IRS Freer to Do More of Another Kind of Audit

American taxpayers were cheered when the Internal Revenue Service recently announced that budget constraints were forcing the agency to drop plans for random line-by-line audits. But they may be in for an unpleasant surprise.

Dropping the time-consuming Taxpayer Compliance Measurement Program frees IRS examiners to conduct more standard audits, says Laurie Keleman, an IRS spokeswoman in Los Angeles. Each auditor may have planned to handle just 3,000 regular audits per year when TCMP audits were part of the schedule, whereas they may now be able to do closer to 5,000, she says.

Moreover, the agency is beefing up its run-of-the-mill examinations. If you get audited, there’s a good chance the probe will be more thorough than ever before, tax experts say.

At the crux of the changes are two previously announced IRS programs that have just begun to take shape--the “market segment specialization program” and something called “economic reality.”

The market segment specialization program targets people in specific industries that the agency believes have been most likely to harbor tax cheats. The auditors assigned to examining returns in these industries will be specialists, who are expected to quickly ferret out trouble spots.

In addition, the IRS is in the process of training all its examiners on so-called “economic reality” audits, which are aimed at finding unreported income, and will now be part of every in-person audit.

While the IRS maintains there is no set formula for how to conduct an economic reality audit, agency spokespeople acknowledge that a list of 27 questions is being widely circulated among examiners. Taxpayers who are called in for an audit are likely to be grilled for answers to all or part of these questions.

Some of the questions are less harmless than they may seem, says Blake Christian, partner at the tax accounting firm of Holthouse, Carlin & Van Trigt in Long Beach.

For instance, when the IRS asks you about your educational background, don’t be tempted to brag. What the agency is doing is setting you up for hefty penalties if they later find out that you understated your income or deducted something that wasn’t allowed, he says. The bottom line, if you’re well-educated and sophisticated, the agency is going to argue that you should have known better. And the penalties for cheating are substantially worse than the penalty for making a mistake.

Other questions you’re likely face, if audited: Who holds your mortgage? What’s the monthly payment? Do you own other real estate? When did you buy it? Do you rent it out? What’s the rent? Do you manage the property yourself, or does someone else manage it for you? Did you make improvements to any real estate in 1993? If so, what was done and how was it paid for?

What kind of cars do you own? What are the monthly payments? Do you own any large assets, worth more than $10,000, besides automobiles and real estate? If so, what is it and where is it kept?

Did you sell anything or lend out money in the tax year in question? Did you receive loan repayments from anyone? What’s the largest amount of cash you had at any one time during the year? What cash do you have that’s not in a bank account? Do you have a safe deposit box and, if so, where is it and what’s in it?

The point of all these questions is to find income that you haven’t reported, says Keleman. If you’re driving a new Mercedes, but you’re only making $10,000 a year, for example, the IRS has reason to believe you’re cheating--unless that Mercedes was a gift from some rich relative. And if it was, your relative may owe gift taxes.

It’s important to note that when you are answering, the IRS agent may not know whether or not you’re telling the truth. But the agent is likely to pull records and check the accuracy of your responses later. If they find out you lied--or simply answered a question inaccurately--you could be in serious trouble later.

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The bottom line: Don’t answer off the cuff, says Robert G. Nath, principal at Odin, Feldman & Pittleman in Fairfax, Va. Try to find out, in advance of an in-person audit, what questions are likely to be posed, he suggests. Then, with the help of a tax adviser, prepare your responses so they are as accurate as possible. Also seriously consider having an accountant or an attorney represent you.

“Once you have answered these questions, there is no turning back the clock,” adds Christian. “You have a response recorded. If you aren’t careful, it could be very self-incriminating.”

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Kathy M. Kristof welcomes your comments and suggestions for columns but regrets that she cannot respond individually to letters and phone calls. Write to Personal Finance, Los Angeles Times, Times Mirror Square, Los Angeles, CA 90053, or message kristof@news.latimes.com on the Internet.