IRS Discusses Financial Status Audit Techniques

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 reportable income that do not appear on a taxpayer's return. For example, the Service tracks funds from known sources to deposits made to a taxpayer's bank accounts, rather than analyzing bank deposits to identify unreported income from unknown sources. The IRS does not use specific items to support an inference of unreported income from unidentified sources. The use of direct methods simply does not implicate Sec. 7602(e). Thus, there is no prohibition requiring the Service to have a reasonable indication that there is a likelihood of unreported income before resorting to such methods.

When using an indirect method, a taxpayer's finances are reconstructed through circumstantial evidence. For example, the IRS shows (through increases in net worth, increases in bank deposits or the presence of cash expenditures) that a taxpayer's wealth grew during a tax year beyond what could be attributed to his reported income, thereby raising an inference of unreported income. Indirect methods are used to support an inference of unreported income from unidentified sources.

The bank-deposits indirect method is an analysis of bank deposits to prove unreported income from unidentified sources. This method, which computes income by showing what happened to a taxpayer's funds, may be considered to be a financial status technique when it is used without specific knowledge of a possible traceable source. As such, it is used to supply leads to possible unreported income from sources of such deposits.

For the cash-transaction indirect method, the Service calculates the unreported income as the amount that a taxpayer's cash expenditures exceeded his sources of cash, including cash on hand at the beginning of the tax period in question, for the particular year. The IRS uses the taxpayer's return and other sources to ensure that adequate income has been reported to cover expenses.

The net-worth method requires establishing a taxpayer's net worth at the start of a tax year by listing all assets (including cash on hand) and all liabilities, with the balance being the taxpayer's net worth. A similar analysis is made for the first day of the next tax year. To any change in the net worth, the Service adds nondeductible expenditures for living expenses, then deducts receipts from sources that are not taxable income and the amounts represented by applicable tax deductions and exemptions. If the increase in net worth, as adjusted, exceeds the reported taxable income, the inference is drawn that there is unreported income.

With the percentage-of-markup method, the IRS reconstructs income derived from percentages or ratios considered typical for a business or item under examination. This method consists of an analysis of either sales or cost of sales and the appropriate application of a percentage of markup to arrive at a taxpayer's gross profit. By reference to similar businesses or situations, percentage computations are secured to determine sales, cost of sales, gross profit or even net profit. Likewise, by the use of some known base and the typical percentage applicable, individual items of income or expenses may be determined. These percentages can be obtained from an analysis of Bureau of Labor Statistics data, commercial publications or a taxpayer's records for other periods.

With the unit-and-volume method, gross receipts are determined or verified by applying price and profit figures to the volume of business done by a taxpayer. The number of units or volume of business may be determined from the taxpayer's books and records if they adequately reflect cost of goods sold or expenses. This method is recommended when the Service can determine the number of units handled by the taxpayer and knows the price or profit charged per unit.

Conclusion

We have not been provided with any specific factual circumstances under which a revenue agent would drive by a taxpayer's house. Nonetheless, this activity would not be prohibited if used in determining whether there is a reasonable indication of the likelihood of unreported income, so that the IRS could resort to setting up unreported income under an indirect method. Notably, driving by a taxpayer's house would not be an intrusion on the taxpayer. However, the Internal Revenue Manual cautions that, due to privacy issues and the intrusiveness of inspecting a taxpayer's residence, agents should limit such inspections. The purpose of inspecting a taxpayer's residence includes, but is not limited to, determining the validity of deductions for an office or business located in the residence and determining the taxpayer's financial status.

Conducting a Lexis search to ascertain if a taxpayer purchased real estate would be useful when using the net-worth method. Such a search would not be prohibited if used in determining whether there is a reasonable indication that there is a likelihood of unreported income so that the Service could resort to setting up unreported income under the net-worth method or any other indirect method. A search of property records available to the public is not an intrusion on a taxpayer.

Field Service Advice (FSA) 200101030 (10/25/00)

REFLECTIONS: Practitioner and taxpayer concerns over the IRS's use of financial status audit techniques led to the enactment of Sec. 7602(e). For a discussion of some of the issues and problems involved (and the AICPA's efforts in this area), see TTA, Feb. 1996, p. 110, and April 1996, p. 218.