Guidance on Financial Status Audits: It's Not Just for CPAs

An Interview with Arthur S. Hoffman and Walter M. Primoff

By James L. Craig, Jr.

The IRS is using a new auditing approach called financial status (previously economic reality) auditing. The purpose is to increase the effectiveness of the IRS's audit effort by uncovering unreported income. The intent is for the IRS agent to determine if the income reported on the tax return matches with the financial status of the taxpayer. The agents have been trained to gather the financial status information by, among other things, directly interviewing the taxpayer even if to do so means doing an end around the taxpayer's representative (often a CPA) holding an appropriate power of attorney. The training prepares the IRS agent to begin the probing for unreported income at the very beginning of the examination.

Asking financial status questions at the beginning of an examination rather than after the agent has some specific indication that unreported income does exist throws CPAs into a quandary. The AICPA has recently issued guidance to the CPA who is confronted with representing a taxpayer being subjected to a financial status audit. Arthur Hoffman and Walter Primoff are old hands at the issues raised by the program and explain how and why to use the AICPA advice.

The U.S. tax system is a voluntary compliance system that depends on each taxpayer honestly reporting taxable income to the IRS, computing the tax, and remitting the balance due to the appropriate district office.

The IRS conducts audits of a very small number of taxpayers as a check on the effectiveness of the voluntary system and to act as a deterrent to those that might otherwise be tempted to not be completely forthcoming with all taxable income.

A basic tenet of a voluntary system is that most taxpayers are honest and willing to pay their share of taxes. Some countries have taken other approaches, for example, where taxes are assessed based upon an estimate of the net worth of the taxpayer. Other countries use value added taxes as a principal method of taxing citizens, which by its nature reduces the ability of some to circumvent the system.

Recently, the IRS has equipped and trained its field agents who examine tax returns of individuals to conduct their audits in such a way as to see that the tax return reflects the economic reality or financial status of the individual as reflected by the taxpayer's lifestyle. The underlying presumption is that the taxpayer is not voluntarily reporting and paying tax on material amounts of his or her income, a challenge to the very underpinning of our tax system.

There is no question that an appropriate role of the IRS is to monitor and see that the system is working. Yet, there is a serious question as to the appropriateness of the IRS carrying out that role on the assumption that taxpayers are intentionally underreporting income on their tax returns.

The CPA Journal, in an attempt to understand the approach the IRS is taking with the economic reality audits and the appropriate response by CPAs, spoke with Arthur S. Hoffman, tax partner at Goldstein Golub Kessler & Co., P.C. and Walter M. Primoff, director of professional programs at the New York State Society of Certified Public Accountants. These two CPAs had successfully worked to cause the IRS to retreat from a similar program a number of years ago.

In addition, Primoff served on the AICPA's financial status audit working group that recently developed guidance appearing in the April 1996 Tax Advisor and the May Journal of Accountancy to CPAs who represent taxpayers who are being subjected to financial status audit procedures that go beyond the bounds of reasonableness and due process in seeking to assure returns are being prepared accurately. Hoffman, who is a past chair of the AICPA Tax Division executive committee, served in an unofficial capacity as advisor and contributor to the working group, which was officially comprised of presently serving AICPA tax committee members. The AICPA guidance as it appeared in the Journal of Accounting is reprinted as a sidebar.

The CPA Journal: Tell us about the prior project that you two worked on.

Arthur Hoffman: Every once in a while the IRS crosses the line and becomes so aggressive and inquisitorial as to become offensive. My earliest recollection of such a program occurred with an initiative back in the 70s that became known as the eleven questions. This was directed to corporations, principally those engaged in foreign commerce. This program raised such a furor in Washington that it was soon ended.

Then came a 1980s program of interviewing that the New York State Society of CPAs successfully challenged. It all began with an announcement from the local district director that the IRS would be conducting interviews of taxpayers--the CPA was free to attend the interview. This rather innocent sounding announcement struck a strident note. It was an end run around the power of attorney concept whereby CPAs and other professionals represent clients in tax practice matters. We raised the issue with the local district office but were told that the initiative was coming directly from Washington.

That program raised the same problem that is being created with the financial status audit. The CPA, under the profession's code of conduct, has a confidential relationship and duty with his or her client. However, communications between client and CPA are not privileged--i.e., protected from discovery by third parties in a legal proceeding. If the CPA stands by in an interview process and hears the taxpayer reveal information about unreported income to the point it indicates fraud has been committed, that CPA has not properly represented the taxpayer. Where there is the possibility of fraud or the likelihood of the IRS pursuing a fraud claim, the taxpayer should be represented by an attorney who specializes in tax fraud defenses, not a CPA. The CPA has been backed into a corner from which there is no exit.

Upon learning this was a national program, Walter and I and others from the NYSSCPA, after expressing our concern in correspondence to the IRS with copies to influential members of Congress, marched on Washington to meet with then new IRS Commissioner Larry Gibbs. Our initial meeting was frank and positive. The Gibbs point of view was different than the staffers who had developed the program--his view was that the taxpayer is an IRS customer. Gibbs asked the IRS staff to reconsider the program.

But after a six-month period, no change was made to the policy. The IRS was stonewalling. So we decided to send Gibbs a draft of a society newsletter that gave advice to our members on how to respond when a taxpayer interview was requested. It was typeset and ready to be mailed to our 32,000 members. It said that you shall not be a party to a taxpayer interview but shall turn the matter over to an attorney specializing in tax fraud. We gave a deadline for the IRS to act, otherwise the newsletter would be mailed.

Ultimately, the IRS sent a letter (which was acceptable to us) to all districts saying the agents could work exclusively with the CPA or other representative with a power of attorney and it would not be necessary to interview the taxpayer, unless of course the agent could not get the information he or she reasonably sought. This notion actually made it into the Taxpayer's Bill of Rights being drafted at about that time.

CPAJ: Then how can this become an issue now?

Walter Primoff: The IRS has focused on language in its guidance that permits the agent to have contact with the taxpayer in those cases where the taxpayer's representative is unable to get the information needed or is being uncooperative to achieve its purpose. In the financial status audit situation, the IRS is saying the representative is not likely to know the answers to the questions being asked. Therefore the agent is free to ask the taxpayer directly.

CPAJ: What caused the IRS to revive the procedure of making inquiry to taxpayer's about financial status matters?

Hoffman: My guess is that the present commissioner, Margaret Richardson, felt pressure from Congress to do more to close the so-called tax gap. She is not in the same mold as Gibbs and his two immediate successors, who all viewed the taxpayer as the customer. No doubt she asked her staff to come up with a program to catch the tax cheats that we all hear about so she could bring it back to Congress.

CPAJ: The IRS's matching program of information returns, withholding statements, and the like is very effective. Why does the IRS feel the need to take on this very aggressive program of questioning about lifestyle and financial status when it is already armed with a great deal of information about a taxpayer's income?

Hoffman: One of the purposes of the program is to focus on taxpayers with income that is not matched with a piece of paper or magnetic tape sent to the IRS--those that are conducting unincorporated business activities reported on Schedule C of Form 1040. This would include all the self-employed. Presumably Schedule C types will have a greater likelihood of being selected for the program. The IRS has, from time to time, gone after particular classes of taxpayers--e.g., used car dealers in California--who are likely to have unreported income and may be using such programs to support this new initiative.

CPAJ: What is the nature of this new program?

Hoffman: It is, first of all, a training program that gets agents into a mind-set that taxpayers are more likely than not to have significant unreported income.

Primoff: The training program is an indoctrination. It ingrains a point of view that most taxpayers under audit are tax cheats, and that those representing them are shielding taxpayers to keep the agent from learning the truth. More than ten thousand agents took 36 hours of financial status audit training, which included a "game" to tune the agents into the culture of distrusting the taxpayer and his or her representative. They take this frame of mind to their examinations.

CPAJ: How is it the program is this far along, and the AICPA is only now doing something about it?

Hoffman: There was an announcement made in the fall of 1994 by an assistant commissioner that this program was about to take place. Visions of the taxpayer interview program entered my head, and I contacted the AICPA representative on the commissioner's advisory group, a position I had recently held, and told him to be on notice.

Primoff: Arthur called me about his concerns. I was on an AICPA tax committee that deals with these kinds of issues and immediately discussed it with the committee. This was December 1994. At that point, there were not yet any examples of abuse, and we did not pursue the issue. Having gone through the audit interviewing experience, however, I was certain we would have our examples. We were not disappointed; the anecdotes of financial status type audits came soon thereafter.

By May 1995, these audits were the number one concern at the Tax Division meetings. At that point, the working group to come up with guidance was formed.

How widespread is the actual implementation of the program?

Primoff: The zeal with which the program is being implemented varies from district to district. I know of one where the director has told his agents to use the program sparingly--where the circumstances warrant. On the other hand, I heard of the program's use where the husband was an executive of a large corporation making a seven-figure income and the wife had a small business whose income was reported on Schedule C. The agent wanted to ask her the financial status questions.

CPAJ: What is wrong with the IRS seeking to uncover tax cheats and underreported income? If the shoe fits...

Hoffman: A basic precept in this great democracy is that what the government does to one citizen it should be prepared to do for all citizens. I therefore think if the IRS is going to examine one taxpayer in this manner it should be prepared to examine all taxpayers this way. The ultimate result would be if the IRS thinks it needs to know the answers to these questions, it should be prepared to make them a part of the tax return of all taxpayers. Why not make the taxpayers' annual cost of living detail a schedule on the return? Can you imagine the clamor that would be voiced with Congress if that approach were taken?

Primoff: No one is saying the IRS should not go after tax cheats. But until this point, the process of conducting an audit of a tax return always began on the basis of accepting the representations made to the agent. If the agent suspected fraud, he or she consulted with the IRS Criminal Investigations Division (CID). If it was decided there was criminality involved, the case was turned over to a special agent who would continue the case. The taxpayer knew the nature of the audit had changed and would be advised to engage the services of an attorney. The financial status audit has blurred the distinction between these two distinct types of processes--the tax audit and the criminal investigation. It is important to understand that innocent taxpayers are, at times, accused of tax fraud. A key element causing problems is the taxpayer's failure to retain the proper legal counsel soon enough. CPAs are often the most competent professionals in handling the tax audit as it relates to transactions, documentation, records, and return preparation. But CPAs have no business being around in a criminal situation. Conversely, the attorneys skilled at handling the administrative and judicial procedures and other elements of tax fraud investigations and prosecutions may not be knowledgeable in the transactional aspects of tax compliance and be ill equipped to perform the CPA's role in a tax return audit. The taxpayer, to my way of thinking, has the right to know to what extent his or her rights need to be defended and by whom.

Hoffman: The financial status audit process has completely blurred the distinction between a tax examination, civil fraud with attendant penalties, and criminal fraud. Let's examine its potential for putting the CPA representing a client in a completely impossible situation. The question is raised by the agent as to whether the taxpayer has a safe-deposit box and what is kept in it. The CPA innocently asks his client on behalf of the agent and hears, "I don't tell you everything. Yeah, I have a safe-deposit box with a little cash in it, about one hundred thousand. But you're not going to tell the agent, are you?" The CPA has been hung out to dry. He or she is subject to summons and has to tell the truth. If the CPA removes herself, the agent will know she heard something that caused her removal and immediately issue a summons.

The financial status audit is not unlike asking all the drivers going over a major toll bridge to submit to a search of their automobiles. There is no doubt some illegal items would be found. But what about the rights of the innocent drivers?

Primoff: A major fallacy in the program is the results that will be obtained from it. Congress is talking about a tax gap that, for the most part, is created by the underground economy where no returns are filed. By the time the financial status program is played out, the IRS will find very little will have been uncovered by asking taxpayers financial status-type questions. And especially the results from asking these questions of taxpayers represented by CPAs, who very often have done their own preengagement investigatory procedures to provide some assurance the client is reputable.

Hoffman: In the past, we have tried to point out to the IRS the nature of the client and group of clients that CPAs serve. We keep a tremendous body of wealth filing honestly, accurately, and within the law. That is our role. That is what we do. What this program is saying is Mr. or Ms. CPA, "Get out of our way and let us at the taxpayer."

CPAJ: What I'm hearing is the least likely taxpayer that will yield results for the IRS is the one represented by the CPA.

Hoffman: That may be true. But neither do I believe they should turn this program loose on those that are not represented by CPAs or other professionals. They have rights. This program should only kick in where there is a suspicion of fraud.

CPAJ: What you are saying is so sensible and now obvious. Why doesn't the IRS understand?

Hoffman: It has become a political matter. Those that recommended the program cannot withstand the repercussions of an admission the program is ill conceived. And look at the investment that has been made in training.

CPAJ: What is the general nature
of the response the AICPA is
recommending?

Primoff: Our goal is to assist in the conduct of an effective and efficient audit of the taxpayer's return. It envisions the agent doing the kinds of checking and verifying that have been traditionally done. However, the financial status questions would only kick in if there is a basis for digging deeper beyond normal procedures. The AICPA guidelines would act as a series of brakes to keep the process under control and the taxpayer protected. The idea is that the financial status type investigation would only become operational when there is reasonable suspicion of wrongdoing at which point tax counsel would be called in.

The AICPA Nine-Step Program

CPAJ: Let's review the specific steps recommended by the AICPA. Step one says obtain an engagement letter, which among other things points out the communications between CPA and taxpayer are not privileged and subject to disclosure. It also says the client should acknowledge that direct contact by the IRS will be referred to the CPA. Why are we trying to keep the IRS from making direct contact with the taxpayer? Are we afraid the taxpayer may be hiding something?

Hoffman: If the CPA representing the taxpayer has a power of attorney to act on the taxpayer's behalf, it should be made clear to the taxpayer that, for the CPA to carry out his or her duties, all dealings with the agent must be under the control and direction of the CPA. The taxpayer is engaging the CPA because of his or her knowledge, training, and experience in tax matters. The relationship of agent to CPA is professional to professional--knowledgeable tax person to knowledgeable tax person. More than half of all taxpayers seek professional help in the preparation of their tax return. They don't know, nor necessarily care to know, all the nuances of tax laws and regulations.

Primoff: This is what the right to be represented is all about. That right is expressed in the Taxpayer's Bill of Rights. The engagement letter is saying that, as a knowledgeable professional, it is in the taxpayer's best interest that the agent deal with the CPA.

Hoffman: Remember the old saying, "He who tries to represent himself has a fool for a client."

CPAJ: The next step is to perform a preaudit evaluation. Does this mean the CPA should do his or her own financial status audit to see whether there is an exposure to understated income?

Primoff: Not necessarily. The CPA is preparing for where the examination of the tax return may likely lead, to be better prepared to respond to requests for documentation and information. Where are the likely holes that may need to be filled in?

Hoffman: The CPA would typically have a good understanding of the taxpayer having prepared his or her return over a period of time. By focusing on potential areas of concern prior to the audit, however, the CPA will be able to provide answers to assuage suspicions as the examination proceeds. The CPA is trying to keep the agent from reaching erroneous conclusions.

CPAJ: In effect you don't want to be blindsided?

Hoffman: This review should be in the nature of a refresher of the various issues reflected in the return.

CPAJ: The guidance goes on to say the CPA should not question the taxpayer. I assume that means, at this time, no financial status type questions should be asked?

Primoff: When I'm preparing a return, I ask all manner of questions. I am allowed to rely on information given to me. I will ask if I have all that I need to prepare the return.

Hoffman: However, once I sign the jurat, it becomes my return. There is no need to seek information that might undermine it. If I learn of a significant error in the return, however, I will take the necessary steps to suggest that it be amended, and, if the client does not agree, to discontinue representing the client. I will follow the ethical standards of the profession.

CPAJ: The guidance goes on to say that if "as a result of preaudit evaluation it seems the agent might conduct an audit using financial status techniques, this guidance offers some important strategies for representing the client." What is this all about?

Primoff: This is not suggesting a strategy to deceive or conceal information from the agent. It is just arming the CPA to properly represent the taxpayer. If in fact the CPA were to suspect a problem, he might want to suggest that tax fraud counsel be brought into the picture.

Hoffman: It also is preparing the CPA as to how he or she will make use of the additional steps as suggested by
the AICPA.

CPAJ: Step three says to ask for the IRS file on the taxpayer. The fact that it would be made available is interesting.

Hoffman: Let's say a CPA has done his preaudit review and, as a result, feels very comfortable with the return. The agent then, however, begins to ask financial status type questions. The CPA at that point should ask about the basis for such probing by asking to see the IRS files of preaudit findings. If the agent fails to produce any, the CPA will be guided accordingly in handling the rest of the audit.

Primoff: The agent is supposed to furnish the information from the IRS's taxpayer file except that related to informants, if any.

CPAJ: The fourth step says if financial status questions are raised during an audit, challenge the reasons for asking them. It goes on to say if the IRS agent suspects there is unreported income, the CPA should notify the client and recommend the client consider retaining legal counsel. I think we have covered the reasons for such action.

Step five says the CPA should not discuss the answers to financial status questions with the client. This seems like strange advice. Instead the CPA explains "badges of fraud" and concludes by asking the client to consider the need to retain an attorney.

Primoff: This is because of the lack of accountant/client privilege. If the CPA obtains an incriminating answer from the client, he or she will not be in a position to deal with that answer. So instead, the guidance goes through a discussion of the kinds of things that might indicate a fraud situation. The whole point is to lead the taxpayer to the right course of action if, in fact, he or she has intentionally withheld information.

Primoff: Our ethics keep us from harming our clients. I have to maintain a position where I do my best not to harm the client and that includes advising the client of the potential need to retain tax fraud counsel. CPAs are compelled to obey the law and uphold their ethical principles.

CPAJ: Don't tell me, Mr. Taxpayer, because I can't help you if you do. Is that the idea? It is a strange way to have to deal with a problem.

Hoffman: You got it!!

CPAJ: The next step says to attend interviews without taxpayer present.

Hoffman: This is consistent with the other guidance.

CPAJ: Step seven says if an agent persists with financial status questions, consider responding: "I need to inform the taxpayer of the possible significance of your question." Ask the agent to put questions in writing and suggest he or she continue the audit while the issue of financial status questions is being resolved.

Primoff: What the CPA has learned to this point will help him or her as to what advice should be given to the client. The whole idea is that, as long as there is no basis for the questions, there is no reason for the taxpayer to respond to them. If there is a basis, both the taxpayer and the CPA need to consider the best course of action and whether to retain tax fraud counsel.

CPAJ: Step eight says wait for an administrative summons.

Hoffman: Obtaining a summons is serious business. The only time an agent should issue a summons is when he or she is serious about pursuing a criminal action. Certainly the criminal section is not interested in agents willy-nilly issuing summonses without reasonable cause.

Primoff: Unfortunately, the financial status audit program can lead IRS agents to believe that summons issuance is a routine matter.

CPAJ: The last step instructs the CPA, if an administrative summons is issued, to recommend legal representation.

Hoffman: Surprise, surprise. A summons can be resisted and, because of that, they normally would only be issued where there was evidence to support it. There must be reasonable suspicion.

CPAJ: The AICPA and its task force seem to have done a good job in developing advice to the CPA. It is important that the public understand the position being taken and that it is by no means an attempt to impede the proper audit and collection of taxes under the U.S. system. Are there other things the IRS could have done to detect unreported revenue?

Hoffman: The IRS's matching of tax return information to information returns such as W-2s, 1099s, and the like, most of which are now filed electronically. Also the withholding of taxes at the source of payment have been very effective in auditing a growing percentage of reported taxable income. I believe there is more of this kind of auditing to be done. But for some reason the IRS has been hesitant to pursue this. This to me is much more fertile ground.

CPAJ: What's likely to happen now?

Hoffman: The AICPA task force met with Nancy Johnson of the House Ways and Means Committee. Ms. Johnson said she is very upset and wanted a prohibition put into the Taxpayer Bill of Rights, which at the time was under revision. The IRS said they would back off: As a result, the Bill of Rights was not adjusted for this item. However, the IRS did not substantially change its approach. Taxpayer interviews are still called for even if controls are considered good and there is no indication of the need to perform unreported income probes. We wrote to Commissioner Richardson with copies to Treasury officials, chairs of Congressional committees, other IRS officials, and the like telling them that the program has not been changed to our satisfaction.