IRS to Grade on Appearance : Agency Will Look Beyond Return for Other Income Clues

After years of checking W-2s and 1099s and making sure taxpayers have receipts for their deductions, the Internal Revenue Service is adding a new weapon to its audit arsenal.

It’s called “economic reality,” and it means that IRS agents will start looking beyond the numbers of the return to make sure the report fits with the taxpayer’s assets and lifestyle.

If you have a big house and a couple of fancy cars but your return shows, say, $25,000 in taxable income, the IRS will be asking you to explain how you make ends meet. If you suddenly start reporting a lot of investment or interest income after years of reporting none, agents will want to know about those investments.

In other words, they’ll be looking at your finances and asking, in effect, “What’s wrong with this picture?”

The program stems in part from the agency’s realization that unreported income is the fastest-growing segment of the “tax gap”--the $100 million or so in uncollected taxes that escapes the IRS each year.

“A lot of examination activity was based on verification of deductions and known income,” said Phil Brand, IRS chief compliance officer, but that method is “not the best, in our judgment,” in dealing with cash transactions and other unreported income.

The agency has begun training auditors in “economic reality” techniques, and agents will be expected to implement them as soon as they complete the course.

The techniques will be applied to both garden-variety audits and to all-encompassing “taxpayer compliance measurement program” audits, in which a small number of randomly chosen taxpayers are audited in excruciating detail to help the agency gauge the overall extent of cheating.

The new program will involve checking sources such as motor vehicle records, real estate transfers and other documents that might show assets that seem greater than what the taxpayer could acquire with the income he or she is reporting. A taxpayer such as Soviet spy Aldrich Ames, for example, might have attracted IRS attention under this program, even if the CIA didn’t notice.

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If a taxpayer reports $2,000 in interest income from a bank account this year but none in previous years and his or her income hasn’t changed, “we would ask what amount of money earns $2,000 in interest” and where did it come from, said John Monaco, who is assistant commissioner for examinations at the agency.

Monaco acknowledged that there are certainly many legitimate explanations--inheritance, for example--and said that if the taxpayer can show where the money came from, that will be that.

Monaco also said the training includes a heavy emphasis on matters of privacy and ethics designed to make sure taxpayers’ rights are protected. Nonetheless, some experts and a number of the agency’s regular critics are voicing concern.

“There are major privacy issues here,” said Pete Sepp of the National Taxpayers Union, a nonprofit group that often takes issue with IRS practices. “This represents a fundamental shift in the philosophy behind audits. Before, the IRS was concerned about information that appeared on the return. Now an agent could conceivably delve into many, many other portions of your life.”

Donald Alexander, a former IRS commissioner who is now a lawyer in private practice, said, “I think that for individual examinations it’s a good idea if not carried too far.”

If a taxpayer is in a business in which cash payments are common, reports $12,000 in income and has four Mercedes-Benzes parked outside, “the IRS agent knows full well there is a problem and should seek it out,” Alexander said.

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However, the program “should be strictly limited,” Alexander said. “The IRS doesn’t have the time to run net worth examinations on many taxpayers, nor should it.”

IRS officials said “economic reality” checks will not be applied indiscriminately. Returns will continue to be selected for audit by computer and then reviewed by IRS workers. Only those that seem suspicious will get the full treatment.

Although this program is new, the techniques of “economic reality” audits have been around for many years. Until now, their most common use was in estimating incomes of individuals who have failed to file returns, not those who have filed. In such cases, which often involve criminal activity such as drug dealing, IRS agents track down the individual’s assets, examine his or her spending habits and lifestyle, then calculate the income necessary to support them. The agency then taxes the person on that income. The results in such cases have been tested in court and widely upheld.

A key spur for the new program is the widespread computerization of the kinds of records the IRS needs to see. In the past, Brand noted, checking car licenses and the like meant laborious manual searches. Now they can be done quickly and cheaply by computer.