Currently, President Joe Biden’s tax plan as contained in the Build Back Better Act is dead in the water. With Senators Manchin and Sinema largely resistant to major increases in government spending and acting as roadblocks in the Senate, any giveaways would need to be accompanied by provisions that reduce the federal deficit.
While it looks like the IRS will not be receiving an additional $80 billion to increase enforcement activity any time soon, we believe that―as we have warned for a few years―audits on high-net-worth and ultra-high-net-worth individuals and other targeted groups, as noted below, will nonetheless rise as the IRS recovers from the pandemic. Even without the additional funding the Build Back Better Act would have provided, the IRS Chief Counsel’s Office earlier this year announced that they are looking to hire 200 experienced attorneys to focus on abusive tax schemes. Further, increased IRS spending is always more politically palatable than increasing taxes on any one group, so to the extent the current Congress can get any legislation through, IRS budget increases may be used to “pay” for any spending packages that win complete Democratic or bipartisan support. The possibility remains that some form of IRS budget increase or increased funding will occur in 2022.
Who Will Be Targeted?
Over the past few years, we have observed modest audit increases for small businesses, particularly high-earners and businesses that deal mostly in cash transactions, and expect more audits targeting high-income individuals, complex partnerships, LLCs, large corporations and international taxpayers. We expect audit rates to further intensify as the country pulls out of the pandemic, staffing levels return to normal and IRS backlogs relating to the pandemic subside. Additionally, audits and enforcement may act as a revenue source to reduce the federal budget deficit and/or tax gap without raising taxes.
The tax gap is simply the difference between total taxes owed and taxes paid on time. The most recent IRS tax gap report was released in 2019 and reported an average annual gross tax gap of $441 billion, or about 16 percent of the total projected federal tax liability.
Similarly, state tax audits are expected to rise due to budget deficits and the inability of legislatures to raise taxes without upsetting voters. So expect plenty of residency audits, business nexus audits and updates to nonresident audit guidelines across the board. New York in particular has emphasized nonresidency audits in recent years. We expect New York to be at the forefront of updating their Nonresident Audit Guidelines and aggressively pursuing residency determinations.
Recently, the IRS released their updated audit rates as of May 1, 2022, for fiscal year 2021. While the onset of the pandemic resulted in the lowest number of audits initiated in recent years, 0.5 percent of all individual returns filed for the most recently closed tax year were audited. However, overall audit rates remain lower than before the pandemic. In fiscal year 2021, the IRS closed 738,959 audits, down from 771,095 in fiscal year 2019 (the last complete year prior to the pandemic), and nearly 1.1 million in fiscal year 2017. While the number of audits decreased over the last several years, the IRS has been assessing more tax through audits recently―nearly $27 billion in recommended additional tax in fiscal year 2021, up from approximately $13 billion in 2020 and $17 billion in 2019.
This is because, while IRS examination rates may remain low, the likelihood of an audit significantly increases as income grows. For example, for 2019 tax returns, as of May 1, 1.3 percent of taxpayers with total positive income between $1 million and $5 million were audited, while 8.7 percent of those taxpayers with total positive income of $10 million and over were audited.
As we wrote in a previous Alert, the IRS enacted new compliance initiatives in the summer of 2020 targeting high-net-worth individuals and connected entities both foreign and domestic such as trusts, foundations, partnerships, LLCs and other pass-through entities. At that time, the IRS was targeting these individuals through specific lines on the return, such as the qualified business income deduction, business interest deduction, repatriation of previously untaxed foreign earnings, net operating losses and foreign reporting and assets. Then, last year, the IRS also added two additional compliance campaigns related to offshore investments and residency in Puerto Rico, as we discussed previously. In addition, reporting requirements of businesses have increased and intensified in recent years as partnerships began reporting capital accounts on a tax basis, and will have to prepare additional and new schedules (K-2 and K-3) for tax years 2021 and forward to disclose certain international transactions.
Additionally, the IRS has recently increased its focus on the underreporting of cryptocurrency transactions. In March 2021, the IRS launched Operation Hidden Treasure to seek out unreported income related to cryptocurrency, where agents focus on money laundering and tax evasion tactics, such as the use of shell companies and structuring of transactions beneath what the parties think the future reporting thresholds might be.
Another area subject to increased scrutiny due to perennial underreporting are domestic workers. While many high-net-worth individuals may employ or contract drivers, babysitters, nannies, maids, landscapers and other domestic workers, new IRS rules that increase reporting requirements may hamper the ability for the wealthy to pay “under the table.” The American Rescue Plan Act, passed in March 2021, will require third-party payment systems, including Venmo, PayPal and Zelle, to report payments totaling over $600 per year beginning for tax year 2022, with no transaction minimum. Such increased reporting will likely lead to increased audits of workers and employers when associated taxable income is unreported or underreported.
Finally, with IRS funding under President Biden, it is very likely for any additional funding for enforcement to strictly target high-net-worth individuals. The Build Back Better Act specifically stated that “no use of these funds is intended to increase taxes on any taxpayer with taxable income below $400,000,” consistent with the president’s campaign promises. Even if most of the additional funding is available immediately, the IRS may have trouble hiring and bringing on capable staff quickly―though IRS Commissioner Charles P. Rettig has said they would direct efforts to hiring experienced tax and audit practitioners so revenue gains from enforcement would not be delayed. The Congressional Budget Office estimates that the additional $80 billion in IRS funding, as the Build Back Better Act would have provided, would generate an additional $200 billion in tax collection over a 10-year period.
How Should I Prepare for a Potential Audit?
Even with reduced staffing and inefficiencies created by the pandemic, the IRS will audit hundreds of thousands of individual tax returns this year. Although that represents only a small percentage of all returns filed, that’s little consolation if your return is selected for an audit.
The purpose of the audit is to verify items reported on a tax return, to verify the correct tax has been calculated and to enhance collections. The best way to survive a tax audit is to prepare in advance. You should regularly maintain appropriate documentation for all items reported on your tax return―including invoices, bills, cancelled checks, receipts or other proof. Keep all of your records in one place and hold on to your calculations. In addition, you may wish to conduct a “mock” audit in conjunction with your tax adviser to simulate the questions and techniques an auditor may ask and use. By doing so, you should be able to identify the risks and readily address any concerns or issues the auditor may have.
The government normally has three years within which to conduct an audit, and often the audit will not begin until a year or more after you file your return. For certain items on your tax return, you may need to keep records for much longer―such as the closing statement for the home you bought in 1980, the improvements you made five years ago, the marketable securities you purchased 30 years ago or the business assets acquired over a decade. In such cases, you would generally need to hold on to those records until three years after you dispose of the asset.
For those with the interest, time and a high pain threshold who self-prepare their own tax returns, it is advisable to have a tax professional represent you at an audit. For those who engage a CPA or a tax service provider without deep tax representation experience, it is also advisable to have a tax professional represent you at an audit. A CPA or tax lawyer well versed in tax representation, such as those in our National Tax Controversy Group, knows what issues the IRS agent is likely to focus on and can often achieve a faster and more favorable result than an audit without professional representation would produce. More importantly, a tax professional knows that, in many instances, IRS agents will take a position (for example, to disallow deduction of a certain type of expense) even though courts and other authorities have expressed a contrary opinion on the issue.
For a taxpayer undergoing a civil examination or collection action, a knowledgeable tax lawyer or CPA can help preserve the taxpayer’s rights by resolving the civil case while also making every effort to determine if, in fact, a criminal investigation may be lurking in the shadows. Often, civil agents can tip their hand to an experienced tax professional by engaging in certain activities that are indicative of a simultaneous criminal investigation, including, but not limited to:
- More extensive reviews of aggressive transactions than might otherwise be conducted during a civil investigation;
- Repeated requests to interview the taxpayer;
- Unusual focus by the agent on taxpayer intent, as opposed to transaction structure; and
- Requesting copies rather than a review of originals, evidencing an intent to provide documents to the Criminal Investigation Division.
If there is any chance the IRS may be building a criminal case, the taxpayer may not wish to provide copies of select records and source documents to the agent. Of course, these documents would still be available for the agent to review in the taxpayer or representative’s office, but copies would not be provided for the civil agent to share with the criminal agents. Taxpayers should not provide any information to the IRS without the involvement of tax counsel.
If you are facing a tax audit or simply want to improve your recordkeeping, we stand ready to assist you. In the event you are contacted by the IRS and informed that your return or a component of your return is being audited or adjusted, it is imprudent to ignore it. But we urge caution―do not respond directly. Instead, seek the counsel of qualified tax advisers.
For those high- and ultra-high-net-worth individuals and businesses who are targeted groups in recent IRS compliance initiatives, the time to develop a plan and maintain documentation is now. We recommend those with exposure engage truly independent tax lawyers and CPAs who fall under attorney-client privilege, such as those in our National Tax Controversy Group, to represent your interests. Or, in advance of any IRS examination, work with experienced tax counsel to conduct a simulated audit to assess exposure and mitigate risk.