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On December 30, 1997, the GAO issued its long-awaited report on the IRS' financial status auditing program. The report, Tax Administration: More Criteria Needed on IRS' Use of Financial Status Audit Techniques, was done at the request of Ways & Means Committee Chairman William Archer (R-TX) and IRS Oversight Committee Chairperson Nancy Johnson (R-CT).

The GAO compared the periods immediately before and after the 1994 issuance of the IRS' controversial training program for financial status auditing techniques, formerly referred to as economic reality auditing. The report estimates how often the IRS used financial status audit techniques in audits closed in 1992 and 1993 and in tax years 1995 and 1996.

The GAO then considered how the IRS' need to contact taxpayers for additional information when using financial status techniques might be intrusive. The report estimates the audit results from using financial status audit techniques in terms of the amount of adjustments to reported income and determines how IRS applied its audit standards, quality controls, and measurement of audit quality to the use of financial status techniques.

The GAO's summary of the report concluded the following:

  • On the basis of its review of samples of IRS audits completed before and after the IRS reemphasized the use of financial status techniques, GAO found no statistically significant change in the frequency with which these techniques were used or in the types of returns for which the techniques were used;

  • During both periods reviewed, over 75% of the audits using financial status techniques involved individual returns with business or farm income--the types of taxpayers that IRS has historically found to be the most likely to underreport income;

  • Financial status audit techniques vary in the need for taxpayer contact and how much additional burden or intrusiveness may be perceived by the taxpayer;

  • Financial status audits have been criticized by tax professionals and others for, among other things, seeking information about financial status without having evidence of unreported income;

  • IRS used the Personal Living Expense (PLE) form to inquire about expenses at the time of the notification letter in fewer than five percent of the audits for both the 1992 and 1993 and 1995 and 1996 periods;

  • The case files showed that auditors infrequently asked intrusive, financial status-type questions at the initial interview;

  • Concerning the results, auditors made no adjustments to the individual's reported income attributable to the use of financial status audit techniques in 83% of the audits in which these techniques were used;

  • IRS has three tools to oversee the use of financial status audit techniques: (a) audit standards to guide auditors; (b) supervisory review of auditors' adherence to the standards; and (c) a system to measure adherence to the standards;

  • While these tools offered important controls over the use of the financial status techniques, they each have limitations;

  • On the basis of GAO's review of IRS audit workpapers, the lack of specific criteria may have contributed to the relatively large percentage of audits in which the use of financial status audit techniques resulted in no adjustments to income.

The CPA profession had noted an important consequence of the financial status auditing program which the GAO study did not address: The extensive use of financial status auditing techniques might cause CPAs to have to withdraw from the tax auditing process and leave that work to attorneys who could enshroud clients in the protections offered by attorney-client privilege.

Source: Tax Administration: More Criteria Needed on IRS' Use of Financial Status Audit Techniques. This document is available online at http://www.access.gpo.gov.

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