(Barron's) - Taxpayers who take big deductions relative to income, own a business structured as a partnership or S corporation, trade crypto, or have income from foreign sources face increased likelihood of an IRS audit.
Taxpayers, be forewarned. A new era of IRS scrutiny is looming.
The Internal Revenue Service is due to receive an infusion of $80 billion over 10 years under the Inflation Reduction Act—the tax, climate and healthcare bill passed by Congress last week and signed Tuesday by President Joe Biden—to upgrade computer systems, hire staff, build enforcement capabilities to narrow the so-called tax gap, or the roughly $600 billion difference between what taxpayers owe and what they pay each year.
Americans can expect a sharp increase in audit rates, particularly among taxpayers who take big tax deductions relative to income, own a business structured as a partnership or S corporation, trade crypto, or have income from foreign sources, tax experts say.
While the IRS’s focus will skew toward higher-income filers with these characteristics, taxpayers at all income levels are likely to get more attention as enforcement capabilities are built out, says Mark Luscombe, principal federal tax analyst at Wolters Kluwer .
He points out that Treasury Secretary Janet Yellen said last week that the new funding won’t be used to raise audit rates above historical norms for taxpayers earning less than $400,000 a year. But given that audit rates are currently at historic lows of around 0.25%—compared with 1% in 2010 and 1.7% in 1995—“that gives some wiggle room for increasing audit rates for people earning less than $400,000 to restore them to historic levels,” Luscombe says.
The investment in the IRS is expected to raise some $124 billion over the next 10 years and is one of the primary revenue raisers in the $430 billion bill alongside several tax increases: a 15% minimum tax on corporations with at least $1 billion in income, a new 1% tax on corporate stock buybacks, and extending a temporary provision that limits deductions on active losses.
“What’s momentous about the $80 billion going to the IRS is not just the magnitude of the money; it’s that over half is going to enforcement,” says Janet Holtzblatt, a senior fellow at the Urban-Brookings Tax Policy Center. “This is an historic moment for the IRS because enforcement has been underfunded for at least the past decade.”
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Congress has pared the IRS budget by over 20% after adjusting for inflation since 2010, causing full-time staff to dwindle to 78,661 from 94,711, even as the number of tax filers steadily increased and the complexity and scope of the IRS’s responsibilities expanded, Holtzblatt says.
As staff dwindled, so did the pool of expertise to conduct highly complex audits. In-person audits—many of which analyze sophisticated tax strategies—account for about 15% of audits now compared with about 40% in the mid-1990s, according to the Transactional Records Access Clearinghouse , or TRAC, a tax data-gathering nonprofit at Syracuse University.
Most current audits are automatic notices sent to taxpayers based on inconsistencies found by computerized data matching, such as 1099 income reported as paid out by a company but not reported as income by a taxpayer.
More rigorous in-person audits are likely to pick up once the IRS staffs up.
If you’re a target, here’s what to expect: “The IRS starts with information requests, and you have to respond to each one. Communications during the audit are conducted either by phone or video conferencing,” says Miri Forster, a partner and national tax controversy leader at Eisner Advisory Group. “It can take time. You have to add this to your everyday responsibilities, and the unknown can be a little stressful.”
To smooth the process, Forster suggests vigilance when it comes to keeping documentation as evidence of deductible expenses, charitable contributions, and investment cost bases particularly related to crypto trades, which aren’t necessarily documented by trading platforms and can be a big headache to track down.
If you work with an accountant and an attorney, they will often handle the entire audit without you, says Michael Greenwald, a partner at Friedman, a New York–based accounting firm. “Clients give power of attorney to the account and attorneys, and we deal with the examination process.”
There is some good news to counter the dread of an audit: Some $35 billion of the IRS funding will go toward upgrading computer systems, hiring staff for taxpayer services, and improving operations.
Individual taxpayers and tax preparers—many of whom faced hassles during the last tax-filing season due to a massive backlog in the processing of returns and the inability to get an IRS agent on the phone—may benefit.
“Maybe they’ll pick up the phone when people call, and maybe the people who pick up the phone will have a clue as to what they’re being asked about,” says Edward Renn, a partner at Withers, who says the only reason his office still has a fax machine is because the IRS accepts certain documents only by fax. “Most correspondence with the IRS is still by paper or fax.”
A major hurdle for the IRS is finding talent in a tight labor market.
“It will take time for this funding to translate to results,” says Garrett Watson, a senior policy analyst at the Tax Foundation, who adds that he is disappointed in the emphasis on enforcement rather than other agency improvements in the legislation.
“Given that the IRS is still grappling with return backlogs and reduced customer service as measured by activities like the portion of calls answered, it would have been better to have a larger focus on how to improve customer service,” he says. “This would help rebuild trust in the IRS.”
By Karen Hube
