The Truth About the IRS’s New Funding

Contrary to what you may have heard, the agency’s $80 billion budget increase is not for financing an auditing army.

By Mallon FitzPatrick & Alicia Denton
Mallon FitzPatrick and Alicia Denton

If recent headlines are to be believed, an armed unit of IRS agents is gearing up to mobilize and audit the taxpaying masses by force. While the rhetoric surrounding the agency’s increased funding (a provision of the Inflation Reduction Act) has been quite heated, the reality is considerably more level-headed.

The legislation, enacted in August, contains several wide-ranging initiatives and policy changes. It includes provisions that help reduce costs for Medicare recipients and provide for climate and energy spending by offering tax credits and incentives for renewable energy projects. Although there are some tax changes in the legislation, none directly increase personal income tax.

The revenue-raising measure in the Act that received the most attention from commentators is one that had already been in place for some time: enforcing the existing tax code.

The bill allocated $80 billion to the IRS to boost the federal agency’s capabilities. The U.S. Treasury recently estimated that the IRS is missing $600 billion in collections yearly. This deficit is known as the “tax gap,” or the difference between what is owed to the government and what is actually paid. The new funding provided by the Act is meant to help the IRS close this gap and will be invested over a 10-year period.

News of the increased budget set aside for the IRS caused much speculation, with some claiming that it would be used to encroach on Americans’ privacy and elevate auditing levels to an unreasonable degree.

However, according to a Congressional Budget Office memo released in October, only half of the new funds will be earmarked for enforcement. The remaining funds will be dedicated to bolstering operations support and front-facing taxpayer services, as well as modernizing the agency’s internal systems.

U.S. Treasury Secretary Janet Yellen has publicly clarified that the IRS’s four main priorities for this funding are: working through the backlog of tax returns, improving customer service, hiring, and updating in-house technology.

Burgeoning backlog

As of October 31, the agency had a backlog of more than 8 million unprocessed individual returns. During the 2021 fiscal year, the IRS only answered 11% of inbound calls. Many accountants can attest to how frustrating it is to call the agency with a few basic questions only to be placed on a prolonged hold.

Another rapidly compounding systemic issue is employee attrition; more than half of the IRS’s employees are expected to retire over the next five years. Rather than augmenting a well-equipped enforcement army, many new hires are largely expected to replace departing workers.

Another deficiency is the agency’s reliance on antiquated technology.  One of the core applications, the Individual Master File system, is six decades old. These difficulties at the IRS paint a picture of a government agency in decline, a far cry from the robust powerhouse multiple media outlets have characterized it as.

A long time coming

The IRS’s stumbling blocks did not emerge overnight. Funding for the agency dropped by 20% from 2010 to 2017, and hiring has been below historical levels for some time, leaving the IRS struggling to achieve pre-2010 audit levels without pre-2010 resources.

The IRS has 38,000 fewer employees today than its 117,000 head count in 1992 (a 30% decline), IRS Commissioner Charles P. Rettig wrote in an op-ed published in August 2022 in Yahoo! Finance. During this 30-year period, the U.S. population grew by nearly 30%, he also noted. One might expect the number of IRS employees to increase or, at the very least, remain constant.

Staffing the IRS is challenging because the labor market is competitive and candidates can typically find better-paying jobs in the private sector.

The IRS hopes to use the new funds to onboard 87,000 new hires over the next decade. Many new hires are not auditors, but rather customer service representatives. The agency reported in October that it has already hired 4,000 of the 5,000 representatives it seeks to improve phone wait times for the impending filing season. Other planned hires include operational support, front-facing taxpayer services, and replacements for the significant number of employees that are retiring.

Rettig also asserted that replacing staff and modernizing systems will make it easier for taxpayers to comply with the tax code, and in turn, reduce the likelihood of an audit.

It’s a bipartisan issue

The Biden administrated allowed Rettig, appointed under President Trump, to complete his term through November 2022. Rettig’s concerns reflect a bipartisan acknowledgment of the issues surrounding the IRS and its capabilities. If the agency cannot carry out even its most basic functions, that would mean a litany of problems for the government and taxpayers alike.

President Biden recently nominated Danny Werfel to serve as the new IRS Commissioner. Werfel previously served as IRS Acting Commissioner and Office of Management and Budget Controller under Presidents George W. Bush and Barack Obama. Should he be confirmed by the Senate, Werfel will answer to Secretary Yellen and Congress to pursue the renewal efforts outlined above.

As for the peril of escalated enforcement that has many people wringing their hands, Secretary Yellen has instructed the IRS to focus on “high-end noncompliance.” What exactly does “high-end” constitute, you might ask? Per remarks by Rettig and Yellen, this refers to those making more than $400,000 a year.

Both officials have repeatedly stressed that the overwhelming majority of Americans will not receive increased scrutiny as a result of this additional funding. Just 1% to 2% of American taxpayers have an annual income exceeding $400,000.

Putting things in perspective

Even with these assertions and new resources, the chances of being audited by the IRS remain historically low. As of May 2022, taxpayers with annual incomes between $200,000 and $1 million had a less than 1% chance of being audited; those making between $1 million to $10 million had a 2% chance. This represents a precipitous drop in a short amount of time.

As reported in an August Bloomberg report, 16% of Americans making $5 million or more yearly faced audits a decade ago. Furthermore, data shows that audits of individual taxpayer returns decreased across all income levels between 2010 and 2019.

While the average taxpayer was three times less likely to be audited in 2019 than they were in 2010, it’s worth noting that audit rates dropped the most dramatically for higher earners during that same period.

Red flags that can raise scrutiny

With the above in mind, the IRS will more likely pursue corporate entities and high-income earners than the average American taxpayer.

As the agency attempts to restore the scope of its audits to previous levels, its efforts are expected to focus on those making $400,000 a year or more — particularly those receiving income via pass-through entities such as partnerships, LLCs, S corporations and trusts. Large corporations and complex partnerships can expect increased scrutiny, as can cash-heavy businesses such as restaurants.

While the shift in the IRS’ capacities may not be as severe as some have warned, advisors and clients may benefit from understanding the red flags that can raise the risk of an income tax audit.

Sizeable transactions, especially those pertaining to income, raise red flags. These include rental losses, business sales, charitable deductions, gifts, cryptocurrency transactions and foreign transactions. Other audit triggers may be high self-employment income, missed RMDs, suspicious business expenses, failing to report foreign accounts, and self-dealing for private foundations.

How to keep clients calm

While clients tend to fret over the chances of an income tax audit, many overlook the odds of an estate tax audit. As previously covered, an estate tax return can be 10 to 20 times more likely to be audited than an income tax return.

“Although the IRS may be ramping up its efforts, the narrative of militarized auditors assembling to harass taxpayers en masse is inaccurate.”

Should you become the subject of an audit, you enjoy certain rights as a taxpayer: confidentiality, the right to be informed, retain representation, the right to challenge and the right to quality of service.

Under the right to quality of service, taxpayers may ask to speak with an enforcer’s supervisor and replace the agent with a superior. Tyler Perry recently invoked this right when his audit was extended for more than three years, a move that may have helped him win a $9 million refund from the IRS.

The perennial wisdom to decrease the likelihood of an audit is to keep calm and err on the side of caution. We recommend creating and retaining a record of taxable events. Clients should proactively collaborate with their accountants throughout the year to help avoid possible issues.

Although the IRS may be ramping up its efforts, the narrative of militarized auditors assembling to harass taxpayers en masse is inaccurate. Clients working with a qualified accountant to accurately report income tax events and structure businesses should have little to fear in the future.

Mallon FitzPatrick, CFP, is a principal and managing director at Robertson Stephens and heads the firm’s financial planning center. Alicia Denton, CFP, is an associate wealth planner at Robertson Stephens. For more information about Mallon, Alicia or Robertson Stephens, please visit www.rscapital.com or email info@rscapital.com. Advisory services are offered through Robertson Stephens Wealth Management LLC. Opinions presented are those of the author and not necessarily Robertson Stephens. Please read important disclosures.

 

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