So far, both the IRS and Congress have largely ignored complaints of government intrusion into individuals' civil liberties and to the inferred presumption of guilt.
Traditionally, audits focussed on verifying items reported on the tax return unless fraud was suspected. The "economic realty" audit examines your lifestyle, on the premise that the way you spend is a better measure of your income than what your tax return says. The IRS believes that if you are cheating on your taxes, you probably are not hiding your money in a mattress but rather are spending it on yourself.
With the economic reality audit, the IRS evaluates whether you can support your standard of living with the income reported on the return. The starting point is Form 4822, where you are asked to list all personal living expenses paid during the year. The form covers food, housing, utilities, clothing, vacations, alcohol and more.
In addition, the auditor can obtain information from landlords, employers, financial institutions, credit bureaus, social service agencies, motor vehicle departments and professional associations -- all before the actual start of the audit.
Taxpayers and tax professionals are complaining that this procedure is merely a "fishing expedition." The American Institute of Certified Public Accountants is alarmed that economic reality audits blur the distinction between civil and criminal investigations. The association also objects to the practice of auditors asking to interview taxpayers without a tax advisor present.
The IRS has been asked to restrict the procedure to situations in which it has some evidence of unreported income.
In response to criticism, the IRS has issued a memo to its regional chiefs advising them not to use economic reality audits unless there is an indication of nonreporting. It also notes the audits are generally inappropriate for wage-earners, but suggests that self employed persons are candidates for these audits when they do not keep double entry books and have internal controls.
The AICPA has several objections to the memo, including its position towards accounting methods. The association also challenges the overall tone of the IRS' audit training program for conveying a distorted view of taxpayers and tax professionals, for implying that most taxpayers are guilty of underreporting income, and that representatives are a hindrance to the audit process.
If you are being audited and an IRS agent asks you to fill out the personal living expense form, you are not required to prepare it when the audit begins. Contact your tax advisor, who may recommend you refuse to complete the form until you receive an administrative summons. Obtaining the summons requires the IRS to review the necessity of an economic reality audit.
If the IRS pursues a financial status audit, you may desire representation by an attorney to maintain attorney-client privilege (there is no privileged communication between an accountant and a client, although that may change soon). Also, if an auditor wants to interview you without an advisor, you may ask for a delay until you have representation.