AICPA offers guidance on IRS financial status auditing.

• Position: AICPA Tax Division Financial Status Audit Working Group

EXECUTIVE SUMMARY

The IRS's aggressive new emphasis on the use of financial status audit techniques to ferret out unreported income subjects taxpayers to lifestyle and standard of living questions at the very beginning of an audit. The concern is the point at which the disclosure of such information will indicate the existence of tax fraud, necessitating that the CPA refer the case to a criminal tax attorney whose discussions with the client will be privileged. This article provides a blueprint of the steps a CPA may take in response to the IRS's use of financial status auditing techniques against his client.

Many AICPA members have expressed concern over the new "financial status" (formerly, "economic reality") audit approach being used by the IRS to probe for taxpayers' unreported income. The IRS has targeted small businesses and their owners with this new initiative. In response to many requests, a special AICPA Tax Division working group has prepared the following guidance, which applies specifically to the use of financial status auditing techniques.

Traditional IRS audits principally focus on books, records and other audit evidence directly related to the tax return and its preparation. In financial status auditing, on the other hand, there is an increased focus on unreported income at the beginning of the audit. As has always been the case, once an agent has a firm suspicion that fraud exists, the civil audit is suspended in favor of a criminal investigation. However, that suspicion is no longer based just on an audit of the tax return; rather, the agent uses indirect auditing techniques from the outset to gather information about the taxpayer or to support a suspicion of unreported income.

Financial status questions focus on a taxpayer's lifestyle, standard of living, and other elements unrelated to the specific preparation of the tax return. For example, agents are now asking taxpayers the following types of questions:

* What is your educational background?

* Where did you go on vacation? How much did you spend?

* Where do your children go to school?

* How many automobiles do you own? What are they? What is the payment?

* Do you own any large assets (over $10,000) besides autos and real estate? What are they; where are they kept? Are they paid for--if not, what are the payments?

* What cash did you have on hand in 199X, personally or for business, not in a bank--at your home, safe deposit box, hidden somewhere, etc.?

* What is the largest amount of cash you had at any one time in 199X?

* Do you have a safe deposit box? Where? What is kept in it?

In addition, taxpayers are being asked to complete Form 4822, Statement of Annual Estimated Personal and Family Expenses, which breaks down the taxpayer's cost of living. Requests for numerous documents (e.g., personal bank statements) may be made as well.

No one questions the IRS's obligation to find taxpayers committing tax fraud; however, financial status audits seriously blur the distinction between civil audits and criminal investigations. A related result is that agents, in order to complete an audit using financial status techniques, are pressuring taxpayers to submit to face-to-face interviews. The implication that a taxpayer must submit to such an interview is inconsistent with the taxpayer's statutory right to be represented by CPAs and others, as provided by the Taxpayer Bill of Rights.(1)

CPAs are faced with a dilemma. With these investigatory techniques being used throughout financial status auditing, the CPA must carefully determine the point (if any) at which the IRS investigation necessitates a recommendation to the client that a criminal tax attorney be retained.

CPAs are eminently qualified to represent clients at any IRS proceeding dealing with substantive tax law or return preparation. However, the only role for a CPA in a criminal tax fraud case (regardless of the state of development) is in support of an attorney who has expertise in criminal tax law and the advantage of privileged communications with the taxpayer.

As a result of the concerns discussed above and the IRS's renewed emphasis on financial status audit techniques, the following guidance was developed to assist CPAs in evaluating an appropriate response to financial status audit techniques. The guidance should not supersede the CPA's professional judgment. The CPA may face situations in which professional judgment leads him to conclude that no exposure exists to the client and that continuing to represent the client and answering financial status questions will complete the audit...