This article by tax controversy partner Kat Saunders Gregor, senior attorney Gabrielle Hirz and associate Hillel Nadler was originally published in Law360 on Feb. 2, 2017.
Only days before President Trump’s nominee for secretary of the treasury, Steven Mnuchin, testified in his confirmation hearing that the U.S. Internal Revenue Service (IRS) is underfunded and needs more manpower, the National Taxpayer Advocate’s 2016 Report to Congress advocated for IRS budget increases and a friendlier enforcement approach. The first recommendation of National Taxpayer Advocate (NTA) Nina E. Olson’s 2016 report to Congress, released on Jan. 10, 2017, is to increase the IRS’s budget.
Since 2011, the agency's budget has been slashed from a height of almost $14 billion per year, down to less than $11 billion. These cuts have cost the IRS nearly 15,000 staff positions in five years. The IRS now operates with a staff of less than 80,000, smaller than at any time since 1980 and with roughly 50 percent fewer people than at its maximum staffing levels back in 1992.
In addition to concerns about understaffing, the NTA also described IRS struggles with “grossly outdated technology and infrastructure,” including “two of the oldest information systems in the federal government,” which are 56 years old and still used to track individual and business assessments, payments and other related items.
Prior to Mnuchin’s comments, cuts to the IRS budget were expected to continue as early as April 2017, when its current budget authorization expires. However, as both Mnuchin and the NTA have pointed out, these budget cuts, corresponding decreases in staff, and ineffectual, outdated technology have been devastating to traditional tax enforcement. IRS headcount has tumbled roughly 30 percent in recent years, including among key enforcement staff, such as revenue officers, revenue agents and appeals officers:
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When enforcement staff positions are cut, the IRS can simply no longer review the same number of tax returns. It then misses opportunities not only to collect more from tax cheats through additional assessments, but also to correct taxpayers’ good faith, but wrong, tax positions and increase compliance in future years.
IRS Databooks report that the IRS examined approximately 20 percent fewer returns in 2015 than in 2011, and reduced its examinations of large corporate returns by 30 percent despite increased filings. These declines resulted in $18 billion dollars less in proposed additional tax adjustments in 2015, a decrease of more than 40 percent from 2011 levels.
The NTA report charges the agency's obsolete computer systems with creating audit inefficiencies by falsely flagging returns as fraudulent 50 percent of the time. The NTA report also suggests that facing increasing budgetary pressure, the IRS has made “penny-wise, pound-foolish” decisions, such as reducing in-person appeals conferences and walk-in appointments at taxpayer assistance centers, failing to use behavioral science to encourage greater compliance, and conducting unnecessary audits, not only wasting time but also potentially decreasing those taxpayers’ future compliance.
Private debt collection, reauthorized by Congress in 2015 and set to commence shortly, could ameliorate the effect of cuts on the collection side. But private debt collectors have been found to be less effective than IRS employees. And private debt collection will only prevent underreporting and underassessment of liabilities to the extent that it creates an additional deterrent.
Underreporting is the most important driver of the tax gap — the difference between the amount of tax owed and the amount of tax paid by the nation’s taxpayers. It has been estimated at roughly $450 billion per year, roughly 90 percent of which is caused by both individuals and corporations underreporting their income.
Despite these considerable staffing and technological headwinds, the IRS’s tax collections have never been more efficient, bringing in nearly $3 for every $1 spent by the entire agency (Mnuchin cited a $4 return at his confirmation hearing). And its enforcement arm may be even more effective: it appears to have brought in more than $7 for each dollar spent in 2015.
While Mnuchin’s comment that President Trump understands that “where we add people, we make money,” the NTA report urges “a change in IRS culture from enforcement-focused to service first” in addition to staffing increases. It criticizes the agency’s allocation of twice as many dollars to enforcement as to taxpayer service, even though that allocation has remained constant over time.
It also questions whether better results would be obtained if the IRS viewed audits “first and foremost as educational opportunities” in which “the IRS can learn about the challenges taxpayers face in complying with the laws” and taxpayers may “learn that they can’t get away with something they thought they could.”
For those reasons, the NTA report recommends that Congress pair increased funding for the IRS with increased congressional scrutiny of how those dollars are spent, such as by holding hearings to discuss where the agency should spend additional resources and focusing on evidence-based approaches.
Mnuchin likewise mentioned that he was concerned about “customer service for the many hard-working Americans that are paying taxes” and recommended that the IRS “monitor customer satisfaction.” Both the NTA and Mnuchin have also emphasized new technology as critical to the agency's customer service mission and its ability to collect more taxes.
Whether raising the IRS’s budget with or without stricter oversight may appeal to President Trump remains to be seen. A 400 percent return on investment may be too good a deal for President Trump to pass up on, particularly where the NTA claims that there is “universal acknowledgement that the IRS needs more funding to do its job” based on the public forums, meetings with practitioners and in a nationwide survey it conducted in 2016.
Yet while the House Republican “Better Way” proposal calls for IRS to have a greater customer-service focus, echoing the NTA’s approach, it also contemplates a “streamlined” structure and presumably lower budget.
President Trump has remained silent on his plan for the IRS, but his administration acted quickly after his inauguration to freeze most new hiring across the federal government until April 23, 2017, when he anticipates receiving a long-term plan from the Office of Management and Budget and Office of Personnel Management to reduce the size of the federal government workforce through attrition. President Trump is also expected to release his full budget around that time, although a shorter document outlining his budget priorities is expected in March.
In general, taxpayers should expect that if more dollars are allocated to the IRS — a prospect that remains very much in doubt — increases in enforcement will follow. The “friendliness” of that enforcement will likely remain in the eye of the beholder.