Have you ever looked at a neighbor or coworker and wondered how they afford their lifestyle? You know that they have a similar household income to you and yet they drive a luxury car or dress in designer clothes. Something doesn't add up. According to the Association of Certified Fraud Examiners (ACFE), an employee living beyond their means is the most common red flag of fraud. This incongruity could be the basis for a lifestyle audit.

What exactly is a lifestyle audit? Who conducts them? Who may be audited? What is the audit process? This guide covers it all.

Proper documentation is essential during any audit or investigation. Download our free lifestyle audit report template to keep your records organized.

What is a Lifestyle Audit?

A lifestyle audit is a comparison of known income with standard of living to identify gaps and indicators that someone is living above their means. In some circumstances, this audit is carried out by employers who suspect an employee of fraud.

An Internal Revenue Service (IRS) lifestyle audit goes beyond the numbers on a tax return to see the big picture. Also referred to as an "economic reality check," this type of audit aims to see if a taxpayer's income matches his lifestyle. The tax agency may investigate homes, vehicles, clothing, vacations and even charitable donations to see if the taxpayer could realistically afford his or her spending habits.

The Washington Post shared this example when lifestyle audits first started in the 90s: "If a taxpayer has $2,000 in interest income from a bank account this year but none in previous years and his income hasn't changed, 'we would ask what amount of money earns $2,000 in interest' and where did it come from, said John Monaco [of the IRS]."

Who Gets Chosen for a Lifestyle Audit?

Lifestyle audits aren't just performed at random. In a company, an employee might be singled out for an audit if they exhibit a sudden, unexplained lifestyle change. Without getting a raise, the employee suddenly purchases a new car or home, wears more expensive clothing or jets off on lavish vacations.

In tax fraud cases, a tax return is first selected by a computer program for audit based on factors including large changes in income, a very large or small amount of income and occupation. Self-employed people, small business owners and those who work in industries where fraud is more prevalent (e.g. retail or construction) may be chosen over others.

From those, agents then manually review the returns to determine which ones require full audits. Taxpayers who are chosen for a lifestyle audit have the opportunity to prove that their income is legitimate through documentation and in-person interviews. According to the IRS, lifestyle audit steps include:

• financial status analysis
• initial interview
• tour of sites (e.g. homes, workplaces, etc.)
• bank account analysis

Additionally, investigators may use less traditional methods to paint a full picture of a person's lifestyle. For instance, in today's digital world, many of us share our lives on social media. If social media posts reveal a lifestyle that doesn't match the person's reported income (e.g. lavish vacations or a new luxury car), the IRS or employer may suspect fraud.

Whistleblowers are also a valuable asset for uncovering fraud. In the 2011-12 fiscal year, the IRS paid 128 whistleblowers to share information about unreported income.

RELATED: Offshore Tax Havens: Where Fraudsters Hide Their Money

The Lifestyle Audit Process

In an employee fraud investigation, the auditor will analyze payment records for the employee's properties and vehicles. They also review the person's credit history to see if their newfound wealth is a result of increased credit or if they have been buying things in cash.

For tax fraud investigations, tax returns can be audited three years after the due date of the return. If a tax agency believes a taxpayer understated his income by over 25 per cent, though, this deadline extends to six years. There is no time limit on auditing fraudulent or non-filed tax returns.

Even if a person is selected for a lifestyle audit, agents won't examine every item on the tax return. Items determined to be questionable are usually:

• significant in size compared with the return as a whole
• out of character for the taxpayer and/or his occupation
• reported in the wrong place on the return

Other factors that may lead to a lifestyle audit include:

• evidence of intent to mislead the tax agency
• a large gross income
• self-employment income
• claimed losses from businesses and/or investments
• round numbers
• a return that appears sloppy, careless or thrown-together

A lifestyle audit can trigger a fraud investigation. Check out our eBook Conducting Fraud Investigations with Case Management Software to learn how software can streamline your investigation process.

Lifestyle Audit Concerns

The lifestyle audit is a powerful tool to combat fraud, however, some taxpayers and employees have concerns about the process.

One of the main concerns people have with lifestyle audits involves privacy. Some feel that submitting documentation of all of their purchases and answering questions about their spending is too personal, especially without a lawyer present.

In addition, some people complain that the process is not discriminatory enough and that agents are overzealous about performing lifestyle audits. A lifestyle audit should only occur if there is reasonable indication that the person has unreported income or is living beyond their means.

Each year, tax evasion costs the US government an estimated $458 billion. Workplace fraud costs the average organization five per cent of its annual revenue every year. While most people don't commit fraud, lifestyle audits can cut down on the financial damage of this crime and act as a deterrent to would-be fraudsters.