You get an ominous letter: Your tax return has been selected for an audit. The agent asks to meet at your house. Once she's there, she seems curious--about your cars, your kids' school tuition. Suddenly, you realize that she's not just examining your mileage expenses--she's auditing your life.
Welcome to the "financial status audit," better known as the lifestyle audit. It's the same technique that G-men used in the '30s to put Al Capone behind bars: Match your living expenses against the income you reported on your 1040. If there's a gap, the Internal Revenue Service may suspect the difference is from off-the-books cash, and its auditors are charged with finding it.
HUGE STASH. Sometimes, they do. Take the Beverly Hills couple who claimed to live on $17,000 a year but deducted $28,000 in mortgage interest on their house. In that case, an audit turned up $250,000 in hidden income. Indeed, the General Accounting Office reckons that unreported income accounts for $62 billion in unpaid taxes annually--almost half of all revenues lost to tax cheating. To find that huge stash, the IRS began new audit training in 1994. "The techniques are nothing new," says Andre Re, national director of the IRS's auditing programs. "But many of our agents were rusty or hadn't done this type of audit."
And many of them got carried away. Agents started requiring taxpayers to detail all living expenses. Auditors were taught to bypass accountants and question taxpayers directly, and some interrogations "turned into intimidation," says Douglas Stives, an accountant with Curchin & Co. in Red Bank, N.J. Faced with angry protests from accountants and members of Congress, the IRS issued orders in 1996 telling agents to use "in-depth income probes" only when they suspected cheating.
Still, IRS agents haven't lost interest in your lifestyle, especially if you file a Schedule C. The IRS is focusing on cash-intensive small businesses, such as restaurants, bed-and-breakfasts, and gas stations, whose owners have opportunities to hide income. Entrepreneurs whose returns show large losses in startups also "invite the IRS to ask, `Just what are you living on?"' says Mark Rigotti, a Taylor (Mich.) accountant. Sometimes, a probe is based on informants' tips, large cash deposits, or real estate records showing purchases out of line with reported income.
But any taxpayer could find herself on the receiving end of probing questions. A way to avoid that: Never meet an auditor at home, where chitchat could lead to queries about how you could afford to collect those vases. Better yet, don't talk to the auditor at all. If you don't already have a tax preparer--an enrolled agent, an accountant, or a lawyer--hire one when you're notified of an audit needing more than a letter in response. Give your preparer the power of attorney and tell the IRS to send him all questions.
Make sure your preparer is aware of the American Institute of Certified Public Accountants' guidelines for handling a lifestyle audit. They recommend that preparers ask the IRS to show data that raises suspicions you're hiding income. On request, the IRS must release records gathered in an audit, except for reports from confidential informants.
Don't give the tax man more data than you have to. That's why accountants prefer that you avoid meeting with auditors. "When the agent asks me, `What's your client's house worth?,' I can say, `I haven't a clue,"' says Stives. Without compelling evidence of cheating, overworked agents might give up.
Then again, they might not. The IRS has access to more data than ever, such as credit reports, car registrations, and economic profiles of neighborhoods. Auditors use it to estimate how much money you need to live in the style to which you seem accustomed. If your reported income doesn't come close, the IRS can compel you to document your income and expenses--a long slog through bank statements and invoices.
Of course, the best defense is good records, compiled long before the IRS shows up. Agents have been ordered to ease up on business owners whose accounting systems have tight controls against skimming. Or, if you're living on loans from your in-laws while you start a business, tell your preparer.
But if you are hiding something, accountants make one request: Don't go to them. Under federal law, they can be compelled to testify against you. Hire a lawyer instead, so your communications will be privileged. Otherwise, to the IRS's lifestyle probers, your private life may become an open book.
TAX TIP: Never meet an auditor at home. Better yet, leave all the talking to your tax preparer