The business accounts were supposed to hold business money.
In practice, the person running the business treated them like personal accounts. Money came in, personal expenses went out, and the records did not clearly explain what every deposit represented.
That became a serious problem when the IRS reviewed the returns.
In Chernomordikov v. Commissioner, a 2025 Tax Court case, the IRS did not simply accept the income shown on the books. It reviewed the bank activity and used the IRS bank deposits method to reconstruct income.
That does not mean every deposit was taxable.
Transfers, loans, gifts, and reimbursements may not be income. But when funds are mixed, proving which deposits should be removed from the IRS calculation becomes harder.
- The Accounts Were Business on Paper, Personal in Practice
- Why the IRS Did Not Rely on the Tax Returns
- How the IRS Bank Deposits Method Rebuilt the Income
- Not Every Bank Deposit Is Taxable Income
- The Explanation Is Only as Strong as the Records
- Mixed Accounts Can Put Business Deductions at Risk Too
- What This Tax Court Case Teaches Business Owners
- What to Do If the IRS Is Already Rebuilding Your Income
- What If the IRS Calculation Is Wrong?
- How IRSProb May Help With the Audit
- What to Do Next
- Frequently Asked Questions
The Accounts Were Business on Paper, Personal in Practice
One of the taxpayers ran a business called ONY Sales and controlled its bank accounts, even though he was not a shareholder during the years at issue. According to the Tax Court opinion , he testified that he did not feel there was a difference between the company accounts and his personal accounts.
He also said he used company money for personal expenses because he did not receive a paycheck.
The problem becomes clearer during an audit.
The IRS wants to know where the money came from, why it was deposited, whether it was reported, and whether payments labeled as business expenses were actually business related.
When the same accounts contain customer payments, transfers, cash deposits, and personal spending, a general explanation may not be enough.
Why the IRS Did Not Rely on the Tax Returns
A tax return is based on the information given to the preparer and the records behind it.
If those records are incomplete or unreliable, the IRS may look beyond the return.
In this case, the business used QuickBooks, but the court found serious record problems.
The revenue agent concluded that the QuickBooks records had been altered after the examination began and considered them unreliable.
The Tax Court noted, however, that the evidence did not establish that the taxpayer personally directed or participated in those changes.
The taxpayer provided some bank statements, but supporting records were missing for important items, including claimed cost of goods sold.
The case involved serious recordkeeping and unreported-income problems, but that is different from a finding that the taxpayer committed fraud.
The IRS obtained bank records and analyzed deposits in personal and business accounts because money moved between them.
How the IRS Bank Deposits Method Rebuilt the Income
The IRS bank deposits method starts with a practical idea.
Money deposited into an account may represent taxable income unless the available evidence shows that it came from somewhere else.
An examiner may review business and personal accounts, identify transfers and nontaxable deposits, and compare the remainder with reported income.
This is not supposed to be a blind decision that every deposit is taxable.
The IRS should consider known nontaxable sources and avoid counting an identified transfer twice. Its examination-of-income procedures instruct examiners to evaluate potential sources of income and reconcile financial information.
Before relying on this method, the IRS generally needs a factual foundation connecting the taxpayer with an income-producing activity or showing the receipt of income.
IRS examination techniques also emphasize reviewing records and developing the facts before making adjustments.
Once the IRS produces a reasonable reconstruction, vague explanations may not undo it.
The taxpayer generally needs evidence showing the calculation is wrong or specific deposits were nontaxable.
In Chernomordikov, the Tax Court found the IRS analyses well supported.
The taxpayers did not produce evidence showing that the analyses were unfair or flawed, and they did not adequately refute how the IRS classified specific deposits.
Not Every Bank Deposit Is Taxable Income
This point matters.
A bank deposit is not automatically business income.
A deposit could be:
- A transfer between accounts
- Loan proceeds
- A gift
- A refund
- A reimbursement
- An owner contribution
- The return of money previously advanced
The tax treatment depends on the facts.
But a label given after an audit starts may not be enough.
If a taxpayer says a deposit was a loan, the IRS may ask for the agreement, payment history, proof of the transfer, and evidence that repayment was expected.
If the deposit was a transfer, the statements from both accounts may show the same amount leaving one account and entering the other.
If it was an owner contribution, business records should show how it was recorded and where the owner obtained the funds.
The stronger response is not simply “this was not income.” It is a documented trail showing what the money was and where it came from.
The Explanation Is Only as Strong as the Records
Business owners may remember that a deposit came from a relative or that cash moved between accounts.
Years later, however, memory is difficult to verify.
Records created near the transaction are usually more useful than a spreadsheet prepared after an audit notice arrives.
The IRS does not require every business to use one particular accounting system. Its business recordkeeping guidance explains that records should clearly support income and expenses reported on the tax return.
The IRS also provides guidance about what kinds of records a business should keep .
General IRS recordkeeping requirements also explain that records should generally be retained as long as they may be needed to administer the tax rules.
Records That May Help
Depending on the transaction, useful records may include:
- Complete bank and payment-processor statements
- Deposit slips and images of deposited checks
- Customer invoices and sales records
- Receipts, purchase orders, and vendor invoices
- Loan agreements and repayment records
- Records showing transfers between accounts
- Credit-card statements with business-purpose notes
- Payroll records and owner-distribution records
- Emails, contracts, or other documents explaining unusual payments
- A clean general ledger that reconciles to the bank activity and tax return
Mixed Accounts Can Put Business Deductions at Risk Too
The income side is only half the problem.
Mixed accounts can also make legitimate deductions harder to prove.
Writing a check from a business account does not make the payment a business expense.
A deductible expense generally needs a business purpose and adequate support.
If the account also pays for groceries, vacations, personal insurance, or household bills, the examiner may question other payments that are not clearly documented.
The taxpayers in Chernomordikov also had problems supporting claimed cost of goods sold.
The court explained that testimony and broad explanations could not replace the missing evidence.
The IRS may identify deposits as income while disallowing costs or deductions that the taxpayer cannot substantiate.
What This Tax Court Case Teaches Business Owners
The lesson is not that one personal purchase automatically causes the IRS to reconstruct income.
Mixed funds, weak books, missing documents, and unexplained deposits can combine into a serious problem.
Separate accounts make the story easier to follow.
They do not replace good records, but they reduce confusion.
Business income should generally go into the business account.
Personal spending should generally be kept out of business accounts.
When money moves from the business to an owner or another person, it should be properly recorded and treated as wages, a draw, a distribution, repayment, or another appropriate transaction based on the entity and the facts.
What to Do If the IRS Is Already Rebuilding Your Income
Do not begin by guessing at explanations for deposits.
Start by collecting the complete records.
First, identify every account that held business money.
Include:
- Business bank accounts
- Personal accounts used for business
- Payment processors
- Merchant accounts
- Other places where customers paid you
Next, create a deposit schedule.
List each deposit, the account, date, amount, claimed source, tax treatment, and supporting documents.
Transfers should be matched on both sides so they are not counted twice.
Nontaxable items should be supported individually.
Then compare the schedule with the gross receipts on the return and in the books.
Identify differences before the IRS builds the explanation for you.
Expenses need a separate review.
Do not assume that locating a bank payment proves a deduction.
Connect it to an invoice, receipt, contract, business purpose, or other reliable record.
Finally, be careful about handing over a disorganized pile of statements with no analysis. Respond completely and on time, but understand what the records show. An IRS audit representative can help organize the response, identify missing evidence, and present the facts without making unsupported claims.
IRSProb also explains what to expect during an IRS audit and how preparation can affect the examination process.
What If the IRS Calculation Is Wrong?
An IRS reconstruction can be challenged.
The right response depends on the error.
The analysis may:
- Count a transfer twice
- Treat a loan as taxable income
- Overlook a refund or other nontaxable item
- Miss supported business costs
A strong response identifies the item, explains the error, and provides proof.
For example, saying “some deposits were transfers” leaves the examiner with more work and little reason to change the calculation.
A schedule matching each disputed deposit to the withdrawal from another disclosed account is more useful.
The same approach applies to unreported income patterns and disputed deductions.
Break the calculation into transactions and document every requested adjustment.
Deadlines matter too.
Depending on the audit stage, a taxpayer may have opportunities to provide records, meet with a manager, use IRS Appeals, or petition the Tax Court. IRSProb's guide to responding to an IRS notice explains why the notice and its deadline matter.
Ignoring a notice can eliminate valuable options.
How IRSProb May Help With the Audit
IRSProb helps taxpayers understand what the IRS is asking for, reconstruct the financial history, and respond with organized evidence.
That may include:
- Reviewing the deposit schedule
- Tracing transfers between accounts
- Identifying possible nontaxable deposits
- Testing the IRS income calculation
- Organizing business-expense records
The goal is not to invent a better story.
It is to present the real facts clearly, fix errors in the IRS analysis, and explain any remaining problem honestly.
If the audit produces additional tax, IRS penalties and interest may also need to be reviewed.
If the resulting balance cannot be paid in full, the next step may include reviewing what to do when you cannot pay the IRS .
What to Do Next
If you have mixed business and personal money, separate the accounts now.
Reconcile the records and preserve documents for unusual deposits.
If an IRS examination is already open, do not wait for the agent to finish a bank-deposit analysis before reviewing the accounts yourself.
Get the notices, returns, books, and statements together.
Then identify what can be proven and where the real gaps remain.
Is the IRS reconstructing your business income from bank deposits?
Review every account, trace transfers, identify nontaxable deposits, and organize support for legitimate expenses before responding to the examination.
Review Your IRS Audit OptionsFrequently Asked Questions
Can the IRS look at a personal bank account during a business audit?
Yes, it may. Personal accounts can become relevant when they receive business income, fund business activity, or help explain transfers. The scope depends on the audit facts and the information needed to verify the return.
Does the IRS treat every bank deposit as taxable income?
No. Known transfers and documented nontaxable sources should be considered. The practical problem is proving what a disputed deposit represents. Unsupported explanations may not be enough.
Is using a business account for personal expenses illegal?
Not every personal payment from a business account creates a tax violation. It can still cause accounting, entity, payroll, deduction, and audit problems. The correct treatment depends on the business structure and facts.
Can a spreadsheet created during an audit prove the source of deposits?
It can help organize the response, but it is stronger when tied to original evidence such as statements, checks, invoices, loan documents, and correspondence. A new spreadsheet does not prove its own entries.
What if some business expenses were paid in cash?
Cash expenses may still be deductible if they meet the tax rules and can be substantiated. Receipts, invoices, logs, and other reliable records become especially important because the bank account may not show the payment.
What happens if reconstructed income creates a tax bill I cannot pay?
First, make sure the audit result is accurate. If a correct balance remains, options may include an installment agreement or another collection alternative based on the taxpayer's circumstances. Penalties and interest may continue, so the issue should not be ignored.
