New IRS Audit an ‘Economic Reality’ Check

The Internal Revenue Service is getting smarter, and that can be trouble even for honest taxpayers.

After 83 years of peering mainly at deductions, the tax collection agency and its auditors have figured out that the big money is not hidden in fake deductions. It’s buried in unreported income.

So the IRS is leaning ever more heavily on a relatively new audit technique: the “economic reality” or “lifestyle” audit, according to Carol Thompson, a tax preparer in Monterey, Calif., who has started specializing in these types of tax examinations.

It’s a valid strategy on the part of the IRS, given the propensity of some taxpayers to submit outrageous returns, many say.

For example, one California couple “forgot” to include $250,000 of business income in their forms. They said they lived it up in Beverly Hills on $17,000 a year. What tripped them up? They claimed a $28,000 mortgage interest deduction.

In an economic reality audit, an IRS examiner may ask questions having nothing to do with your tax return. Questions such as “How big is your monthly car payment?” Or “Do you spend a lot of money on clothes?”

If you hear questions like that, it may mean the auditor is trying to build a case that you’ve spent more money in a year than you claimed in income. It’s possible the IRS may already have some of the answers.

IRS examiners who are trained to find fraud may have already searched national real estate records to find the average living expenses of someone in your ZIP Code.

Or they might have checked your credit rating and found that pricey new car loan, or received a notice from the local boatyard that you paid cash for that new speedboat. Then there are Labor Department statistics to see what someone in your income level typically spends on food, clothing, shelter and extras.

For taxpayers and preparers, these audits can provoke special problems, even if consciences are clean.

An economic reality audit is likely to require the taxpayer to reconstruct all kinds of records: a year’s worth of 2-year-old bank statements, for starters. The taxpayer may be asked to explain all of the deposits on that bank statement. He or she may also be asked a series of 27 other difficult-to-answer questions, according to Robert Pielech, a New Bedford, Mass., certified public accountant who has been helping other accountants deal with these new audits.

There are other complications. Auditors asking economic reality questions can get an accountant kicked out of the room quick: Once fraud is suspected, your CPA will probably have to call in an attorney to represent you. Taxpayers confronted with these audits will thus have two sets of hourly fees to contend with instead of just one.

Furthermore, a less careful auditor can cause serious problems for a taxpayer who hasn’t been hiding any money.

Thompson tells of a couple who had been living way beyond their means on credit cards. The IRS examiner looked at some of the expenses, extrapolated others from government statistics, and “imputed” what the taxpaying couple should have been earning. He sent them a bill for $9,000 in back taxes.

Thompson was called in as a consultant. She combed through bank statement and credit card bills until she could prove that extra income really wasn’t there. The IRS canceled the $9,000 charge, but by then the taxpayers owed Thompson about $1,000.

Avoid these audits before they come, suggests Thompson, by documenting unusual tax-free income if you receive it. For example, when you submit your tax return, include a note explaining any recent windfalls or heavy credit card debt.

In recent years, tax preparers have been abandoning the conventional wisdom that you should never attach a note to your return.

How should you handle an economic reality audit?

Mark Rigotti, a Taylor, Mich., CPA, strongly suggests taxpayers send their tax preparers to a first audit without any extra personal information. If the auditor starts posing lifestyle questions, the tax preparer can just say, “We didn’t declare any expenses relative to that, and I don’t know the answer.” Those answers will quickly discourage an auditor who is merely fishing, Rigotti says.

LINDA STERN is a freelance writer who covers personal finance for Reuters.