A Mississippi auditor pulled a construction company’s bank statements for 2017 through 2020, scheduled every deposit and issued a sales tax assessment of $220,362. The company never denied the deposits; its position was that most of the money was not its revenue, since some belonged to five other businesses the same shareholder owned and some was the shareholder funding payroll.
New Mexico business owners meet that arithmetic from two directions. The IRS uses the bank deposits method when it believes a return understates income, and the New Mexico Taxation and Revenue Department runs similar reconstructions in gross receipts tax audits of contractors. Either way the assessment arrives presumed correct, and federal rules govern most of the dollars.
How does an auditor turn bank deposits into taxable income?
In DiLeo v. Commissioner, 96 T.C. 858 (1991), the Tax Court held that bank deposits are prima facie evidence of income, while requiring the government to account for nontaxable sources of which it has knowledge. Clayton v. Commissioner, 102 T.C. 632 (1994), accepted such an analysis as reasonable after rejecting the percentage estimate the IRS tried first.
26 U.S.C. § 6001 requires every person liable for tax to keep such records as the Secretary prescribes, and Treas. Reg. § 1.6001-1(a) turns that into permanent books sufficient to establish gross income, deductions, and credits. A contractor with no job-cost ledger tied to bank activity has supplied the reason for a reconstruction.
What did the Mississippi Court of Appeals decide in ABG Contractors?
In ABG Contractors, Inc. v. Graham, No. 2025-CA-00329-COA (Miss. Ct. App. Aug. 18, 2026), the court reversed summary judgment for the Mississippi Department of Revenue and remanded for trial. The taxpayer had produced bank statements for six entities owned by one individual, separate employer identification numbers, formation filings, ledger entries flagging shareholder contributions, and contracts for jobs in other counties, which raised genuine factual disputes the presumption could not survive.
The ruling is procedural, but for a New Mexico reader those categories are the ones that move a federal examiner, and nearly all are accounting records.
How strong is the presumption of correctness in a federal tax case?
Welch v. Helvering, 290 U.S. 111 (1933), sets the baseline: the Commissioner’s “ruling has the support of a presumption of correctness, and the petitioner has the burden of proving it to be wrong.” Tax Court Rule 142(a)(1) puts the burden on the petitioner except as a statute provides otherwise.
The Tenth Circuit, which hears New Mexico appeals, marks the limit. Erickson v. Commissioner, 937 F.2d 1548 (10th Cir. 1991), a cash expenditures case, stated that “[n]aked or purely arbitrary assessments are not entitled to a presumption of correctness,” that some reasonable foundation is necessary to preserve it, and that the government must show the taxpayer received income from the activity charged. Rey v. Commissioner, T.C. Memo. 2016-58, found that showing satisfied by the bank records themselves, which a working contractor’s account will supply.
When does 26 U.S.C. § 7491 shift the burden to the IRS?
Section 7491(a)(1) shifts the burden of proof to the Secretary where a taxpayer introduces credible evidence on a factual issue relevant to income, estate, or gift tax liability. The conditions in § 7491(a)(2) do the real work: substantiation, required records, and cooperation with reasonable requests for information, documents, and interviews. Cooperation is where audits are lost, since an owner who stops answering the examiner forfeits a shift his documents would have earned.
Entities carry an extra condition: under § 7491(a)(2)(C) a partnership, corporation, or trust must meet the net worth requirement of 26 U.S.C. § 7430(c)(4)(A)(ii), incorporating 28 U.S.C. § 2412(d)(2)(B), of net worth no greater than $7,000,000 and no more than 500 employees. Individuals face no such cap, and § 7491(c) gives the Secretary the burden of production on penalties against an individual.
Facing a Bank Deposits Audit in New Mexico? Contact Us Now
What makes a New Mexico contractor’s deposits look like unreported income?
Three patterns produce most of the gap. Related entities sharing an owner, a bookkeeper, and a bank move money between accounts to cover payroll, and every landing is a deposit. Owners fund working capital with contributions and shareholder loans, neither of which is income. Gross receipts tax is deposited gross.
State and federal treatment differ there. NMSA 1978 § 7-9-3.5(A)(3)(b) excludes gross receipts tax payable for the reporting period from the state tax base. Federally, the reimbursement enters receipts and is offset by the deduction 26 U.S.C. § 164(a) allows for state and local business taxes. Net income is zero either way, if someone shows the examiner both halves.
Here an attorney and CPA does what a litigator cannot, because the rebuttal is a schedule, not a brief. Each deposit gets a line with its date, amount, payor, ledger account, and the document proving its character: a promissory note, an equity entry, an invoice showing separately billed tax. Reported receipts then reconcile against the information returns the IRS holds, including Forms 1099-NEC and any Form 1099-K, issued above $20,000 in more than 200 transactions.
How would a Las Cruces contractor rebut a $310,000 reconstruction?
Take a hypothetical. A Las Cruces general contractor taxed as an S corporation files its 2023 return and draws a 2025 examination. Deposits to the operating account total $2,100,000. The ledger was never reconciled, so the examiner calls $310,000 unreported income.
| Deposit category | Amount | Proof | Effect |
|---|---|---|---|
| Capital contribution | $120,000 | Equity entries, source statement | Not income; removed |
| Transfers from owner’s other LLC | $95,000 | Sending statement, separate EIN | Not its income; removed |
| Equipment loan proceeds | $60,000 | Note and payoff schedule | Loan, not income; removed |
| Gross receipts tax remitted | $35,000 | Invoices, filed returns | Offset by the § 164 deduction |
| Total in dispute | $310,000 | Full schedule | Adjustment to zero |
Because S corporation income flows to the shareholder, the $310,000 lands on a Form 1040. At a 32 percent marginal rate the tax is $99,200, substantial under 26 U.S.C. § 6662(d)(1)(A) (the greater of 10 percent of the tax required to be shown or $5,000), so the 20 percent accuracy-related penalty under § 6662(a) adds $19,840. At the 7 percent underpayment rate set for the quarter beginning October 1, 2026, two and a half years of interest adds roughly $19,000. Four deposit categories carry $138,000.
How does New Mexico’s own presumption of correctness work?
NMSA 1978 § 7-1-17(C) provides that any assessment of taxes or demand for payment made by the department is presumed to be correct, and NMSA 1978 § 7-1-24 requires a protest to be filed with the secretary within ninety days, under the Administrative Hearings Office Act.
A federal adjustment does not stay federal. NMSA 1978 § 7-1-13(E) requires a taxpayer with final net-positive federal adjustments from an IRS audit or amended return to file a federal adjustments report within 180 days of the final determination date. State audit mechanics appear in the firm’s New Mexico gross receipts tax audit guide.
What should you do when the 30-day letter or notice of deficiency arrives?
A 30-day letter closes the examination with a proposed adjustment and offers a protest to the IRS Independent Office of Appeals, which the agency describes as resolving disputes without litigation. A notice of deficiency starts a clock instead: under 26 U.S.C. § 6213(a) the taxpayer has 90 days from mailing, or 150 days if the notice is addressed to a person outside the United States, to petition the United States Tax Court. Filing preserves the record without foreclosing settlement through IRS Appeals.
Frequently Asked Questions
What is the bank deposits method?
It is an indirect reconstruction: the examiner totals deposits and treats them as receipts. In DiLeo v. Commissioner, 96 T.C. 858 (1991), the Tax Court held bank deposits are prima facie evidence of income, subject to nontaxable sources the government knows of.
Must the IRS show anything before the presumption of correctness applies?
A minimum, yes. Welch v. Helvering, 290 U.S. 111 (1933), presumes the determination correct. But the Tenth Circuit held in Erickson v. Commissioner, 937 F.2d 1548 (10th Cir. 1991), that naked or purely arbitrary assessments receive no presumption without some reasonable foundation.
How does 26 U.S.C. section 7491 shift the burden of proof?
Under 26 U.S.C. § 7491(a)(1), a taxpayer who introduces credible evidence shifts the burden to the Secretary. Section 7491(a)(2) conditions that on substantiation, required records, and cooperation. A corporation, partnership, or trust must also meet the § 7430(c)(4)(A)(ii) net worth test.
Are shareholder contributions and owner loans taxable income to the business?
No. A capital contribution increases the owner’s basis and a loan creates a repayment obligation, so neither is gross income to the company. Proof matters more than the label: equity entries and a signed note are what sent ABG Contractors back for trial.
Does New Mexico gross receipts tax deposited into a business account count as income?
It is deposited gross, so it looks like revenue. NMSA 1978 § 7-9-3.5(A)(3)(b) excludes New Mexico gross receipts tax payable for the reporting period from gross receipts. Federally, the reimbursement enters receipts and is offset by the 26 U.S.C. § 164(a) deduction.
How long do you have to respond to a notice of deficiency?
Ninety days from mailing, or 150 days if the notice is sent to a person outside the United States, under 26 U.S.C. § 6213(a). Saturdays, Sundays, and District of Columbia holidays do not count as the last day. Missing it forfeits Tax Court review.
How North Star Law Firm Can Help
North Star Law Firm represents New Mexico taxpayers whose income has been rebuilt from bank records, whether by a federal or state examiner. The firm assembles the deposit-by-deposit schedule from the general ledger and loan and equity records, reconciles reported receipts against information returns, and presses the § 7491 conditions so the burden question is decided on a full record. That is IRS audit defense, and the firm also handles New Mexico gross receipts tax matters.
Phillip Zagotti, JD/CPA, is an attorney and CPA admitted to the United States Tax Court who practices before the Internal Revenue Service. For New Mexico state-law questions the firm works alongside New Mexico-licensed counsel. The accounting side is what makes a deposits case winnable. See also the firm’s note on the redesigned IRS voluntary disclosure practice and New Mexico managed audits. If an examiner has proposed an adjustment built from your bank statements, contact North Star Law Firm before the deadlines run.