Dan Ginsburg: The White House has said increasing the IRS budget by $80 billion over the next 10 years will raise an additional $700 billion thanks to tougher enforcement and auditing. And some are saying it will even bring in much more than that. This is on top of Treasury Secretary Janet Yellen’s call for increased IRS funding to address a projected tax gap of $7 trillion over the next decade.
Before we get into the actions that we want businesses and business owners to take to address these potential changes, Patti, can you explain this tax gap and, more broadly, what you make of the overall proposal?
Patti Burquest: The Biden administration has made it clear that it considers this to be an issue of tax code fairness. To that point, the Treasury Department has estimated that over the next decade, the tax gap in this country will balloon to $7 trillion.
So what is the tax gap? It is the difference between taxes owed to the government and taxes actually paid. A $7 trillion difference is quite significant. Remember, the president’s two economic plans total $4.1 trillion as it is.
To be clear, the tax gap is generally created by underreported taxable income, by unfiled and unpaid tax returns, and the difficulty that the IRS encounters when identifying opaque sources of income. Contributors to this growth in the tax gap include the complexity of the tax law, aggressive—and sometimes unlawful—tax understatements, and the uneven enforcement by the IRS.
Dan: So that is where the $80 billion is going?
Patti: Exactly. To put the amount into context, the IRS’s proposed budget for fiscal year 2022 was approximately $12 billion with an additional $1.2 billion being requested. This $80 billion increase over the next decade would enable the IRS to catch up technologically and also to enhance its examination resources.
Toward the end of 2020, the Treasury Inspector General for Tax Administration, or TIGTA, issued three reports that illustrate for us this whole tax gap problem.
First, some of the wealthiest individual taxpayers have not filed their returns or paid the tax estimated to be due based on information returns that have been provided to them. The IRS has not had the resources to go after each of these individuals, and thus has left billions of dollars on the table.
Next, the TIGTA issued a report on large corporate audits, finding a 47% “no-change” rate for cases where the revenue agent has spent more than 200 hours of time auditing those companies. That’s a lot of time invested for no real tax result.
A third report describes the lack of transparency involving opaque sources of income, and that would include partnerships and transactions using virtual currency.
With that as context, the IRS commissioner recently testified to the Senate Finance Committee and stated that he believes that the tax gap is likely $1 trillion per year—pretty significant.
Dan: Absolutely, that is significant. Some huge numbers involved there. So, Alina, in your experience as a former IRS attorney, how do you expect the IRS is going to use this $80 billion in new funding?
Alina Solodchikova: Well, additional funding would be dedicated to hiring, training and deploying auditors to focus on complex investigations of large corporations, partnerships and global high wealth individuals. Also, the IRS would spend additional funding on improving technology it uses in its enforcement efforts. An example would be upgrading software that analyzes characteristics of tax returns and flags them for examinations.
Dan: So, assuming it’s approved, once those enforcement capabilities are enhanced, what exactly should taxpayers expect?
Alina: First and foremost, we can expect increased audits. The audit rate for individuals and large corporations has dropped to historic lows in the past few years. Last fall, however, there was an increase in audit activity for high wealth individuals with partnership investments and in private foundations. Those audits have also included audits of the partnerships in which the individual under audit holds an investment.
Under the partnership audit rules that began with the 2018 tax year, the IRS has new tools to propose adjustments at the partnership level, which can then quickly result in a tax liability for the partners. In addition, transactions with a private foundation and its founder can result in significant penalties.
The focus here is on what the IRS has termed “opaque sources of income.” The sources can also be focused on virtual currency transactions that currently do not require the exchanges to issue information returns.
Dan: You mentioned large corporations earlier. What about those? What considerations do we want to think about there?
Alina: That’s right. Increasing enforcement against corporations is a very large focus of President Biden’s plan. Currently, the Large Business and International Division of the IRS that conducts examinations of taxpayers with assets over $10 million has moved away from the traditional IRS examination approach to issue-specific examinations.
It has adopted what is called a campaign approach, where a compliance issue is identified; and then, taxpayers with that issue may be selected for examination or for various other tailored treatment streams. There are currently 57 active campaigns.
In addition, the IRS is now using a pointing criteria, as well as data analytics, to select the largest corporate taxpayers for examination. Points are assigned to various taxpayer attributes based on the tax return filed to identify returns to be examined.
Dan: Got it. So, the Biden plan also mentions enhanced information reporting by banks. Does this mean that banks are going to be required to provide new information about individual and corporate accounts directly to the IRS?
Alina: Yes, this is part of that push to identify opaque sources of income. The White House wants to see banks reporting on cash inflows and outflows from bank accounts. This reporting would likely be addressed by new legislation, similar to what was done a few years ago regarding certain credit and debit card receipts now reported on Form 1099-K.
Dan: That brings us to the real question our audience is really concerned about. And although, again, these just remain proposals, what are the steps people should be taking right now?
Alina: Near the top of the list—large corporations and high wealth individuals need to review their returns with their tax advisors to ensure that they are audit ready.
What do I mean by saying audit-ready? I mean identifying risk areas, maybe campaign issues, and collect the documents that support those positions. Maintaining the records to substantiate positions taken on the return is very important. If there were any formal opinions issued to the taxpayer by the taxpayer’s advisors, make sure you keep them handy to show reasonable reliance on the authorities and advice from tax professionals.
If you identify an error, file a qualified amended return to correct the error. This is typically a penalty-free filing. If you identify an issue that you believe you have support for, but that the IRS may challenge, consider filing Form 8275 disclosing your position of the return. That Form 8275 can also be filed with an amended return to protect against penalties. This is another area in which you need the advice of a qualified tax advisor.
Patti: And another thing—Alina mentioned the IRS campaign approach. It’s important to review the list of active IRS campaigns on the IRS website. You would go to IRS.gov and find the search bar in the upper right-hand corner of the screen and search for active campaigns. Now, have you engaged in any of these transactions that you see? If the answer is yes, review the action steps the IRS will be taking and make sure that you have the documentation you need to support the position that you’ve taken on your return.
Dan: Got it. All very useful suggestions, indeed. Thank you, Patti and Alina for your terrific insights. They certainly help clarify how IRS enforcement fits into the bigger tax picture that’s slowly coming into focus.