-4-
reconstruct the taxpayer's income using any method that clearly
reflects income. Sec. 446(b); Petzoldt v. Commissioner, 92 T.C.
661, 687, 693 (1989); Meneguzzo v. Commissioner, 43 T.C. 824, 831
(1965); Sutherland v. Commissioner, 32 T.C. 862 (1959). The
method of reconstructing income may be indirect and need only be
reasonable in light of all surrounding circumstances. Holland v.
United States, 348 U.S. 121 (1954); Giddio v. Commissioner, 54
T.C. 1530, 1533 (1970); Schroeder v. Commissioner, 40 T.C. 30, 33
(1963).
Respondent reconstructed petitioner's income for the years
at issue using the source and application of funds method. This
method has long been regarded as a reasonable method of
determining income. See United States v. Johnson, 319 U.S. 503,
517-518 (1943); Meier v. Commissioner, 91 T.C. 273, 295-296
(1988). The source and application of funds method is based on
the assumption that the amount by which the taxpayer's
applications of funds exceed his known sources of funds is
taxable income, unless the taxpayer can show his expenditures
were made from some nontaxable source of funds. See Taglianetti
v. United States, 398 F.2d 558, 562 (1st Cir. 1968), affd. 394
U.S. 316 (1969).
The Commissioner's analysis should be adjusted, however,
whenever the taxpayer demonstrates: (1) The analysis does not
reflect, as a nontaxable source of income, funds accumulated from
prior taxable years and expended during the current year, or (2)
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