This is the second of two columns discussing the Inflation Reduction Act. Part 1 appeared in Tuesday’s edition.
In my previous column, I discussed several tax issues surrounding the Inflation Reduction Act, but I reserved commenting on the most controversial aspect of the legislation, IRS funding, for this column. Clearly, the IRS is underfunded. The IRA increases IRS funding by $80 billion over 10 years ($8 billion/year).
For the past quarter-century the IRS has been the political whipping boy of Congress. In the 1990s, Congress perceived abusive IRS behavior and curtailed its enforcement capabilities. The result was a resurgence of tax shelter activity that led to new sets of taxpayer penalties for aggressive behavior and greater regulation of tax practitioners.
Since 2012, the IRS has been seriously defunded during a period when its responsibilities have significantly increased. Its 2012 budget was $14.4 billion. Adjusting that amount for inflation would translate to a 2022 budget of $18 billion. The actual IRS budget for several years had been reduced to $12 billion. The IRS received extra funding in 2021 to deal with COVID. Clearly the IRS budget has not kept pace with inflation and half of the IRS budget increase merely addresses inflationary pressures.
Compared with 10 years ago, the IRS has 20% fewer employees, many of whom are not as well trained. Yet today the IRS receives 9% more returns and is responsible for administering significantly more complex tax law.
The IRS infrastructure is antiquated. Its basic computer systems were implemented 50 years ago. In the IRS Service Centers, the computers use Windows XP. If you deal with an IRS agent, you are likely going to communicate via fax, rather than e-mail, because of security concerns over personal information. Paper-filed forms must be manually processed because the IRS lacks the capability to scan printed information. All of these deficiencies (and others) adversely affect the IRS’ ability to interact with taxpayers.
The IRS audit selection criteria were developed 50 years ago. Over the past decades, the accounting profession has developed risk-based audit techniques that target amounts most likely to be misstated. The IRS lacks the capacity to do so, and consequently, selects a disproportionately high number of low- and middle-income taxpayers for examination.
Mega-wealthy individuals and large corporations structure their operations to avoid IRS scrutiny. They rarely are selected for examination, and when they are, the examining agents lack the sophistication to address relevant tax issues. Therefore, the IRS gets more bang for its buck auditing smaller returns.
Several senior IRS officials have told me that any additional examination resources will be devoted to examining the tax returns of large corporations, hedge funds and mega-wealthy individuals who pay no tax. From a tax policy perspective, this make sense.
In the closing years of the Bush Administration, the IRS asked for funding to increase its capacity to audit the international operations of multinational corporations. The IRS received the requested funding and over the next several years enhanced its ability to audit those taxpayers.
Consider the case of Amgen, which pays extremely low effective tax rates. A company of that size is audited by the IRS every year. Amgen recently announced that the IRS has assessed back taxes of $10.7 billion for 2010-2015 related to international tax matters. In its Tax Court filing, Amgen stated that the assessment is “arbitrary and capricious” because the IRS never challenged the position in earlier years. The probable reason why the IRS previously didn’t challenge Amgen is because it lacked the ability to thoroughly evaluate the situation.
The IRS is seeking nearly $11 billion from one taxpayer. Amgen is not alone. If you read the financial statements of the S&P 500 companies, you will note that the statute of limitations expires on about $500 billion of their avoided taxes each year.
How many middle-income taxpayers would the IRS have to audit to raise $11 billion in additional tax?
The narrative that additional IRS funding will increase your chances of getting audited is misleading. If the IRS updates its selection criteria to that of the accounting profession, I suspect the average person will have a lower chance of being selected for examination.
Unfortunately, this narrative caused the Treasury Department to issue a policy indicating that the additional IRS funding will not be used to increase examinations of taxpayers having income of less than $400,000. While this may appease political opposition to the IRS funding, the reality is that it unreasonably constrains the IRS from doing its job.
During my career, I prepared tax returns for billionaires who paid less tax than first-year associates working for my former firm. They do so by reducing their income to an amount less than $400,000. Taking them out of the examination pool is counterproductive.
Undoubtedly, modernizing the IRS is going to be a long and controversial process that is complicated by political interference.
Jim de Bree is a semi-retired CPA who resides in Valencia.