From the January 1996 issue of Entrepreneur

As 1996 dawns, you may want to be especially careful with your record-keeping. Why? Because a revived IRS program will be peering into your lifestyle if you're unfortunate enough to be selected for an audit. It's all happening under the guise of something called "economic reality."

Come again?

The reality of the situation is that if your return gets selected for an audit, the IRS will essentially audit your lifestyle in an effort to uncover unreported income.

What does this mean? Let's say the issues on your return are too complicated to be handled by mail. This would require you to visit an IRS field office. As you arrive for your scheduled appointment, don't be surprised if you see the agent peeking through the miniblinds to see what kind of car you drive. And if you step out of a chauffeur-driven Rolls Royce, wearing a full-length mink coat and a blinding array of diamonds-well, be prepared for some tough questions. It may well be you won it all on "Wheel of Fortune," but you'd better be prepared to prove that with documentation.

What's all the fuss about? The IRS, in its never-ending quest to close the tax gap (that is, the measure of tax Americans owe vs. what they actually pay), has determined that the majority of this gap comes from unreported income. "Especially cash transactions," says Steve Pyrek of the IRS. "We're looking for people who have cash businesses on the side and are not reporting income." To uncover this income, the IRS has recently begun making greater use of an old technique now known as the economic reality audit, the financial status audit or, perhaps most evocatively, the "financial probe."

The concept is that once a return is selected for an audit, the auditors should go beyond what is reported on the return and look at how the person is living or how the business is being operated. "The concept that you should take a look at how someone is living when conducting an audit has been around for about 30 years," says Jack Heaney, a CPA in Union City, New Jersey, who formerly worked for the IRS. "But this is the first time it's been formalized. They're now training their personnel to go into targeted businesses."

Pyrek agrees. "It's a classic technique," he says. "All agents should be doing this when they conduct an audit. When something doesn't make sense on a return, financial probes are aimed at finding unreported income."


Nancy Scarlato contributed to this article.

Why Me? Why Now?

After 30 years of gathering dust at the IRS, why are financial probes in the spotlight? There are several possible reasons. The first is that, in its effort to collect revenue, the IRS has simply rounded up the usual suspects, and unreported income usually garners a first-place spot on that list.

Heaney makes the case that standardizing the financial probe procedures for auditors and placing new emphasis on financial probes in the training manuals should help the IRS become more efficient.

Another reason for economic reality audits is the tremendous growth of small business. There seems to be a natural fear on the part of the IRS that once you hang out your shingle, you cease to pay attention to the tax code.

Pyrek confirms that a lot of noncompliance is related to inexperienced start-up businesses. "There's an education gap for people starting out on their own," he says. "It's a big job to keep track of what's required in terms of quarterly filings and Social Security tax, for example. You almost have to become a tax accountant in the process of opening a business."

But lest you think the IRS will turn its collective head and look the other way just because you appear bewildered, Pyrek adds, "A lot of unreported income is on purpose because of cash transactions. People don't think they have to report all this income. Those are the people we're looking for."

Itchy Trigger Fingers

What kinds of items on your return trigger financial status audits? Since a financial probe isn't a specific type of audit but rather a component of a regular audit, you won't know in advance what the auditor decides merits questioning. Peter Pfister, a CPA with Curchin & Co. in Red Bank, New Jersey, suggests you are a target for economic reality testing "if you have reported negative or very low income and you have a large number of expenses or deductions. This is usually a red flag for the IRS to look at a business or personal return." Or, Pfister adds, you might be lucky enough to be in an industry that is being targeted by the IRS for audits because of a history of noncompliance. The restaurant and construction industries are current favorites of the IRS.

The lifestyle check comes into play during the office visit. "We're basically comparing what's on the return with what is visible to the eye," says Pyrek. "If someone has reported a very low income and also lists a boat as an expense, how is this guy living? There may be a logical explanation-or there may be some buried income."

In fact, while for many small-business owners there exists a gray area regarding what should be considered a business expense and what is a personal expense, careful documentation is not solely an exercise for personal returns. Heaney says that while it may be important to convey a prosperous image to your clients, this can all be done with borrowed money. The key is to be able to show the IRS that the money was borrowed and dispel any notions that you have buried income.

According to Pfister, the IRS targets certain sections of the business's return, such as benefits, travel and entertainment expenses, depreciation for office equipment and auto expenses, to see if income is buried there. These items are then compared against the IRS' national guidelines and levels; areas that exceed the established levels are zeroed in on for closer examination.

Between A Rock And A Hard Place

Adequate record-keeping is the only garlic that will keep away the IRS vampires. "Certainly, proper documentation will keep the IRS from digging deeper," says Pfister. But don't forget, it's not unheard of for the IRS to compare your records with those of your suppliers or outside vendors to see if the numbers are the same. For that reason, Pfister says, "it's a bad idea to try to recreate your records after you get the audit notice. There's not much of this information that can't be verified by outside sources." A simple example would be an employee's W-2 form, which can be verified through your company.

Pfister stresses that the most important thing during any audit is to have all your records in order and make sure they detail the flow of money and the purchase of assets under consideration. Without proper documentation, the IRS can disallow deductions-and, worse yet, go back to other years and check those tax returns as well.

Exemplary record-keeping or not, what right does the IRS have to ask how you acquired that Rolls Royce sitting in your parking lot? "Unfortunately," says Heaney, "if I list my vehicles as assets, it's well within the power of the IRS to ask how I acquired these assets."

What can you do to avoid a financial probe? Not much, it seems. It all comes back to one caveat: "You win the game by knowing the rules," says Heaney. To do so, he has two basic suggestions. For starters, your accountant should be educating you on proper record-keeping. In addition, it's a good idea to keep current with IRS literature.

There are IRS publications that detail national and regional guidelines for housing, the cost of living and a host of other expenses, which Heaney says will help you learn what to expect if the IRS comes knocking. To request information or IRS publications, call the Freedom of Information Reading Room at (202) 622-5164. And remember, as accountants are fond of saying, "Preparation for an audit begins with the preparation of the return." A word to the wise.

The Good News

Fortunately, there is some good news emanating from the IRS: Thanks to budget cuts, full implementation of the dreaded Taxpayer Compliance Measurement Program (TCMP) has been "postponed indefinitely," according to Don Roberts at the IRS. (For more on these superaudits, which require taxpayers to verify every single line on their returns, see "Tax Talk," June 1994).

With no word as to when these audits might threaten to rear their ugly heads again, the good news is that 150,000 random taxpayers who might have been selected as laboratory rats in this experiment to gauge the nation's compliance with the tax code can breathe a sigh of relief.

Contact Sources

Curchin & Co., 125 Half Mile Rd., Red Bank, NJ 07701-6749, (908)747-0500;

Jack Heaney, CPA, 100 Manhattan Ave., #2110, Union City, NJ 07087, (201) 348-3475.