Financial status audits: a widespread problem.

The issues that practitioners and their clients have faced.

Steven L. Wilson, managing partner of Wilson & Cuite in Tulsa, Oklahoma, was prepared to meet an Internal Revenue Service agent for a very simple audit. His clients, two married physicians, filing jointly, had a large salary income, interest and dividends. Wilson expected the audit to be so simple he had intended to drop off the records and let the auditor develop questions he would answer later. There was no reason an auditor should suspect unreported income. Although the audit did not prompt any change in tax liability, the auditor asked personal questions that Wilson believed infringed on his clients' privacy.

While Wilson's clients had asked him to represent them during the audit, the IRS agent insisted on talking to one or both of the taxpayers. "My client said he had nothing to hide and agreed to speak with the agent;' said Wilson, who, using his professional judgment, agreed to set up a conference call. The agent immediately began asking invasive personal questions about the clients' hobbies, vacation costs and their children's school tuition costs. The agent also said he would visit their residence to see it and also to see what cars were parked out front. "What was absurd about this" said Wilson, "was, given the level of my clients' income, they. could own a house anywhere in Tulsa."

The IRS agent also asked to go through the clients' personal bank statements. The client had to tie the 12 monthly statements with the net W-2 income and show transfers between accounts. "I asked the auditor what triggered this kind of audit and he replied that it was nothing out of the ordinary--the audit was routine."

Complaints of such over-aggressive and intrusive agent inquiries have been attributed to an IRS audit technique-- known as the financial status or economic reality audit--that is part of an initiative to find unreported income. Congress, taxpayers and practitioner groups, including the American Institute of CPAs, have expressed concern that this audit technique blurs the line between a probe for unreported income and a fraud investigation. Also at issue are CPAs' lack of client privilege and the possibility that they might be sued for malpractice if they do not advise a client to have an attorney present when the questions arise.

"Financial status auditing should not be routine, but it has become a widespread problem," said Jeffrey L. Raymon, chair of the AICPA financial status audit (FSA) working group. In fact, the techniques drew so much public attention that last year then-IRS assistant commissioner Lou E. Carlow asked IRS regional chief compliance officers to "assess the facts and apply sound judgment" before asking certain financial status audit questions. But this advice has not been consistently applied across the country, said Raymon.

Acting Assistant Commissioner of Examination Thomas Wilson told the Journal there were certain questions IRS agents needed answered early in an audit. "I expect our agents to find out whether there are any inheritances, any substantial gifts or any types of income the taxpayer feels are nontaxable," said Wilson. "Apparently agents sometimes asked a lot more personal questions early in the audit." The assistant commissioner said the IRS was looking at agent training and attitude. "We do not want to give the taxpayer the impression that we start the audit with an assumption of guilt unless the facts and circumstances indicate a problem," said Wilson, noting the IRS was drafting a memo to regional compliance officers to ensure all the agents understand this position.

The FSA working group has developed guidance for CPAs confronted by financial status audits. "In Mr. Wilson's case, we would recommend he challenge the IRS agent's reasons for asking those questions so early in the audit," said Raymon. "CPAs should try to get the agent to understand there should first be reasonable suspicion."

Some financial status auditing questions

How much do you spend on

* Groceries.

* Clothing.

* Barber, beauty shop and cosmetics.

* Education--tuition, room, board and books.

Source: IRS Form 4822, "Statement of Annual Estimated Personal and Family Expenses"

JOHN VON BRACHEL is a news editor with the Journal. He is an employee of the American Institute of CPAs and his views, as expressed in this article, do not necessarily reflect the views of the AICPA. Official positions are determined through certain specific committee procedures, due process and deliberation.