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Legal Tax Expert Discusses AI in IRS Auditing and the Future of the ERC

Christopher Wood, CPP  

· 9 minute read

Christopher Wood, CPP  

· 9 minute read

This tax filing season, the IRS is implementing the use of artificial intelligence (AI) and other improved technology with funding from the Inflation Reduction Act of 2022 in its audit processes to help compliance teams better detect tax avoidance issues in certain areas where audit coverage has declined, including large partnerships, large corporations, and employment tax returns.

AI audit concerns and improvements

Although there can be benefits to utilizing AI for auditing taxpayers, there are also concerns about what guardrails are in place regarding privacy, bias, transparency, and the potential for unintended consequences, such as taxpayers being subjected to audits for returns simply falling outside the usual fact patterns.

“I think that’s where I’m more worried about it,” James Creech, a senior manager with Baker Tilly’s tax advocacy and controversy team, began. “What happens when the IRS AI finds [an issue] because it’s 1.2 standard deviations away from the norm because they’re designed to find anything over one standard deviation,” he added.

Conversely, Creech explained that the AI tools the IRS uses have seen “significant improvements” in areas that include partnerships where the audits are more targeted and have been much better than anything Creech has seen before. He further noted that the AI is coming up with targeted questions about what the IRS should be asking and as a result, “it let them do better issue selection faster.”

Per the IRS’s Strategic Operating Plan for fiscal year (FY) 2023 through 2031, expanded enforcement is on the radar for large partnerships and large corporations, with additional focus on the employment tax returns these and other entities file. The IRS said it will improve tools and processes for auditing these returns and “pursue noncompliance through a variety of robust mechanisms, including audits and non-audit contacts.”

However, there is some uneasiness about the use of AI in IRS audits by not realizing the full picture of a tax return. “Tax is really just the story of people’s lives,” Creech said. “A lot of times there are special circumstances that make a statistical anomaly perfectly reasonable,” he added, noting that such instances could be a dataset risk.

“There’s a reason why people are worried about AI as a kind of an existential threat,” Creech stated, questioning that if the IRS imposes a tax enforcement algorithm, “is it going to maximize for enforcement – we just don’t know.”

Human element in AI

As far as other potential issues with implementing AI in IRS audits, Creech believes the human element could be a “bigger, short-term” concern. Specifically, how humans interpret algorithm enforcement. Creech provided an example from several years ago where the IRS created a program called the “Reasonable Cause Assistant” (RCA), a computer-based decision support system designed to help IRS employees make fair and consistent abatement decisions based upon reasonable cause for failure to file, pay, and deposit penalties under Code Sec. 6651 and Code Sec. 6656.

Creech explained that a Taxpayer Advocate report found that the low rate at which RCA users aborted the program’s conclusions showed that the system did not encourage users to override an RCA decision, even when appropriate. “Not a single IRS phone operator abated the penalties even though the facts warranted it because the incentive structure was to follow the computer,” he noted.

“So I think we’re going to be combating this interface of technology and human interactions again,” Creech said regarding the use of AI in IRS audits.

Will practitioner guidance change?

Another area of interest regarding the increased use of AI in IRS audits is whether or not tax preparers, CPAs, and other practitioners will adjust how they advise a client to avoid a possible red flag if certain information on a tax return falls outside a regular fact pattern.

While Creech admitted that some practitioners may consider adjusting how they advise clients “to make sure you’re not falling into the AI gray area,” he also reiterated that “tax is just the story of people’s lives and I don’t see why you should edit that story because of a possible aggressive algorithm.”

“We’ve got laws implemented by Congress that authorized deductions for certain things and if you have the facts and circumstances, why not follow the law,” he reasoned. “Why are we going to deviate from the law because we’re worried about a computer?”

Creech added that IRS “audits have been driven by algorithms for a long time” and explained how the IRS has been using a “DIF” (discriminant function) score to drive audit selection for many years. Although Creech remains optimistic that the IRS’ process for issue selection is “going to get better and better,” he again wondered “then what does the human being do with that” information, regarding how the algorithm will be interpreted.

AI and the ERC

When it comes to issues for the IRS, few have been more troublesome in recent years than the massive influx of questionable employee retention credit (ERC) claims submitted since the credit expired at the end of 2021 for all employers (see Payroll Guide ¶20,905). It reached a tipping point last September when the IRS froze the processing of any new claims until further notice. Despite offering a withdrawal program and a temporary voluntary disclosure program to help those who may have claimed the credit in error, the IRS may have to deal with examining more dubious claims when/if the moratorium is lifted.

Creech, who has discussed the ERC before, noted that “AI would not work for the ERC because there’s so little data.” He explained that when it comes to documentation for ERC audits, the IRS has “got the 941-Xs themselves to claim the credit, they’ve got some kind of historical data about how many W-2s the company filed, and that’s really about it.”

So when it comes to the limitations of the IRS utilizing AI in audits, Creech believes the “ERC is just one good example” since “AI only works with very large amounts of data.”

ERC audits can escalate quickly

On the other side of an ERC audit, Creech stressed that a taxpayer can “go from zero to 100 very quickly” on this issue where a standard Information Document Request (IDR, Form 4564) is provided “that says give me everything under the sun needed to calculate the credit” to determine eligibility.

He added that since the ERC is a refund claim, and there is no right to deficiency procedures, it can be very challenging “to know how much trouble you’re in right off the bat.” Creech admitted, “It’s all kind of crisis work, to tell you the truth.”

Preparing for an ERC audit

Regarding a taxpayer who believes they have a valid claim, but is concerned about an ERC audit, Creech advised first getting the paperwork in order by organizing payroll data, “especially if the credit is claimed under the suspension test.”

He would also “want a second set of eyes” on any calculations, including determining if the gross receipts qualify a business for the credit. “Can I feel confident in this where I’m going to get that audit selection notice and say I’m happy with these numbers,” Creech said.

In addition, Creech advised that keeping on top of any IRS audit notices and being ready to respond quickly with the correct information “goes a long way into getting [ERC claim audits] resolved.”

IRS attitude toward ERC changing

Creech also looked toward the future of the ERC, as the statute of limitations for claiming the credit will expire on April 15, 2024 for 2020 claims and April 15, 2025 for 2021 claims. “The ERC you’re seeing in 2023 and 2024 is going to be far different than the ERC in 2020 and 2021,” he said.

He explained that during the COVID-19 pandemic, the IRS’ attitude about the ERC was more to help taxpayers during a difficult situation. “But now, it’s really a kind of guilty until proven innocent and so the burden has shifted back to the taxpayer to say, ‘Do I qualify for this?'”

ERC legal challenge may not result in intended outcome

Creech noted an interesting issue related to the ERC that he believes will develop over the next year, which has to do with a legal challenge that argues the IRS’ guidance on the credit is unlawful under the Administrative Procedure Act (APA) because it did not follow the required “notice and comment” procedures for Notice 2021-20 (Southern California Emergency Medicine, Inc. v. United States et. al., C.D. Cal., Dkt. No. 5:23-cv-02450, 12/01/23).

Specifically, the complaint claims that certain rules related to the ERC’s partial suspension test, including the requirement to show an employer had “more than a nominal portion of its business operations suspended by a governmental order,” should be ruled unlawful.

“I think that challenge is going to be one of those ‘be careful what you ask for’ because those notices were evenhanded,” Creech cautioned. He added, “I think any guidance that has to be re-released because of this litigation has the possibility of being very taxpayer unfavorable.”

Creech again noted that the attitude within the IRS about the ERC has changed and said he would be “really curious to look at a redline version of the [IRS] guidance to see what has changed” if there is a favorable ruling for the plaintiff in the case.

Alternative idea for claiming the ERC and other tax credits 

As for possible solutions for claiming the ERC or other tax credits, Creech would like to see a program implemented with a Private Letter Ruling-type process “so you can go to the IRS and say I filed this claim for refund and I’m willing to pay for IRS time for someone to review it.” He added, “Give me a thumbs up or thumbs down on if I’m entitled to this refund or credit” as a way to alleviate the burden on the IRS and provide more certainty to the taxpayer.

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