Imputed Income: Definition, Calculation, and Evidence

The reality show, “Jersey Shore,” may not interest legal professionals, yet the case of its star, Mike Sorrentino—AKA “The Situation”—may be. Among his tax fraud charges, he was accused of false documenting his imputed income through one of his companies. If you’re involved in tax fraud litigation, matrimonial actions, and shareholder or partnership disputes, advice about imputed income and its calculations is crucial.

The IRS defines imputed income as the value of any benefits or services provided to an employee. The value of this cash or non-cash compensation must be considered in order to accurately reflect an individual’s taxable income.

Employees can have income tax withheld for their imputed income or pay the amount due with their tax installment payments. Examples of imputed income are:

  • Dependent care assistance exceeding the tax-free amount,
  • Health and dental insurance for non-dependent domestic partners or same-sex partners or spouses,
  • Basic or group life insurance in excess of $50,000,
  • Personal use of company or employer-provided car,
  • Non-deductible moving expense reimbursements,
  • Educational assistance exceeding the excluded amount, and
  • Below market rate loans.

There are three approaches in determining imputed income:

  1. Detailed Transaction Listing and Analysis,
  2. Proof of luxury spending inappropriate for the claimed income, and
  3. The Net Worth Method.

A Detailed Transaction Listing and Analysis consists of a listing of everything a person spends. A thorough analysis of these lists can be approached in two different ways:

  1. Adding up all the deposits to calculate after-tax earnings, and then comparing this total to the claimed earnings.
  2. List spending activity to compare with claimed after-tax income.

Through this analysis, proof that claimed income was understated can be found.

The Proof of Luxury approach is based on the assumption that people only spend what they can afford. Spouses who spend on expensive items have trouble claiming poverty during a divorce. One can assume that if they can buy luxury items, their claims on lack of money are incorrect or false.

Luxury items can sometimes be attributed to perquisites (“perks”), which are benefits given to an employee in addition to wages or salary and can be non-cash in nature. Some can be given a company vehicle or club membership, for instance, which are not included in their W-2 or 1099 forms. However, these items must be considered when calculating imputed income.

The Net Worth Method traces back to the 1930s and is connected to the persecution of one of Al Capone’s brothers in 1931. Initially used for criminal cases, this method in now generally used in determining income.

A person’s net worth refers to their total assets minus total liabilities. The Net Worth Method looks at the changes that occur in net worth between any two dates. Statements that record a person’s net worth at a particular time, like a loan or credit application, can be used as a point of reference. In executing any analyses, one must take into consideration some elements:

  • the initial net worth of the individual at a fixed starting point,
  • the reported income,
  • the expenses,
  • the individual’s ending net worth at the close of the period under consideration, and
  • the appreciation of, and depreciation, applied to listed assets.

If there is a net worth increase greater than the reported income, then understated income can be suspected. Similarly, if there is no change between initial and ending net worth, but the person has spent more than the reported income, unreported income can be suspected. Differences between initial and ending net worth require adjustments that include:

  • adding personal and living non-deductible expenses,
  • deducting nontaxable receipts such as gifts and inheritances,
  • excluding nontaxable capital gains’ profit as guided by the capital gains provisions of the IRS code, and
  • adjusting trade or business property as guided by section 167 of the code.

The methods discussed above are crucial in tax fraud litigation, family law, and shareholder or partnership disputes. Forensic accountants, with years of experience and expertise in fraud examination, can be essential to successfully calculating imputed income and discovering any discrepancies.

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