FOR THOSE WHO-fresh from the annual purgatory of doing their taxes — already regard the Internal Revenue Service with dread, IRS commissioner Margaret Richardson has a solemn warning: Tax cheats and law-abiding citizens alike, get ready for the audit from Hell.
The Wall Street Journal reported on April 3 that taxpayer complaints about the IRS’s new “economic reality audits” are “pouring in,” as furious citizens question the IRS’s need to know what schools they send their kids to and where they went on vacation last summer. Taxpayers protest that the audits more closely resemble criminal investigations than routine checks to verify the accuracy of a tax return.
Launched early last year, the economic reality audit rests on the premise that the most effective way to monitor how much income tax you owe is to monitor how much you spent during the year. By conducting a full-scale study of the assets and lifestyle of each citizen selected for audit, the IRS intends to ferret out tax evaders. IRS manuals explain that these are ” investigative” audits, not “verification” audits. The auditor is expected to ” evaluate the whole taxpayer . . . from an economic reality point of view instead of only focusing the audit on some narrow aspect of tax consequence.”
This, of course, is a fundamental departure from the standard audit. In the past, if you were audited, you merely had to prove that your tax returns were accurately based on valid financial records. The economic reality audit explores whether you can afford the life you lead on the income you declared. To determine this, the IRS wants to know how often you go out for dinner, where you go to eat, how you were able to pay for that custom-made Italian suit hanging in your closet, how much you shelled out for those Air Jordans, and whether you pump them up. The new audit has been disparagingly called the “underwear audit” because agents may actually ask to look through your cabinets and drawers.
It gets worse. IRS examiners now create a dossier that amounts to an economic profile of the taxpayer. IRS Training Aid 3302-102, entitled ” Components of Economic Reality,” identifies some 47 different aspects of a person’s life as elements of the dossier. Included are: neighborhood, home, investment income, recreatitmal vehicles, college tuition, trips, club membership, weddings of children (maybe Ross Perot wasn’t so paranoid after all!), and hobbies. Also on this list are level of sophistication and cultural background. Yes, those notoriously suave and debonair IRS auditors will now be measuring your enlightenment.
In sum the new IRS wants to get to know all about you. This raises fairly obvious privacy and civil-liberties-concerns. But John Monaco, former assistant commissioner for examinations at the IRS, insists that agent training for lifestyle audits emphasizes privacy, ethics, and other such niceties to “make sure that taxpayers’ rights are protected.” Now, that’s comforting. A bit like sending Howard Stern to charm school.
This year the IRS will conduct face-to-face audits of roughly one million taxpayers, and auditors will use the economic reality approach wherever they see fit. To help citizens prepare, the IRS has developed a “Personal Living Expense (PLE) Checklist.” The taxpayer is requested to list all personal living expenses paid during the years in question. These include expenditures on “food, alcohol, housing, utilities, supplies, equipment, apparel, entertainment, personal care, reading, education, tobacco,” and so on. Why is all this information needed? The IRS manual states: “Most taxpayers will not intentionally deposit skimmed funds, but will use the cash to increase their standard of living.” Hence, “The more information an examiner can develop, the larger the understatement [of tax]. The development of the personal living expense can be extremely critical in this process.”
But the IRS has no intention of relying solely on the citizen’s own statements in building a dossJer. The agency intends to develop external sources of data not ordinarily available to the IRS. These include the U.S. Postal Service, the Department of Motor Vehicles, the Occupational Safety and Health Administration, the Department of Agriculture, social-services agencies, courts (which record marriages, divorces, liens, inheritances, property transactions, mortgages, and bankruptcies), trade associations, banks and credit unions, insurance providers, and commercial databases such as Dunn & Bradstreet, Robert Morris, and LEXIS.
But the invasiveness of the new audits doesn’t stop there. The IRS intends to contact third parties — informants,”as it sometimes calls them — who may have information about the citizen under audit. These include landlords, employers, business and personal associates, ex-spouses, even your next-door neighbor. In some cases informants will be paid if information leads to higher tax collections.
Eventually, the plan is that the IRS will gain access to all public and many private computer databases in the nation. The IRS also intends to track electronically any significant financial transactions, property acquisitions, business moves, and the like. Investor’s Business Daily reported last year that the IRS recently began an information reciprocity arrangement with San Francisco-area banks. Under the arrangement, banks transmit to the IRS all information given them by prospective borrowers. The IRS checks the disclosures made on loan applications against the information on tax returns. When discrepancies are found, the IRS asks the individual for an explanation, and an economic reality audit is set in motion.
Shortly after the computer-access proposal was published in the Federal Register last year, a firestorm of controversy flared. Within weeks, the IRS claimed that its system had been misunderstood and that it was withdrawing the proposal. But it never did.
So just who is watching the watchdog? The IRS launched its economic reality audits during the Republican ascendancy on Capitol Hill, but so far they have drawn only yawns from Congress. That’s not too surprising. Traditionally Washington takes a bipartisan laissez-faire attitude toward IRS collection activities. The Treasury Department estimates that at least $ 150 billion in income tax goes uncollected each year, and Congress wants the money desperately.
Meanwhile, the IRS insists that as our economy proceeds further into the Information Age, where funds can be transferred invisibly from computer terminals, tracking income through conventional audits is increasingly futile. Phil Brand, chief compliance offcer at the IRS, told the Washington Post that “examination activity based on verification of deductions and known income” is no longer “the best in our judgment” for hunting down underreported income.
Alas, he is probably right. As long as we preserve our modern income-tax system, these outrageously invasive and intimidating audit procedures will become routine. The government will demand ever greater access to the details of our private lives. If the survival of the tax system demands such probes of lawabiding citizens, maybe it’s time to uproot the system itself.
Stephen Moore is director of fiscal policy studies at the Cato Institute. Dan Pilla is a tax litigation consultant and the author of How to Fire the IRS.
