscaping.
Furthermore, the industrial park was not even owned by
the company, so it was peculiar for the company to be apparently
paying for the landscaping of someone else's property. Something
was obviously out of order, but the necessary proof was
missing.
The document production procedure being followed was that
all of the documents requested were provided in xerox form.
Because the home remodeling was apparently not paid by the
homeowner or his business, which was bizarre, and because
of the unusual landscaping situation, we specifically demanded
the original home remodeling invoices.
We were eventually shown the original invoices for all
of the home remodeling, and it was clear that the job locations
and some of the work descriptions had all been whited out
and changed. When the whited out documents were held up
to a light, the original writing was legible, and it showed
that the remodeling work and the landscaping were done at
the family residence.
The remodeling deductions were added to the gross income
available for support and to the valuation calculations.
Techniques Used to Find Unreported Income and Hidden
Assets
The above examples demonstrate that finding unreported
income and hidden assets is not a matter of guesswork. While
success is never guaranteed, the use of certain techniques
may produce successful results. Here are a few tips to consider:
1. Look at the lifestyle
One of the first steps is to look at the lifestyle of the
person earning the income and match it with the income being
reported. What kind of car does he/she drive and how was
it paid for? What kind of clothes are being purchased, where
does he travel and what hotels does he stay at?
If there
is a disparity between the lifestyle and the reported income,
then one must look at the person's debt to see if the lifestyle
is paid for by borrowed money. If the debt has not increased,
one must look for other possible explanations, such as a
recent inheritance. If nothing seems to justify the lifestyle
in excess of the reported income, then there is a good possibility
that unreported income is funding the lifestyle. This hypothesis,
with its justifications, may not, by itself, be convincing
to the court, but it will lend significant support to other
evidence.
2. Look at the expenses
Certain expenses are indicative of the nature of the business,
and often they can be verified. In the above example of
the restaurant, that business sold a huge amount of
beer. Since there are only a small number of beer distributors
and their records are computerized, it is relatively easy
in such a situation to determine the volume of beer
being purchased.
The same technique was used in a case involving
unreported pastrami sales. The key to the case was determining
the amount of raw beef navels purchased. Once one knows
the amount of goods purchased for sale or manufacture, the
actual sales can be determined fairly accurately after
one determines the usual markup.
Similarly, certain manufacturing processes may require
certain usage of utilities. A product that has water
as a main ingredient will have production in direct relationship
to the amount of water being used by the factory. A review
of the company's utility bills may demonstrate whether production
is going up or down. If the business records show that sales
are down, production is down, but water usage is up, then
someone will have to explain the disparity.
3. Look at the cash flow
How does the money come in and who receives it? If a certain
person opens the mail, records what payments came in, and
then delivers the checks to a second person, who actually
makes the deposits, then there is good internal control
over the funds. In that situation, it is probable that all
receipts are being recorded.
In smaller businesses, such as in professional practices,
it is possible for the same person to open the mail and
to make the deposits, and it is not unusual for the owner
himself to get the mail once in a while. Furthermore, payments
are often made out to an individual instead of the formal
business name.
Particularly with a professional practice, the name of
the person is often the name of the business, or a client
may issue payment in the name of the partner who provided
the services. In situations where the owner might open the
mail and where checks could be payable to the owner, one
should review the accounts receivable records with the cash
receipts records.
All write-offs of significant amounts should be reviewed
to see if the write-offs are merely cover-ups for receipts
that were simply deposited into a personal bank account
instead of the business account. The write-offs should be
supported by documents indicating attempts to collect, such
as correspondence, letters from the company's attorney,
lawsuits, etc.
4. Look at the business operations
A visit to the business premises is very helpful, and sometimes
it helps rule out certain areas which might otherwise he
explored. For example, a business with gas stations has
less of a probability of unreported income than a supermarket.
A visit to the gas stations will show that all sales, in
dollars, is reported by each gas pump.
If the owner does not work at the gas station, he would
not want the pump to malfunction, because that is his only
way to determine that his employees are not stealing from
him. Therefore, the pump equipment itself is very useful
in determining the actual sales. In a supermarket,
an owner could simply arrange that certain cash receipts
are simply not deposited.
It is essential to understand how the business is run,
how often the owner comes to the business, what is his relationship
with his employees, etc.
5. Look at the industry
There are statistics available for many businesses, and
the statistics of the subject business should be compared
with others similar to it. In particular, the gross profit
margins should be compared, and the overall profitability
should be compared. If in the industry, it costs fifty cents
for each dollar of sales, and in the subject business, it
costs sixty five cents for every dollar of sales. then one
should examine the expenses to see if they are inflated
by personal or unusual expenses.
It may be that there is a logical explanation for the variance
of the subject business from the industry norm, but the
variance itself is an indication that something is unusual,
and deserving of special analysis.
Summary
In summary, while it is often very difficult to find unreported
income and hidden assets, sometimes clues are left that
are very meaningful to a trained eye. The problem then becomes
a matter of proving the allegation, rather than determining
it.
This
Article is based on Unreported
Income And Hidden Assets by
Mark Kohn, CPA , CVA
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