A former senior litigation counsel at the U.S. Department of Justice (DOJ) has stressed that since the IRS’ funding plan mentions more enforcement in areas that include employment taxes, businesses should start planning for audits “now.”
Funding and IRS plan.
The Inflation Reduction Act was signed into law by President Joseph Biden on August 16, 2022, with a provision earmarking nearly $80 billion in funding for the IRS that Treasury Secretary Janet Yellen said on April 4, 2023 will help ensure fair enforcement of federal tax laws. On April 6, 2023, new IRS Commissioner Daniel Werfel and Deputy Treasury Secretary Wally Adeyemo held a conference to discuss the Service’s 10-year strategic operating plan for the massive financial support.
Employment tax audits part of plan.
On page 74 of the 150-page plan, the IRS discusses developing enforcement approaches and compliance treatments for tax types including federal employment taxes by refining tools and processes for auditing key areas and using improved analytics to identify patterns of noncompliance. The plan notes that enforcement and compliance have been too low in employment tax, among other areas.
Withholding and paying employment taxes.
Employers are generally required to withhold federal income, Social Security, Medicare, and Additional Medicare taxes (commonly known as “employment” taxes) from their employees’ earnings and forward to the U.S. Treasury on the employees’ behalf. Additionally, employers are liable for taxes imposed by the Federal Unemployment Tax Act (FUTA). The IRS examines some employment tax returns to determine if wages, tips, compensation, credits, and taxes are reported accurately.
Get ready for audits now.
“Any taxpayer that the IRS has targeted for enforcement needs to start getting ready for audits now,” said Rob Kovacev, a former DOJ attorney and current Member at the law firm of Miller & Chevalier.
Kovacev, who represented the IRS as lead trial counsel in several large and complex civil tax cases, reasoned that the urgency for audit preparation is “because now [employers] have a chance to… improve their compliance and make sure they are following the rules.”
TIGTA report calls for audit improvements.
On February 13, 2023, the Treasury Inspector General for Tax Administration (TIGTA) released a report on the need for improvements to the employment tax examination process to increase taxpayer compliance and collection potential. The report explains that although employment tax workstreams are set up to focus on probable areas of noncompliance to show cases with a high potential for audit adjustments, the IRS does not have a computer program to prioritize employment tax returns.
The report made a handful of recommendations to the IRS, and now that the Service has funding that includes an estimated $4.8 billion for business system modernization and $25.3 billion for operations support, the employment tax audit process is likely to improve and may involve using more technology in selecting who will be subject to an examination.
Algorithms in audits.
There is an upfront cost when adding technology, but “the use of it is actually relatively cheap” said Kovacev regarding the use of artificial intelligence (A.I.) in the IRS audit selection process. He further discussed how an A.I. algorithm could look through thousands of tax returns and isolate “certain areas where there are anomalies and could do that in milliseconds,” and added that audit targets based on statistical models will become more the norm.
“So, you are going to see a lot more instances where the computer is picking targets for audits.” Kovacev stated and then ruminated that ” the question is, what degree of human intervention is going to be involved?” He noted that the past use of algorithms at the IRS has at times “come up with results that were just incorrect” and stressed that a key issue when using A.I. for audit decisions would be if “there is meaningful supervision.”
More steps to prepare for audits.
There are two other steps that Kovacev believes employers should take to prepare for an IRS employment tax audit. One is to “make sure they have substantiation” regarding an issue with the law “so they can be prepared when the questions come from the IRS.” The other step is to “get advice from tax professionals on potential areas of concern where the IRS is likely to adopt scrutiny so you can prepare for it all.”
Kovacev explained that even though the IRS funding from the Inflation Reduction Act will not “result in additional enforcement activities for two to three years,” it is important for employers to be prepared for the increased possibility of employment tax audits.
Internal and external audits.
A way for businesses to test their level of compliance with employment tax law is to conduct internal and external audits. Kovacev believes there is merit to both of these types of audits. He said that larger employers with an “in-house” tax department responsible for filing tax returns and other levels of compliance “should absolutely be working on [internal audits].”
For smaller employers without an integrated and internal tax system, Kovacev advises seeking outside help with an external audit, but also noted how larger employers could benefit from an external audit as well. A universal benefit of conducting an external audit is that these tax experts “see things from a variety of clients that may cut across industry groups… and would be able to use that knowledge to tell other taxpayers” that certain issues are being probed.
IRS looking globally for solutions.
The IRS funding plan says that some of the trends that helped to shape the development of the plan were to look abroad to other countries. Specific to payroll, the IRS noted that in Ireland, employers can establish a two-way connection between their payroll systems and the tax authority’s systems so that employees can claim credits in real-time.
“It’s no question that other countries have made great strides in digitalization and modernization of their tax collection systems,” Kovacev said and concluded that he is “encouraged that the IRS is looking to other tax authorities for ideas.”
This article originally appeared in Checkpoint’s Payroll Update.
For more information on employment taxes in general, see Checkpoint’s Federal Tax Update ¶H-4220.
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