IRS discusses financial status audit techniques.

• Author: Fiore, Nicholas J.

Revenue agents have inquired whether they are still permitted to drive by a taxpayer's house or conduct a Lexis search to ascertain if the taxpayer purchased real estate during the year(s) at issue prior to having a reasonable indication that there is a likelihood of unreported income, in light of Sec. 7602(e) (which restricts the use of financial status audit techniques).

Analysis

The Internal Revenue Service Restructuring and Reform Act of 1998 added Sec. 7602(e),"Limitation on Financial Status Audit Techniques." Sec. 7602(e) provides that "[t]he 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."

The legislative history of Sec. 7602(e) reflects that, prior to its enactment, the IRS could use financial status or economic reality audit techniques to determine the existence of unreported income. The legislative history states that Sec. 7602(e) merely prohibits the use of such audit techniques to determine the existence of unreported income until the Service has a reasonable indication that there is a likelihood of such unreported income.

Prior to enacting Sec. 7602(e), the House Committee on Ways and Means requested that the General Accounting Office (GAO) report on the frequency and results of the use of financial status audit techniques to identify unreported income, due to concerns over the treatment of (and the burdens placed on) taxpayers. The Code does not define the term "financial status audit techniques." As used in the GAO's report, financial status or economic reality audit techniques consist of indirect methods of examination, such as the bank-deposits method, the cash-transaction method, the net-worth method, the percentage-of-markup method, and the unit-and-volume method. The GAO concluded that these techniques were never used alone; they were used with other techniques to explore issues other than unreported income, such as overstated deductions.

There are two distinct types of methods of proof in tax cases--direct (or specific-item) methods and indirect methods (financial status or economic reality examination techniques). In the direct or specific-item methods, specific items are demonstrated as the source of unreported income. With the specific-item method of proof, the IRS uses evidence of the receipt of specific items of...