IRS Tags Cheats With New Tools

IF you recently bought a snappy new Mercedes, took a vacation to France, added a hot tub to your pool deck -- yet reported only $15,000 in income on your 1994 tax returns -- you just might meet your local Internal Revenue Service (IRS) tax auditor in the near future.

To crack down on tax cheats -- who cost the federal government an estimated $150 billion annually in unpaid taxes -- the IRS has launched a new enforcement strategy appropriately called ''economic reality.''

The way it works is simple: If your lifestyle -- starting with your address and zip code -- doesn't match up with your tax returns, you could be asked to explain why.

The IRS says the new approach -- which is based on the increasingly extensive computerization of IRS records -- is necessary to catch tax cheats. But some private tax professionals and civil-liberties groups say the IRS may also be tapping into non-IRS third-party data, such as bank and brokerage accounts, motor-vehicle records, county-tax rosters, and court and credit reports, thus constituting a threat to the civil liberties of all Americans.

''Economic reality is essentially a broad-based methodology, teaching examiners how to look at tax returns,'' says IRS spokesman Anthony Burke. ''This is a fine-tuning of programs that we've had in the past.'' The IRS, says Mr. Burke, is looking at the totality of the return. Civil libertarians and some private tax preparers, however, argue that the policy is both new and intrusive. ''The scope of this program is definitely new,'' says Donald Haines, a legislative counsel with the American Civil Liberties Union (ACLU), in Washington.

The program ''threatens the civil liberties and First Amendment rights of all Americans,'' Mr. Haines says. ''The ACLU has told the IRS that the program is illegal and unconstitutional.''

IRS attempts to gain access to commercial databases is not new, according to the ACLU and the Center for Democracy and Technology, a Washington-based public-policy group. The IRS gained access to private databases about 10 years ago, the groups say. But it pulled back from using commercial mailing lists following congressional complaints and numerous news media reports.

From agents to investigators

Some critics argue that economic reality alters the relationship between the IRS and individual taxpayers. ''IRS agents are being transformed from tax verifiers to tax investigators,'' says Joseph Lane, a former IRS revenue officer who is now a private tax professional in Menlo Park, Calif.

According to Mr. Lane, most of the nation's IRS revenue agents began an intensive 32-hour preliminary training course on economic reality earlier this year, the first time the IRS has begun such intensive training for all of its agents, he says. (An IRS agent confirmed the 32 hours of instruction.) Subsequent instruction will include 24 sessions of 2 hours each, he says.

The areas IRS agents and auditors will consider, Lane says, include: a taxpayer's address, neighborhood, and zip code; number and ages of dependents; investment income; acquisitions; home furnishings and fixtures; recreational vehicles and cars; college-tuition costs; trips and vacations; club memberships; hobbies and toys; weddings of children; credit usage; insurance coverage; and cultural background.

''Clearly, the philosophy of the IRS has changed,'' says A.J. Baradat, president of the California Society of Enrolled Agents, a trade group of tax professionals. ''Instead of being concerned about deductions, as used to be the case, the IRS is now looking for hidden income,'' Mr. Baradat says. ''Their main concern seems to be with businesses or professionals that are heavily cash-oriented,'' such as laundromats, gas stations, and the entertainment industry.

He cites a recent California case where the IRS suspected a laundromat owner of underreporting income. IRS agents went to the laundromat, counted the number of machines available for washing and drying, obtained records on water usage, and then determined that the suspicion was correct.

Another initiative under way at the IRS is market segmentation, where the IRS groups businesses and professions into related analytical economic segments. Called the Market Segment Specialization Program (MSSP), the program enables IRS agents to identify returns that look considerably different from most returns with similar occupational characteristics.

Tracking Al Capone

Over the years, the IRS has employed strategies similar to economic reality, although usually in specialized, high-profile cases, tax experts say.

''That's how they got [mobster] Al Capone,'' back in the 1930s, says Robert McIntyre, director of ''Citizens For Tax Justice,'' a Washington-based public-policy group. Economic reality ''is probably a good idea,'' Mr. McIntyre says. ''You've got to give the IRS the tools they need to catch tax cheats.''

Although the IRS is substantially increasing its audits this year, most taxpayers have little to fear, says Edward Wallower, who heads the auditing and appeals program for H&R Block Inc., a national tax-preparation service.

''We occasionally come across returns that are very unusual, such as a person earning $150,000 and having deductions of $300,000, Mr. Wallower, says. ''But those types of [questionable] returns are very rare.''