June 1999 Issue

Less reason to be afraid?

The IRS's New

Approach to Financial

Status Audits

By Philip R. Fink and Charles Gibson

In Brief

Aggressive Use No Longer Allowed

Financial status audits seemed like a good thing at the time. The objective was to close the gap on unreported and underreported income. An IRS agent would be able to tell whether income was missing from a tax return by matching the lifestyle of the taxpayer to the tax return.

The problem is, such an approach smacks of a mindset that the taxpayer intentionally misstated information on the return. Taxpayer advocates, CPAs, and the AICPA objected to this Big Brother approach at the start of an audit before there was any indication of a problem. As a result, the IRS Restructuring and Reform Act of 1998 included a provision to limit the use of financial status audits to those cases where there is indication a problem exists.

The history and the IRS's philosophy behind these audits and a review of the training IRS agents have received will help taxpayers and their CPA advisors deal with IRS decisions to use the technique in the future.

Financial status audits assist the IRS in locating unreported income by comparing the amount of income reported with the lifestyle and the type and value of assets a taxpayer enjoys. These audits have been used by the IRS for many years. Nevertheless, in 1994 the IRS decided to focus on these types of audits much more than they had in the past. Part of this increased effort included a significant amount of training for IRS agents. The wider use of these audits led to an outcry from CPAs and the AICPA that the IRS was performing these audits in an intrusive manner. The IRS Restructuring and Reform Act of 1998 attempts to minimize the number of cases in which the IRS performs a financial status audit.

Training for Financial Status Audits

Because of the IRS decision in 1994 to emphasize financial status audits, many agents went through extensive training to learn how to perform these audits. The objectives of these audits as set forth in the training materials are to--

* evaluate the whole taxpayer (including consideration of related tax entities) from an economic point of view instead of focusing the audit on some narrow aspect or issue of tax consequence;

* perform investigative audits instead of verification audits;

* generate involvement by first line managers of the IRS in supporting financial status audits, which should bring about increased productivity and ensure high quality in these examinations;

* generate support from higher-level IRS managers and executives in using this approach as an integral part of the strategy to close the "tax gap."

The focal point is whether reported income is sufficient to support an individual's financial lifestyle, standard of living, expenditures, and acquisitions. If an individual's tax return lacks economic reality, the cause is most likely unreported income, overstated expenses, or nontaxable sources of funds. In such cases, the IRS will issue a Form 4822 (Personal Living Expenses) to assist the taxpayer in gathering evidence.

Authority to Conduct
Financial Status Audits

The IRS's authority to conduct a financial status audit, including an interview of the taxpayer and other witnesses as appropriate, is found in IRC section 7602. That section empowers the IRS to ascertain the correctness of a return or of preparing a return when the taxpayer has failed to do so--

* to examine the books, papers, records, or other data that may be relevant to such inquiry;

* to summon the taxpayer or any officer or employee of the taxpayer, or any person having possession, custody, or care of books of account relating to the business, or any other person the IRS may deem proper to appear and produce such books, papers, records, or other data, and to give such testimony as may be relevant or material to the inquiry; and

* to take such testimony of the person concerned as may be relevant or material to the inquiry.

Prior to the 1998 act, both the IRS and the courts had interpreted this language liberally. For instance, it has been held that even when the taxpayer's records appear to be flawless, the IRS may test the accuracy of a taxpayer's books and records by resorting to any reasonable method which in the IRS's judgment would clearly reflect taxable income.

This was the finding in Lipsitz v. Comm'r [21 T.C. 917 (1954) affirmed, 220 F.2d 871 (4th Cir. 1955)], where the Tax Court stated, "It is not correct to say that the use of the net worth method is forbidden where the taxpayer presents books from which income can be determined, for the net worth method itself may provide strong evidence that the books are unreliable." With the Tax Court ruling in this manner, it is easy to see why the financial status audit could have been used in any audit of any taxpayer.

Even the Supreme Court had opened the flood gates to this audit technique, used by the IRS in the criminal tax case Holland v. United States [348 US 121 (1954), 54-1 USTC, 9714]. In that case, the Court stated, "To protect revenue from those who do not render true accounts, the government must be free to use all legal evidence available to it in determining whether the story told by the taxpayer's books accurately reflects his financial history."

IRS's Philosophy Prior to
the Restructuring Act of 1998

At least outwardly, the IRS's philosophy has been that lifestyle audit techniques generally are not appropriate in examining all taxpayers. For instance, even before the IRS Restructuring and Reform Act of 1998, Thomas W. Wilson, Jr., acting IRS assistant commissioner (examination), sent a memo to regional chief compliance officers explaining their appropriate use. Wilson warned that lifestyle audit techniques are generally inappropriate in examining a wage earner unless there is an indication of income that is not subject to information reporting. He also cautioned examiners not to assume that an audit of a business or self-employed taxpayer automatically means that there is unreported income; not every audit requires in-depth income probes.

Wilson further noted:

Examiners must evaluate the facts and the circumstances of each case and apply judgment. It is not an efficient use of resources to have examiners perform in-depth income probes and ask questions about personal assets and personal expenditures when there is no reasonable indication of unreported income. The more in-depth probes should only be employed when there is a reasonable indication of unreported income.

Although the Internal Revenue Manual states that the initial interview income probe should attempt to secure sufficient facts to get the taxpayer's overall financial picture, Wilson warned that this does not necessitate automatically sending a Form 4822 with the appointment letter. When there is reasonable indication of unreported income, the examiner should tell the representative or taxpayer that there appears to be a problem regarding income and give them an opportunity to explain or resolve any discrepancies.

A Glimpse of the Training Material

The training material used by the IRS gives some insight into its view as to what might trigger a financial status audit. It also reveals the IRS policy makers' mindset as it relates to the attitude of taxpayers toward the tax system. A 1994 IRS training guide listed the following reasons why taxpayers omit income from their returns:

1. Don't want to pay tax.

2. Can get away with it.

3. Self-employment tax too high.

4. No money to pay.

5. It's part of our culture.

6. Beat the audit lottery.

7. Big guys do it, why not me.

8. My friends cheat.

9. Income not shown on Form 1099.

10. Industry practice, e.g., rebate checks.

11. Expenses = income, why report?

12. My prices won't be competitive if I pay tax.

13. Government waste.

14. Opposed to government programs.

15. No benefits to me.

16. Tax laws are unfair.

17. This is my own tax shelter.

18. Selfish, greedy.

19. To support gambling habit.

Determining the Source of Each Component of a Financial Status Audit. In preparing for a financial status audit, examining agents were trained to develop a two-column grid to assist in determining the economic reality of a return. One column is designated R, which represents information that can be obtained from the taxpayer's tax return. The other column is designated O, which represents information that can be obtained from a variety of other sources. Such a grid is shown in Exhibit 1 .

Case Example. As part of their training on financial status audits, IRS agents are given hypothetical examples that show taxpayers trying to omit or underreport income. One type of business that might be used as a case example is a bar or restaurant. Exhibit 2 can be found in training material for IRS agents performing financial status audits.

Concern About Financial Status Audits

Many practitioners and the AICPA were concerned about the intrusive nature of these audits and the alarming rate at which they were being performed. There was great concern that this type of audit was being performed when there was not a perceived need for it. Many CPAs thought the use of the financial status audit presumed a suspicion on the part of the examiner that the tax return had been prepared fraudulently and recognized that an attorney's services would therefore be required. They believed that if the IRS had such suspicions, they should be communicated at the point they arose, so that the taxpayer could appropriately engage counsel to handle the audit.

IRS Restructuring and Reform Act of 1998

The IRS Restructuring and Reform Act of 1998 added to IRC section 7602(e) the following:

The secretary shall not use financial status or economic reality examination techniques to determine the existence of unreported income of any taxpayer unless the secretary has a reasonable indication that there is a likelihood of such unreported income.

Unfortunately, there is nothing in the IRC or in committee reports to be used as a guideline as to what is meant by a "reasonable indication that there is a likelihood of such unreported income."

A recent case may shed some light on the matter (Pollak v. United States, 1998 U.S. Dist. LEXIS 16224). The taxpayer's 1995 and 1996 individual tax returns were independently selected for audit by the IRS's regular audit selection program for individual returns. Based on what the IRS agent saw, he wanted to perform some of the financial status audit techniques. The 1995 return contained a Schedule C for a consulting business that reported $80,000 in expenses, but no income. There were also large charitable contributions, capital losses of $65,000, and rental property expenses that far exceeded income. The 1996 return reported $55,238 in gross income, while claiming itemized deductions of more than $105,000. The tax return also included an item of gross income labeled "miscellaneous" for $39,000. In addition, the 1996 mortgage interest alone exceeded the taxpayer's reported income. The 1996 return also reported the sale of a home for $1.10 million that had been purchased for $1.24 million. Subsequent inspection of public records revealed that, in 1996, the taxpayer purchased a home for $2.25 million and sought permission to demolish it and spend $800,000 to build a new home on the site.

The court held that, even though the IRS's audit began prior to the enactment of the 1998 act, under the new legislation, the IRS would have had a reasonable indication of a likelihood of unreported income. Moreover, the taxpayer's tax returns indicated that the income reported was inconsistent with the expenses claimed.

While the Pollak case was an attempt to delineate what is a "reasonable indication that there is a likelihood of such unreported income," there will be many more cases to come that will further illuminate when the IRS can instigate a financial status audit.

It is intended that the IRS's attempts to discover unreported income by using financial status audits will be curtailed by the restrictions of the IRS Restructuring and Reform Act of 1998. How closely the restrictions will be enforced is anyone's guess at this time. CPAs should be on the alert for those situations where the IRS commences a financial status audit and should challenge whether there are sufficient grounds to begin this intrusive process. *

Philip R. Fink, CPA, and Charles Gibson, CPA, are professors in the Department of Accounting in the College of Business Administration of the University of Toledo.

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