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Inflation Reduction Act

The Long Read: What to Expect From a Freshly Funded IRS

Tim Shaw  

Tim Shaw  

With the IRS to receive long-sought additional funding under the Inflation Reduction Act (H.R. 5376), questions remain as to how the agency will spend its appropriation.

Incoming agents? Much speculation has centered on a key part of the IRS’ $80 billion funding package through 2031: how audit rates will be affected for certain taxpayers. Some Republicans in Congress have rallied behind the message that an invigorated IRS would bring an “army” of auditors—as described by Senate Finance Committee ranking member Mike Crapo of Idaho in an August 6 statement—to squeeze revenue from low- and middle-income families.

This stems from a May 2021 report from the Treasury Department on President Joe Biden’s then-named American Families Plan. The proposal to provide the IRS about $80 billion over 10 years is largely the same as what was included in the Inflation Reduction Act. In terms of the “army” of IRS agents, Crapo referenced the anticipated 86,852 new personnel that would be brought on by 2031 to help with enforcement efforts. Of the total additional appropriation, slightly over half is allocated to enforcement.

The Treasury report clarified that the investment is aimed “against those with the highest incomes, and audit rates will not rise relative to recent years for those earning less than $400,000 in actual income.” The Biden administration and leading Democratic tax-writers in Congress have maintained since last year that $400,000 is indeed the threshold, and no individuals or businesses making less than that amount have anything to worry about.

Crapo was unconvinced. He warned that the 87,000 new hires, which he implied would all be assigned auditor jobs, “would make the IRS one of the largest federal agencies—larger than the Pentagon, State Department, FBI, and Border Patrol combined.”

“These resources are absolutely not about increasing audit scrutiny on small businesses or middle-income Americans,” IRS Commissioner Chuck Rettig said in a rebuttal in letters to the House of Representatives and the Senate on August 4.

“As we’ve been planning, our investment of these enforcement resources is designed around the Department of the Treasury’s directive that audit rates will not rise relative to recent years for households making under $400,000,” Rettig wrote.

In an August 10 letter to Rettig, Treasury Secretary Janet Yellen ordered that none of the inflation bill funds—”including any new personnel or auditors that are hired”—be used to audit taxpayers under the $400,000 threshold at a rate beyond “historical levels.” Although Yellen leads Treasury, which includes the IRS, the new law’s text designates the IRS commissioner as responsible for determining how to implement the funding.

“Instead, enforcement resources will focus on high-end noncompliance,” Yellen wrote. “There, sustained, multiyear funding is so critical to the agency’s ability to make the investments needed to pursue a robust attack on the tax gap by targeting crucial challenges, like large corporations, high-net-worth individuals and complex pass-throughs.”

While the Senate negotiated provisions of the Inflation Reduction Act, Crapo introduced an amendment to specifically include language to ensure none of the appropriated funds could be used to audit taxpayers below the income threshold. His amendment was narrowly struck down along party lines. Under the enforcement section of the bill’s text, the word “audit” doesn’t appear; instead, it’s assumed that audits would be a way the IRS would “determine and collect tax owed.”

“My colleagues claim this massive funding boost will allow the IRS to go after millionaires, billionaires, and so-called rich ‘tax cheats,’ but the reality is a significant portion raised from their IRS funding bloat would come from taxpayers with income below $400,000,” Crapo said in an August 7 statement. “Otherwise, why would the legislative text say the funding isn’t intended to target taxpayers below that threshold?”

On August 11, the Republican senator said in a statement revisiting the defeated amendment that it was “clear that the president, the IRS, and the secretary of Treasury are scrambling to protest that they are not going to increase audits on people making less than $400,000.”

The next day, Senate Finance Committee Chair Ron Wyden, an Oregon Democrat, responded to Crapo’s claims. “The incendiary conspiracy theories Republicans are pushing about armed IRS agents are increasingly dangerous and out-of-control,” Wyden said in a statement.

“It’s unbelievable that we even need to say this, but there are not going to be 87,000 armed IRS agents going door-to-door with assault weapons,” the Democrat added. “This is funding for answering phone calls and upgrading computer systems.”

On August 17, a day after Biden signed the Inflation Reduction Act into law, Yellen again addressed those concerns. In a memo obtained by Checkpoint, Yellen wrote to Rettig reaffirming that the enforcement investments should spare households and businesses earning $400,000 or less.

“Instead, they will allow the IRS to work to end the two-tiered tax system, where most Americans pay what they owe, but those at the top of the distribution often do not,” the secretary’s memo read. Previous versions of the bill included language requiring the IRS to submit, within six months, a plan for how it would use the new appropriation. That requirement was scrapped during last-minute talks. In lieu of a legislative mandate, Yellen directed Rettig to deliver such a plan by the same deadline.

“I would like the IRS to work closely with the deputy [Treasury] secretary to identify specific operational initiatives and associated timelines that will improve taxpayer service, modernize technology, and increase equity in our system of tax administration by pursuing tax evasion by those at the top who today do not pay their tax bill,” Yellen said.

Audit rates. Robert Kovacev, who practices federal tax controversy and tax litigation at Miller & Chevalier, told Checkpoint that he believes audit rates for those under the $400,000 threshold aren’t likely to change, or at least won’t increase.

“The biggest need for resources in enforcement has to do with auditing large corporations and high-net-worth families, because that’s where the money is,” he said. “And that’s also where you’re dealing with highly sophisticated people.”

In May, the Government Accountability Office published a report that found, on average, the audit rate for individual tax returns across all income levels decreased to 0.25% from 0.9% between 2010 and 2019. According to the GAO, audit rates for those earning under $200,000 a year fell below the level for those making above that amount, and most additional taxes recommended by the IRS came from this group. The average number of hours needed to conduct an audit was comparatively less for audits of those taxpayers, according to the report.

Audit rates were higher on average among those who claimed the earned income tax credit. EITC claimants are subject to higher scrutiny partly due to the credit’s complex eligibility requirements, which contribute to improper claims and subsequent payments. In general, audits of lower-income taxpayers are quicker and easier for the IRS to perform, prompting the agency to shift to this approach as its funding and staffing levels declined since 2010.

Lawmakers have pressured the IRS on multiple occasions this year to ensure low-wage earners and EITC filers don’t face more audit examinations than others. In April, two Democrats—Sen. Elizabeth Warren of Massachusetts and California Rep. Judy Chu—reacted to a Transactional Records Access Clearinghouse analysis concluding that taxpayers making less than $25,000 in gross receipts were audited five times more often other taxpayers in fiscal 2021.

“The most vulnerable taxpayers should not shoulder the burden of insufficient IRS enforcement funding simply because they require fewer resources to audit,” Warren and Chu wrote.

House Democrats have been critical of the IRS’ audit practices in light of the GAO report. “There cannot be one tax system for the wealthy and another for everyone else,” said New Jersey Rep. Bill Pascrell, who chairs the House Ways and Means oversight subcommittee.

The Congressional Research Service reported on June 13 that EITC returns were “disproportionately high compared to the share of taxpayers who claim the credit.” Citing a ProPublica investigation, the CRS noted that lower-income audit rates appear more concentrated in southeastern states and some western states. The IRS has said it doesn’t base EITC audits on geography.

Rettig has gone on the defensive in response to assertions the IRS targets the country’s poorest taxpayers for audit. At a New York University tax forum in late June, Rettig said such narratives run contrary to an objective examination of audit data. According to the commissioner, taxpayers earning over $10 million a year are audited between 7% and 8% of the time. At the NYU event, Rettig spoke of the strain the IRS has felt from diminished financial support, saying more funding would better equip the agency to take enforcement action against wealthy taxpayers.

The question is whether the rates for those making over $400,000 will return to 2010 levels. Kovacev, who represented the IRS as an attorney for the Justice Department’s Tax Division before litigating against the agency in private practice, suggested the IRS may want to “get it even higher.”

“I think that’s definitely a goal of theirs,” he said. “And I think the money will help them approach that.”

Technological advancements. According to Kovacev, the new enforcement funds won’t only be used to bring on more employees. There will also be investments toward “sophisticated data analytics and artificial intelligence tools, which in the long run will probably be much more profitable than just adding a bunch of bodies.”

He explained that advanced algorithms can be run by machine-learning tools that help IRS agents root out anomalies based on data patterns. This can help with discovering underreporting using data the IRS has on hand. An example would be a mismatch between aspects of a corporation’s tax return and their financial statement.

“Certainly with this money, I would expect there to be an increase in that kind of technological advancement,” Kovacev said, adding that “a big chunk” of the appropriation will be deployed fpr current compliance enforcement in areas such as conservation easements, microcaptive insurance companies, and virtual currency.

Recently published research presented at a June webinar co-hosted by the IRS and the Urban-Brookings Tax Policy Center suggests that artificial intelligence can better predict where to recoup owed taxes. A study released in April by a group of Stanford University and IRS researchers presented a possible opportunity for using machine learning to “optimize” audit selection.

The IRS already uses a random selection model to choose which returns are audited based on noncompliance risk factors. The systems are automated and rely on filters to flag returns with an increased likeliness for error. Improved tools developed because of the reconciliation bill could perhaps refine this process.

Beyond enforcement, the additional funds are expected to upgrade the IRS’ computer systems, further advance customer service software, and improve the overall taxpayer experience.

Given that the IRS has had success this year with the rollout of voice chat bots that help taxpayers quickly access certain information without the need for waiting on hold, it’s likely that enhancing both voice and chat bot capabilities will be a priority, as over $3 billion is marked for taxpayer filing and account services. The Inflation Reduction Act also gives the IRS $15 million to design a service allowing taxpayers to electronically file returns with the agency without the need for a third-party preparer. The development of new technologies may be in store on both fronts.

On August 15, a bipartisan group of 93 lawmakers asked Rettig to answer a series of questions relating to the backlog of unprocessed paper returns, including how the IRS plans to eliminate it and what he considered a “healthy level” of outstanding returns relative to pre-pandemic average carryover levels.

Pulling from National Taxpayer Advocate Erin Collins’ June 22 Objectives Report to Congress, the lawmakers stressed the need for urgency. The report found that the paper return backlog has in fact worsened by over 1 million since the beginning of last summer, and the IRS has struggled to fill open processing positions.

The lawmakers wrote that the IRS must address customer service gaps and processing delays by “continuing the maximum use of overtime and surge teams, as well as the continued suspension of automated notices and collections—which have been critical in reducing pandemic-related tax return and correspondence backlogs.”

While the letter doesn’t mention the Inflation Reduction Act or the $80 billion figure, the timing is in all liklihood intentional. The bill’s enactment, however, could be a positive sign for the future of 2-D barcode scanning, an area of technology Collins directed the IRS to look into in March in conjunction with tax software companies.

Theoretically, the paper-return process could be significantly expedited if fields could be automatically populated by scanning a barcode on a paper return, as opposed to manual line-by-line entry. The idea has the support of Republicans on the Senate Finance Committee. In a July 18 letter, the deputy commissioners for services and enforcement and operations support responded to Collins’ directive, stating that they intended to issue Forms 8886, Reportable Transaction Disclosure Statement, in August following a test pilot program that began in late 2021.

“The IRS received approximately 1,000 Forms 8918, of which 253 were on the old paper form and 637 on the new paper forms with 2-D barcodes,” the deputy commissioners wrote. “78% of the 2-D barcoded paper forms that passed manual validation were fully readable with 100% accuracy, requiring close and ongoing scrutiny of only 22% of the forms.”

The letter went on to say that efforts to reduce the error rates are in progress and that the IRS must continue engaging with the software industry before the technology can be used for Forms 1040. In an August 2 appeal of the deputy commissioner’s partial modification and recission of the directive, Collins reiterated that 2-D barcoding would cost only $8.4 million.

“In March, at the time I issued the TAD, my understanding was that 2-D barcoding could realistically be implemented in time for the 2023 filing season because (i) it is a tried-and-true technology in use for more than 20 years by many state tax agencies and (ii) tax return software companies have had significant experience converting return information into 2-D barcodes for the states over this time,” Collins wrote in her appeal to Rettig.

 

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