Imagine receiving an IRS notice claiming that you failed to report thousands of dollars in income. You know that some of the money deposited into your bank account was not additional taxable income. Perhaps it was a transfer between accounts, a loan repayment, or rental income already reported on your tax return. But can you prove it?
The case: When bank deposits don’t match reported income
A recent U.S. Tax Court decision, Shay v. Commissioner, T.C. Memo. 2026-103 (September 30, 2026), illustrates why accurate bookkeeping and proper documentation are essential, particularly for rental property investors and small business owners.
In Shay v. Commissioner, the taxpayer, Allen Shay, was involved in real estate and rental property activities. During an examination, the IRS used the bank deposits method to reconstruct his income. This technique compares deposits into a taxpayer’s bank accounts against the income reported on the tax return.
The IRS identified approximately $24,000 in disputed unreported income. Shay challenged the adjustment, arguing that the amounts had already been accounted for through his tax reporting, including amended-return adjustments.
The problem was that the taxpayer's explanation did not sufficiently establish that the disputed deposits were previously reported or otherwise nontaxable. And the Tax Court sustained the disputed income adjustment.
The important lesson is not that every bank deposit is taxable. Rather, when the IRS questions deposits, the taxpayer needs credible records explaining where the money came from and how it was reported.
How does the IRS bank deposits method work?
Under Internal Revenue Code §61, gross income generally includes income from all sources unless a specific exclusion applies. When the IRS believes a taxpayer’s records are incomplete or unreliable, it may reconstruct income using bank deposits.
Consider a small business owner whose tax return reports $150,000 in gross receipts, but whose bank statements show $210,000 in total deposits.
| Description | Amount |
|---|---|
| Total bank deposits | $210,000 |
| Transfers between own accounts | ($30,000) |
| Documented loan proceeds | ($20,000) |
| Refund of a personal purchase | ($10,000) |
| Potential taxable business receipts | $150,000 |
Five common bank deposits that may not be taxable income
In this example, the taxpayer may have correctly reported $150,000 of revenue. However, without documentation supporting the remaining $60,000, the IRS may question whether additional taxable income was omitted.
A bank statement shows that money was deposited. It does not necessarily explain the transaction’s tax treatment.
Not every deposit represents business revenue. Common examples include:
- Transfers between your own accounts. Moving $15,000 from savings to checking generally does not create taxable income.
- Loan proceeds. Money received from a genuine loan generally is not income because there is an obligation to repay it.
- Owner capital contributions. Transferring personal money into a business account generally is not a sale or service receipt, although the entity’s tax classification matters.
- Refundable security deposits. For rental property owners, a refundable tenant security deposit generally is not rental income when received if there is an obligation to return it. Amounts retained or applied to rent may become taxable.
- Reimbursements and refunds. Some reimbursements and returns of previously paid amounts may be nontaxable, depending on the underlying transaction and prior deductions.
Why rental property owners face particular risks
The critical point is that the taxpayer must be able to identify and substantiate the nature of each deposit.
Real estate investors often manage several properties and move money between personal accounts, rental operating accounts, and LLC accounts. For example, an investor might own three rental properties and use one checking account to receive rent, pay contractors, collect security deposits, and transfer funds for property improvements. Without detailed records, these transactions can become difficult to distinguish during an IRS examination.
Consider an investor who deposits $25,000 of personal savings into an LLC account to fund a roof replacement. That $25,000 generally is not rental income merely because it appears as a deposit. But if the taxpayer cannot document the source, the IRS may question the deposit.
A better approach is to maintain separate accounts and record the transfer properly as an owner contribution or other appropriate transaction. For multi-member LLCs taxed as partnerships, accurate records also support partner capital accounts, outside-basis calculations, and Schedule K-1 preparation.
Will filing an amended return fix the problem?
One of the useful lessons from Shay concerns amended tax returns. Taxpayers sometimes assume that filing Form 1040-X resolves discrepancies identified during an IRS examination.
Not necessarily.
An amended return reports a revised tax position, but it does not independently prove the underlying transactions. If the IRS identifies a $24,000 discrepancy, the taxpayer should be able to connect the disputed deposits to supporting documents and demonstrate how the amounts were reported or why they were excluded.
For example, a proper reconciliation might show that a $12,000 deposit was already included in Schedule E rental income and another $12,000 was a documented transfer from the taxpayer’s savings account.
Without that connection, an amended return may not resolve the dispute.
What small business owners should do before an IRS audit
Good bookkeeping is not just about preparing an accurate tax return. It also creates an audit trail.
Here are five practical steps that can significantly reduce problems during an IRS examination.
Keep business and personal finances separate. Dedicated bank accounts make it easier to identify business income, expenses, and owner transactions.
Reconcile bank accounts regularly. Monthly reconciliations help identify duplicate entries, missing deposits, and incorrectly categorized transfers.
Document unusual deposits. Retain loan agreements, capital contribution records, refund confirmations, and explanations of significant transfers.
Maintain property-level rental records. For rental investors, track rent, security deposits, expenses, and improvements separately for each property.
Review income reporting before filing. Reconcile bookkeeping records with Forms 1099, payment processor statements, and bank deposits before preparing the tax return.
These practices can save considerable time and expense if the IRS later requests supporting documentation.
What if the IRS has already proposed unreported income?
Receiving an IRS notice does not automatically mean the IRS calculation is correct.
The bank deposits method is a recognized examination technique, but errors can occur. For example, an examiner may inadvertently count transfers between accounts as income or overlook amounts already included on the return.
Before agreeing to an adjustment, a CPA should review the IRS calculation and reconcile the disputed transactions individually.
Depending on the facts, the taxpayer may be able to challenge the adjustment during examination or IRS Appeals.
The key is to respond with records and a clear reconciliation rather than simply insisting that the IRS figures are wrong.
The bottom line
Shay v. Commissioner provides a useful reminder for small business owners and real estate investors: Good bookkeeping is more than an administrative task. It is an important part of protecting your tax position.
When bank deposits exceed reported income, there may be perfectly legitimate explanations. But those explanations need to be supported by credible records. Accurate accounting, proper classification of transfers, and regular reconciliations can help prevent costly disputes and make IRS examinations easier to resolve.
Need help with rental property accounting or an IRS notice?
At Mint Hill CPA, we work with small business owners, LLCs, and real estate investors on tax preparation, bookkeeping, and federal and state tax matters.
Whether you own a single rental property or operate multiple businesses, maintaining accurate financial records is an important part of effective tax planning.
If you have received an IRS notice concerning unreported income, or need assistance organizing your rental property or business records, we can help you evaluate the issue and determine the appropriate next steps.
Mint Hill CPA — Mint Hill, North Carolina
Visit www.minthillcpa.com to learn more or schedule a consultation.
Case reference: Shay v. Commissioner, T.C. Memo. 2026-103 (September 30, 2026), Docket No. 22431-19. This article is provided for general educational purposes and is not individualized tax or legal advice. Tax treatment depends on the facts and circumstances of each transaction.