When the federal / state matching program indicates a taxpayer has reported significantly less income on the federal return, the examiner can use the income reported on the state tax return to produce a federal tax examination report. It has been held that positions taken in a tax return signed by a taxpayer may be treated as admissions. See Waring v. Commissioner, 412 F.2d 800, 801 (3rd Cir. 1969); Lare v. Commissioner, 62 T.C. 739, 750 (1974); Kaltreider v. Commissioner, 28 T.C. 121, 125 -126(1957).
As stated in Crigler v. Commissioner, T.C.M. 2003-93, a taxpayer “cannot …disavow … returns without cogent proof that they are incorrect.” Evidence obtained through the taxpayer’s own admission on a state income tax return signed under penalties of perjury is as reliable as evidence from third parties, and perhaps more so if the taxpayer is unable to successfully refute the information contained in the state return. If the taxpayer establishes during the course of the examination that the state information is incorrect, the examiner will adjust their report accordingly.
For example, when the profit margins are consistently low, but the taxpayer is able to continuously service substantial debt (mortgage), the examiner is required to make further inquiries. The inquiry will likely detect unreported gross receipts, overstated expenses, or from a combination of these items.
IRS may ask the taxpayer about their gross profit, and then subsequently test the gross profit percentage by tracing specific transactions from the purchase of a product for resale to the sale of the item. Industry standards can be found at http://www.bizstats.com
Example: The taxpayer sells pianos. The examiner selected a sample of four actual purchases and subsequent sales by the taxpayer; the average markup for the four piano sales was 51.7%. Overall, for the business as reported on Schedule C, the markup is 27%. Based on the comparison, it appears that the taxpayer may not be reporting all of the gross receipts.
If a taxpayer owns and operates a cash-intensive business. To determine whether the taxpayer’s books and records tie to the tax return, the IRS auditor As part of the audit may test gross receipts by tying the original source documents (cash register receipts and/or invoices) to the books.