AICPA offers guidance on IRS financial status auditing.

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 in an acceptable manner. This guidance is intended to address the situation in which the CPA concludes that the client is being subjected to an inappropriate financial status investigation, or that the techniques are being applied in an unreasonable or overly aggressive manner. The Tax Division's Financial Status Audit Working Group continues to work with the IRS National Office to fashion a less burdensome, long-term solution to these issues. The National Office has informed the Tax Division that a memorandum will be issued to the field to clarify the use of financial status audit techniques. As soon as such a memorandum is issued, the Tax Division will make it available to Tax Section members.

Guidelines 

The following guidelines should be considered when representing a taxpayer under examination. While the word "should" appears throughout this guidance, these are guidelines only and are not mandatory. If a CPA chooses to follow them, the AICPA believes they may be helpful.

1. Obtain an Engagement Letter

The terms of the CPA's retention as the client's representative in an IRS examination should be documented in an engagement letter that should include the client's acknowledgment that communications between the CPA and the client are not privileged communications and are subject to disclosure. Communications between CPAs and their clients are "confidential" and may not be disclosed under most circumstances; however, confidential communications are subject to disclosure in court proceedings by the CPA if served by a properly issued administrative summons compelling the CPA to testify. "Privileged" communications are not permitted to be disclosed, even in court. While some states recognize a CPA-client privilege, there is no privilege in Federal matters.(2)

The engagement letter should include a request that the client sign Form 2848, Power of Attorney and Declaration of Representative, which will notify the IRS that the CPA is the client's authorized representative.

The engagement letter should also include the client's acknowledgment that any direct contact by the IRS will be referred to the CPA as the representative. If the client is interviewed by the IRS, he may unwittingly make statements that (especially in the context of financial status techniques) may be misinterpreted or create unnecessary problems or concerns. The right to representation is codified in Sec. 7521 (c) to counter problems with the IRS during taxpayer interviews; thus, the engagement letter should include an acknowledgment that if the client decides to be interviewed by the IRS agent without the CPA's consent, the client does so at his own risk. (A sample engagement letter appears on page 221.)

2. Perform a "Pre-Audit" Evaluation

The CPA's pre-audit activity should include an evaluation of whether the client would generate significant interest to an agent performing an audit using financial status techniques. The evaluation should not include questioning the taxpayer about unreported income, as such communication is not privileged; rather, it should be based on a review of the tax return, the CPA's existing knowledge of the client's lifestyle and the adequacy of any business recordkeeping.

As set forth in the AICPA's Statements on Responsibilities in Tax Practice (SRTP) No. 3, Certain Procedural Aspects of Preparing Returns (1988 rev.), .05, the CPA (as tax return preparer) declares on the income tax return that "the information contained therein is true, correct, and complete to the best of the preparer's knowledge and belief `based on all information of which preparer has any knowledge'." SRTP No. 3, .06, further states, "In fulfilling his or her obligation to exercise due diligence in preparing a return, the CPA ordinarily may rely on information furnished by the client unless it appears to be incorrect, incomplete, or inconsistent. Although the CPA has certain responsibilities in exercising due diligence in preparing a return, the client has ultimate responsibility for the contents of the return."

However, from a CPA's perspective, there is no duty imposed by the Code, Treasury Circular 230(3) or the AICPA Code of Professional Conduct to request personal living expense and lifestyle information from the client.

If the CPA concludes that the agent should have little or no "financial status" concerns (i.e., the return and the taxpayer's lifestyle seem consistent), the CPA can draw on the guidance in this article as needed; however, the agent may never attempt to investigate the client's financial status. If, on the other hand, the evaluation leads the CPA to anticipate a strong "financial status" interest on the part of the agent, this guidance offers some important strategies in representing the client.

3. Request the IRS File

Before the initial conference with the IRS agent, or when the agent introduces financial status procedures, the CPA may want to request any information or documents accumulated by the agent during the pre-audit investigation. This information should help the CPA assess the basis for the agent's decision to pursue a financial status investigation of the client. The request for information also reminds the agent that the CPA intends to closely monitor the use of financial status audit techniques. The agent should give the CPA any third-party information available, except informant information.

On Aug. 8, 1995, the Assistant Commissioner (Examination) issued a Memorandum to the Regional Chief Compliance Officers (IRS Memorandum), providing that:

Examiners are reminded that except for informant information, taxpayers and representatives should be provided with available third party information on request. If an examiner has indications of unreported income, there should be no hesitation to discuss this issue with the taxpayer or practitioner as soon as practical.

If denied, the CPA may choose to contact the agent's group manager to obtain the information.

4. Attend the Initial (and Subsequent) Interview Without the Taxpayer

At any time during the audit, the agent may request the opportunity to interview the taxpayer. The CPA should respond that the taxpayer has a statutory right to be represented under Sec. 7521 (c); thus, the CPA should consider attending the initial (and subsequent) meetings without the taxpayer. If challenged, the CPA should explain to the agent that, as the taxpayer's representative, the CPA can and will obtain the needed information in a timely manner, so that there is no need for a taxpayer interview.

While agents should be aware that taxpayers have a statutory right to representation, they have recently undergone training that emphasizes the importance of taxpayer interviews. Therefore, the agent may continue to insist on interviewing the taxpayer, asserting that the CPA does not have first-hand knowledge of the information sought. Alternatively, the agent may attempt to bypass the CPA by contending that he is being uncooperative or is unable to provide the needed information. As the agent may try to contact the taxpayer directly, the client should be informed of this possibility and advised to refer the agent to the CPA as the taxpayer's representative. Should the agent be uncooperative or overly aggressive in this regard, the CPA should consider contacting the agent's supervisor or group manager to resolve the issue.

5. Challenge the Reasons for Financial Status Questions

The National Office has agreed that indiscriminate use of financial status questions is inappropriate. The IRS Memorandum states:

...examiners must assess the facts and apply sound judgment in determining the scope on a case by case basis....We have been alerted to instances where in-depth initial interviews were routinely used to explore a taxpayer's financial situation when there was no indication of such a need. This may not be appropriate....Examiners should ask the taxpayer only for the information actually needed for the examination of the return in question....While we are required to do probes for unreported income, the degree of the probe is a matter of judgement [sic] which must be determined on a case by case basis.

During the interview, if financial status questions are raised, the CPA, as the taxpayer's representative, should ask the agent whether there is a suspicion that the client has unreported income and the basis for such suspicion. Financial status questions might include a request for personal living expenses (PLE).

According to the IRS:

...no specific authority exists to require the taxpayer to fill out a PLE. The taxpayer or POA [power of attorney] refusal should be documented. Examiner's options are to complete PLE based upon known expenditures or use BLS [Bureau of Labor Statistics].(4)

At this point, the challenge for the CPA is to remind the agent of the National Office's policy, perhaps causing the questions to be dropped.

If the agent responds that there is a suspicion of unreported income, the CPA should notify the client of the facts and consider recommending that legal counsel be retained because of the heightened potential for a criminal fraud investigation. The CPA may want to remind the client of the lack of CPA-client privilege before this discussion takes place. If the client elects not to retain counsel, the CPA should use professional judgment as to whether to continue with the engagement, including an evaluation of how significant the client's exposure might be. Again, the evaluation should not include questioning the client about unreported income, but should be based solely on information provided by the agent and the CPA's existing knowledge of the client.

6. React to the Agent's Persistent Questions

If the agent persists with financial status questions, the CPA should consider responding that the CPA needs to inform the taxpayer of the possible significance of the questions. Under Circular 230 Section 10.22(b), a representative must use due diligence "in determining the correctness of oral or written representations made by him to the Department of Treasury." Stating the need to check with the taxpayer does not violate this due diligence standard. The agent should be requested to put the questions in writing to the CPA.

To protect both the CPA and the client because of the lack of CPA-client privilege, the CPA should advise the agent that he may recommend that the client consider waiting for an IRS administrative summons under Sec. 7602, and that this action may lead to the retention of an attorney.

The CPA might also suggest to the agent that he continue with the audit while the issue of financial status questions is being addressed, as the possible unwarranted use of financial status techniques may unduly prolong the audit. Again, at this point, the CPA's professional judgment must prevail; the CPA might conclude that no significant exposure exists and that responding to financial status questions can efficiently and effectively close the audit.

7. Refrain From Discussing Financial Status Questions

The client should be advised to review the IRS's questions--and reminded that any information the CPA obtains will not be privileged, so that the CPA could be compelled to testify against the client. Thus, if financial status questions are unavoidable, retention of an attorney experienced in criminal tax matters may best protect the client's legal rights (i.e., the privilege exists only between the attorney and the client or an accountant retained by the attorney).

Before the client reviews the IRS questions, it may be helpful for the CPA to summarize for him some of the IRS indicators of fraud. According to the IRS,(5) suggested "badges of fraud" include: omission of specific income; omission of an entire source of income; personal expenditures and asset acquisitions in excess of reported income; the appearance that if additional years are examined, there will be a pattern of omissions; concealment of bank account; not depositing receipts to business account; deducting personal items as business expenses; refusing to make certain records available; admission of unreported income; keeping a double set of books; and repeated attempts to pay up and conclude the audit.

Finally, following the client's review of the requested information, the CPA should ask the client to inform him if (or when) he believes engagement of an attorney might be in his best interests.

8. Wait for an Administrative Summons

Consider advising the client not to consent to an interview without an IRS administrative summons. If the client agrees with this recommendation, notify the IRS agent that a summons is required. Requiring the issuance of the administrative summons should force the agent to evaluate the strength of the case and how important the financial status questions are to the audit, and should curtail "fishing expeditions."

If the client rejects the advice to insist on an administrative summons and instead directs the CPA to provide the IRS with the requested answers, the CPA should use his professional judgment as to whether to continue the engagement.

9. Recommend Legal Representation

The issuance of a summons pursuing financial status information must be seen as an indication that unreported income is a significant audit issue. The potential for development of the audit into a criminal case is heightened, as is the need for legal protection.

The enforceability of a summons can be legally challenged. If challenged, the agent will be required to demonstrate the need for the summons to IRS District Counsel and ultimately to a Federal judge.

The client should be advised to retain an attorney who specializes in criminal tax matters to handle responses to financial status information requests or to pursue a summons enforcement proceeding.

Again, if the client rejects the advice to retain legal counsel and instead directs the CPA to provide the requested information to the IRS, the CPA should use professional judgment in deciding whether to continue with the engagement without the presence of a criminal tax attorney.

Conclusion

The guidance offered in this article is not intended to supersede the exercise of the CPA's professional judgment. In a given situation, professional judgment may lead the CPA to conclude that no exposure exists to either the CPA or the client, and that answering financial status questions will complete the audit in an acceptable manner.

Additionally, various places in this article recommend communication with the IRS or the client; certain circumstances would suggest such communication be in writing, but in other cases, verbal communication is adequate. It is left to the CPA's judgment to determine the need for and extent of documentation.

To receive a copy or fax of the IRS Memorandum, call [phone] and request the financial status audit information; if connected to voicemail, leave a name and telephone number and either an address or fax number (as applicable). Tax Section members with questions or those encountering difficulties in this area should contact Anita L. Horn, AICPA Technical Manager, at phone [phone] or fax [phone]. Members of the Financial Status Audit Working Group will also be monitoring questions and comments in this area on the AICPA's Accountants Forum on CompuServe. This guidance and the engagement letter are also available on the AICPA FAX Hotline, [phone], "Financial Status Audit Techniques: AICPA Guidance to Members, Engagement Letter and IRS Memo" [document No. 965].

Editor's note: The AICPA Tax Division Financial Status Audit Working Group is comprised of Chairman Jeffrey L. Raymon, CPA, Rosenfield, Holland & Raymon, PC, New Bedford, Mass.; and members Harvey L. Coustan, CPA, Ernst & Young LLP, Chicago, Ill.; Arthur S. Hoffman, CPA, Goldstein Golub Kessler & Co., New York, N.Y.; Michael J. Knight, Michael J. Knight & Co., Fairfield, Conn.; Dan L. Mendelson, CPA, J.D., LL.M., Deloitte & Touche LLP, Washington, D.C.; Walter M. Primoff, CPA, New York State Society of CPAs, New York, N.Y.; and Anita L. Horn, CPA, Technical Manager, AICPA, Washington, D.C.

(1) See Technical and Miscellaneous Revenue Act of 1988, Section 6227.

(2) See Friedman and Mendelson, "The Need for CPA-Client Privilege in Federal Tax Matters," 27 The Tax Adviser 154 (March 1996).

(3) Treasury Department Circular 230, Regulations Governing the Practice of Attorneys, Certified Public Accountants, Enrolled Agents, Enrolled Actuaries and Appraisers Before the Internal Revenue Service ("Circular 230").

(4) IRS National Office Economic Reality Training Module 3302-101, p. 3-11.

(5) Id., p. 5-6.