During my first experience as an litigation support expert in a matrimonial matter, there was barely any information on the search for omitted income or hidden assets. Much of what we now call forensic accounting was performed intuitively by those with strong auditing backgrounds.
In that first case, the “money spouse” was in a family business. Income, sales, and payroll tax returns were all filed on time and appeared to be complete and accurate. But when the reported income was compared to the ordinary living expenses on the “non-money spouse’s” Certified Net Worth Statement, the expenses exceeded the funds earned. Two questions emerged: (1) Were the expenses on the statement actually paid or merely a wish list?; and (2) Were other funds, such as loans, credit card debt, or gifts, etc., to account for this difference? You don’t have to be a certified forensic accountant to smell a thief. However, to catch the culprit you need the skills of a gumshoe.
Business tax returns report the assets, liabilities, equity, revenues, and expenses of an entity. The balance sheet lists the historical cost of what the entity owns (assets) and its obligations (liabilities). Commonly referred to as the business’s resources, assets can be cash, inventory, fixed assets, and real estate. Liabilities represent amounts owed, such as amounts due to vendors, mortgage obligations, and other debts.
One must verify that assets and liabilities are truly business related and not personal. Some personal assets hidden within businesses are automobiles, real estate, or investments. A good start is to request a detailed fixed asset schedule and identify what assets are actually being used in the business.
In addition, all debts should be verified to insure that they relate to the business. The payment of obligations can be easily traced to its source. If payments are being made, then an asset or benefit should exist. You may even identify debt payments where an asset is not apparent or recorded.
The income and expense sections of tax returns are also rich sources of information. There are two common ways to identify personal expenses. First, compare expense categories year by year. Spikes and valleys within the same category commonly detect personal spending. Second, obtain grouping schedules and transaction listings for deductions taken. Identifying vendors, suppliers, and other payees often highlights those that may not be business related. The Treasury calls these non-deductible expenses; the forensic accounting community refers to them as discretionary items, such as travel, meals, entertainment, and automobile.
Further analysis can also identify hidden assets, such as real property. A review of the utility and real estate tax payments may uncover property not otherwise known. But these items may not be found only within tax returns. Amounts paid on behalf of the business owner may be recorded as a dividend distribution, loan payment, or even salary. In these instances, the true nature of the disbursement can be easily disguised.
Personal income tax returns can also serve as an investigative tool, especially itemized deductions. For instance, a deduction for investment management fees can lead to the discovery of an undisclosed investment portfolio. Since such fees are commonly based upon the principal value of the portfolio, this amount may be reasonably estimated.
A review of the pass-through entities on Schedule E, can also be informative. Schedule E lists the income and losses attributed to ownership interests from business entities. Bank and brokerage accounts appear on Schedule B, which details interest and dividend Income. What may be the most important in analyzing Schedules E and B is the change in their components from year to year. The change in bank, brokerage, and investment accounts may be an indication of money being moved.
Another item to note is the change in interest and dividend income. This may reflect a change in returns on investment or the alteration of principal investment. You may also want to trace the proceeds for the sale of stocks and investments which are itemized on Schedule D.
The paths on which business and individual income tax returns take you may be limitless. Although this process may be an expensive task, more times than not it provides an insight to a couple’s finances that may otherwise go undetected.