Scope and Methodology

To determine the extent to which IRS’ use of financial status techniques has changed, we selected random samples of audits of individual returns completed before and after IRS began reemphasizing the techniques in 1994. During both periods, financial status techniques were used predominately on returns involving business or farm income. We found no significant change in usage by type of financial status technique since the reemphasis. Need for Taxpayer Contact When Using Financial Status Techniques Varies

Financial status audit techniques vary in the extent of additional taxpayer contact needed and the amount of information being sought from taxpayers. IRS has no data showing how much additional taxpayer contact is associated with each technique or how intrusive the additional information needed might be. Such intrusions into taxpayer’s spending patterns could occur at two points—(1) before the initial interview and (2) during the initial interview. For example, in our 1992 and 1993 sample, 81 percent of the audits using financial status techniques resulted in no adjustments to reported income attributable specifically to the techniques. Similarly, for the 1995 and 1996 sample, 83 percent resulted in no adjustment to reported income attributable to the use of the techniques. Audits having no change attributable to the use of financial status audit techniques may have had changes attributable to other audit techniques. IRS Tools to Oversee Use of Financial Status Techniques

IRS has three primary tools to oversee use of financial status audit techniques: (1) audit standards to guide auditors, (2) supervisory review of auditors’ adherence to the standards, and (3) a system to measure adherence to the standards. Our analyses focused on how IRS applied these tools to the use of financial status audit techniques. While these tools offered important controls over the use of the financial status techniques, they each have limitations. On the basis of our review of the audit workpapers, we believe that this lack of criteria has probably contributed to the large percentage of audits in which the use of financial status techniques resulted in no adjustments to income. The results of using financial status techniques were mixed. To help develop and refine these criteria, we recommend that the IRS Commissioner ensure that these specific criteria on using the techniques are reflected in the instructions for interpreting the audit standards and the evaluations through EQMS and its reason codes of how well audits meet these standards; monitor the use of financial status techniques under the new criteria to identify factors associated with successful and unsuccessful usage in terms of when and to what extent to use the techniques as well as whether the usage identified unreported income and if so, in what amounts; and use these monitoring results to evaluate whether to make further revisions to the criteria on using the techniques or in the system by which IRS monitors their use. On the basis of our sample, we estimate that IRS used the notification letter to request PLE forms in no more than 5 percent of the audits for both the 1992 and 1993 and the 1995 and 1996 samples. AICPA officials were also concerned that auditors were asking personal questions about the taxpayer’s financial status at the initial interview before having any evidence of underreported income.
Why GAO Did This Study

Pursuant to a congressional request, GAO reviewed the Internal Revenue Service's (IRS) use of financial status audit techniques to: (1) estimate how frequently IRS used financial status audit techniques in audits closed in tax years prior to the 1994 initiative (1992 and 1993) and in tax years following the 1994 initiative (1995 and 1996); (2) consider how IRS' need to contact taxpayers for additional taxpayer information when using financial status techniques might intrude on taxpayers; (3) estimate the audit results from using financial status audit techniques in terms of the amount of adjustments to reported income; and (4) determine how IRS applied its audit standards, quality controls, and measurement of audit quality to the use of financial status techniques.

What GAO Found

GAO noted that: (1) on the basis of its review of samples of IRS audits completed before and after IRS reemphasized the use of financial status techniques, GAO found no statistically significant change in the frequency with which these techniques were used or in the types of returns for which the techniques were used; (2) during both periods, over 75 percent of the audits using financial status techniques involved individual returns with business or farm income--the types of taxpayers that IRS has historically found to be the most likely to underreport income; (3) financial status audit techniques vary in the need for taxpayer contact and how much additional burden or intrusiveness may be perceived by the taxpayer; (4) financial status audits have been criticized by tax professionals and others for, among other things, seeking information about financial status without having evidence of unreported income; (5) such intrusions into taxpayers' spending patterns could occur before the initial interview and during the initial interview; (6) IRS used the Personal Living Expense (PLE) form to inquire about expenses at the time of the notification letter in fewer than 5 percent of the audits for both the 1992 and 1993 and 1995 and 1996 periods; (7) the case files showed that auditors infrequently asked intrusive, financial status type questions at the initial interview; (8) concerning the results, auditors made no adjustments to the individual's reported income attributable to the use of financial status audit techniques in 83 percent of the audits in which these techniques were used; (9) IRS has three tools to oversee the use of financial status audit techniques: (a) audit standards to guide auditors; (b) supervisory review of auditors' adherence to the standards; and (c) a system to measure adherence to the standards; (10) while these tools offered important controls over the use of the financial status techniques, they each have limitations; and (11) on the basis of GAO's review of IRS audit workpapers, the lack of specific criteria may have contributed to the relatively large percentage of audits in which the use of financial status audit techniques resulted in no adjustments to income.