Authored by James Creech and Michelle Hobbs
The Internal Revenue Service (IRS), through its Large Business and International Division (LB&I), has been steadily increasing its compliance enforcement. LB&I oversees and directs tax administration for domestic and foreign businesses with at least $10 million in assets as well as U.S. tax reporting requirements. It also conducts compliance programs for high-wealth taxpayers and international individuals. With almost 60 different enforcement campaigns aimed at various subcategories of taxpayers, resources continue to be poured into LB&I in order to collect the greatest amount of tax revenues.
Areas targeted for expanded enforcement include compliance with the many changes due to the Tax Cuts and Jobs Act of 2017 (TCJA) and other legislation, high-wealth taxpayers, and partnerships and other pass-through entities. These campaigns are designed to identify and audit certain noncompliant taxpayers as well as gather data as to how taxpayers adopted recent changes to the tax code and other regulatory guidance. Impacted taxpayers could experience longer examination time frames (from beginning to end) and may be required to supply more information to the IRS agent in order to wrap up the audit. In addition, the IRS may use more soft compliance measures, such as letters, advising taxpayers of an underpayment and advising of a need to file an amended return within months of the correspondence.
One of the more interesting enforcement campaigns in existence for 2018, 2019 and 2020 tax years is the TCJA compliance campaign. Many of these audits are limited to specific issues (such as the business interest expense deduction, global intangible low-taxed income or foreign-derived intangible income) preselected by LB&I and then sent to the field to develop. Once the audit begins, revenue agents are expected to have regular contact with not only their internal experts but also national subject matter experts who relay the findings back to data specialists. For taxpayers and their representatives, this may mean that audits stay open longer or may require more information to close than expected because more approvals are needed within the IRS.
The TCJA compliance campaign is designed to maximize future enforcement revenue more than current-year revenue. Audits are going to focus on more recent tax years and evolving issues will be pushed to the front for selection and exam. Hot issues within tax enforcement may give rise to correspondence from the IRS indicating it believes there is an underpayment and advising the taxpayer to amend returns, within months instead of years.
How the IRS responds to future tax law changes will be influenced by this work being done now. Return preparers working in an area identified for enforcement are going to need to leverage additional resources in order to fully develop an issue. Tax return positions that could expose a taxpayer to excess risk should be evaluated before a return is filed as to whether such positions meet the substantial authority threshold for the purposes of penalty protection.
The long-term result of the TCJA compliance campaign is that the IRS plans to leverage its significant investments in data analytics to quickly establish audit targets, to more accurately pick returns with non-obvious understatements, and to better adjust to future tax law changes. In response, taxpayers and their representatives need to effectively develop return positions in advance of selection.
Currently, the IRS has two enforcement programs, the high-net-wealth initiative and the global wealth initiative, that plainly state income received from a pass-through entity is a factor in taxpayer selection for examination. Further, partnership exams will also happen as part of the TCJA compliance campaign as well as through regular selection procedures. Practically speaking, this heightened focus means it is increasingly likely taxpayers will see more partnership audits in the next few years than they would have in the past.
Complicating matters is that the IRS is implementing the new centralized partnership audit regime (CPAR) which shifts much of the burden of an adjustment from the IRS to the entity and the partnership representative. Unlike the Tax Equity and Fiscal Responsibility Act (TEFRA), where partnership adjustments required audits of the individual partners to ultimately assess and collect a tax due, CPAR lets the IRS make a partnership-level adjustment and forces the partnership representative to choose between having the partnership itself pay any additional tax due and making a push-out election to the partners.
For taxpayers and their representatives, the preparation for audits starts years earlier. Frequent sources of pass-through adjustments, such as net operating losses, research credits, interest expense, and meals and entertainment, should be verified and confirmed. Supporting documentation should be organized under the assumption that an audit is likely.
With the IRS essentially declaring its intention to aggressively pursue partnerships and other pass-throughs, it is important to understand that enforcement resources are going to be pouring into the pass-through area. Anticipate that auditors, either explicitly or implicitly, will be instructed to make adjustments. Suggested revisions will be assessed at the partnership level while the burden of determining how and when to pay for any changes is going to fall to taxpayers and their advisors.
During the second quarter of 2021, the IRS made a drastic change as to how the practitioners’ hotline was able to respond to most penalty abatement requests. This change took away the power of the phone operator to grant most penalty abatement requests, except for first-time abatement. If a substantive penalty abatement request is made, it must be submitted in writing and processed by a specialized unit. This is a vivid illustration of how the IRS’ own internal thinking has evolved over the years and how penalty abatements are no longer quick requests that are easily granted. In 2021, every penalty carries a higher cost, either through payment of the penalty or increased professional fees, to have it waived.
The reasons for the change are not entirely clear; however, they are consistent with several public relation themes the IRS has promoted during the last several years. These adjustments help the IRS “do more with less,” “better allocate human capital,” and “ensure consistent application of the code.” The net result is that penalty abatement has become more difficult, more time-consuming and less predictable. Unfortunately, this also continues a theme of the IRS pushing the responsibility back upon taxpayers and their representatives.
Even before altering the practitioner hotline procedures, there was a shift toward making penalty abatement more difficult to achieve. Penalty abatement is an individual question. The Internal Revenue Code and the Treasury regulations stress that reasonable cause and good faith are discrete questions that require the IRS to attempt to understand the unique situations that lead to the error or missed deadline. This taxpayer-centric approach is time-consuming. It requires the IRS to have human beings answer the phone, actually listen to what the taxpayer has to say, have trained operators in what constitutes reasonable cause and use their individual judgment in granting relief. Despite the costs, this structure has historically been effective for taxpayers.
Simple and generously granted penalty abatement promotes taxpayer belief in due process, is consistent with the right to challenge the IRS and be heard, and frequently enhances voluntarily compliance with a complex tax system in the future.
The IRS has been using data analytics in some fashion for decades. Prior to modern computing power, one of the most misused ways the IRS used data analytics was through lifestyle or financial status audits in the 1980s and into the late 1990s. These lifestyle audits allowed the IRS to look at a taxpayer’s living standard, compare the amount of income reported on the return and then impute income to balance what was shown on the return versus the standard of living the taxpayer enjoyed. Due to IRS mistreatment, Congress banned lifestyle audits. While this ban has mostly held in place for the past two decades, certain groups are seeing a reemergence of lifestyle audits based upon data analytics.
The reason for this increase is the IRS can tie together more data points of what taxpayer lives look like and turn those data points into an indicator of underreporting. For example, a corporate return showing 100% of the usage of a private jet is business related can be contradicted by social media photos of their kids on the jet with the hashtag #skiweekend. Likewise, photos from the golf course without a client in sight can be used to question the business motive of a golf outing. It is not only personal activities that can be screened. Websites that list owners or advisors are matched to K-1s and alternative asset classes, such as claims about how much bitcoin a taxpayer has, are also fair game.
While the various social media platforms have been a powerful and useful tool, the IRS also uses algorithms to match income sources on different loan applications with what is reported on the annual tax return. Data analytics has allowed taxpayer credit information to be matched up against verifiable tax return information. In addition, the IRS can pull together material to ensure taxpayers involved in a series of entities are reporting the appropriate income on the ultimate tax return.
There are some real concerns about certain taxpayer audits being selected by artificial intelligence. Those that are can get sent to the field to develop the facts and could, actually, be considered lifestyle audits. While there is a “reasonable indication” exception to the lifestyle audit ban, how the IRS utilizes data analytics and artificial intelligence is an open question, especially if there is a real risk for a potential underreporting of income. For now, the IRS believes it can hide behind a black box algorithm to justify why an examination is warranted.
Given the current political climate, taxpayers can expect that algorithmically audit selection, based upon information not contained on the return, is going to expand. High-net-worth individuals, particularly those that live well-publicized lifestyles, are seen as not paying their fair share. Public opinion that more Lamborghini drivers should be audited is only going to increase as Treasury releases eye-popping tax gap numbers and the media publishes articles about how little the super-rich pay in taxes compared to their net worth.
It is also worth remembering that these tactics do not apply to just the IRS. State residency audits use less sophisticated versions of data analytics together with information about taxpayer activities.
IRS enforcement is a constantly changing environment. With the current negotiations on the federal budget including discussions on larger appropriations to the IRS plus the need to raise revenue in order to offset some of the administration’s spending priorities, taxpayers should anticipate increased audit activity going forward as the IRS is and will be tasked to raise revenue for the U.S. Treasury. In addition, taxpayers and their representatives are having a more difficult time dealing with the IRS. The challenge in reaching an IRS employee, the expanded enforcement campaigns, the increased scrutiny of partnerships and other pass-through entity returns, and the decreased likelihood of penalty abatement, all create a compelling reason to maintain robust and contemporaneous support for positions taken on a tax return.
For more information on this topic, contact our team.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.