IRS told field agents to alter financial status audit approach, but CPAs don't see a change.

Lou E. Carlow, assistant commissioner - examination, of the Internal Revenue Service in Washington, D.C., asked IRS regional chief compliance officers to "assess the facts and apply sound judgment" before asking taxpayers about personal assets or expenditures. But CPAs around the country still report that their clients are confronted, within the first few minutes of the exam, by a series of inquiries about educational background, health, cash on hand and cash hidden someplace in the home, for example. This auditing technique, known as the financial status audit or the economic reality audit, is part of a recent IRS initiative to find unreported income.

Carlow's memorandum was in response to recent concerns - expressed by Congress, taxpayers md practitioner groups, including the American Institute of CPAs - that the financial status audits blurred the line between a probe for unreported income and a fraud investigation. At issue is CPAs' lack of client privilege and the concern that they could be sued for malpractice if they don't advise a client to have an attorney present when the questions arise. Another concern is the possibility the financial status audits would bog down the audit process. Carlow told the AICPA tax division that asking financial status questions correctly was a matter of timing: When, in the course of the audit, questions about financial status should be asked. His memorandum said the IRS would continue to deal effectively with taxpayers who underreport their income, "however, the timing is as essential as the questions themselves."

A problem plaguing practitioners

Michael J. Knight, principal of Michael J. Knight & Company in Fairfield, Connecticut, and member of the AICPA financial status audit working group, told the Journal that the IRS memorandum was not enough to solve the financial status audit problem plaguing practitioners. "CPAs still are asked if their clients can be interviewed at the very beginning of the audit," said Knight. "The fact that these questions are being asked right away proves this has become routine." Knight said financial status questions always have been a signal to the CPA that the IRS agent thought there was a problem and that the client should retain an attorney. "These audits are a tremendous burden on the practitioners who now have to review each and every question asked by the IRS agent," said Knight.

One CPA in Billings, Montana, told the Journal that one of his clients, a schoolteacher with a small business on the side, recently was told by an IRS revenue agent that he first had to answer a number of financial status audit questions before going on with the audit. "We were not given a warning on this subject," said the CPA. "The client was asked to list his expenses for the entire year. The agent told my client that if he made an error and he wanted to change it later, he would have to go before a court of appeals to do so." The client was asked about his education, whether or not he had made home improvements, how his furniture was financed and whether or not he had taken cash advances from his credit cards. "I could understand these questions if the IRS felt it has reasonable cause for fraud," said the CPA, "but they were asked at the beginning of the audit."

Barry Finkelstein, partner of Finkelstein, Allgeier & Company in Dallas, Texas, said that as recently as September his clients had received up-front questions of living expenses during the audit. "I was surprised when I saw the questions," said Finkelstein. "The agent wanted to know about my clients' groceries and outside meals, laundry and dry cleaning and vacations."

The financial status audit working group and the IRS are trying to resolve the financial status audit problem. The group also is preparing guidelines that will educate and protect CPAs and clients facing such audits. Those encountering difficulties with the IRS in this area should contact Anita L. Horn, AICPA technical manager, at [phone].