Why would the IRS audit high income or high wealth tax returns? 

You don't have to be a genius to see that’s where they stand to collect the most money. For every dollar spent on enforcement, they get back between four and five dollars in income taxes. Yet, Congress has cut the enforcement budget.

Does that make sense? No, but that does contribute to the tax compliance gap. US tax compliance is between 83% and 84%, which doesn’t seem high enough. The US has been a world leader in the past.

It would seem spending too much time on low-income taxpayers instead of high income is the problem. This along with the need for a more balanced focus.

By the way, cutting budgets might change in a post-Trump era. The Biden administration has put a hold on all new regulations for the time being.

Why Focus On the Wealthy Now? 

There are a couple of reasons. 

First, there is a new IRS Commissioner, Charles Rettig. Rettig has a strong background and well-respected tax controversy practice in Beverly Hills. He seeks to level the playing field on non-compliance. How? By going into everyone’s backyard to look for tax cheats.

Second, the watchdog agency for the IRS is the Treasury Inspector General for Tax Administration or TIGTA. In its oversight reports from 2015 to 2020, the TIGTA has pressured the IRS into allocating more resources to high-income taxpayer audits. 

And guess what, the IRS is responding with a grand plan.

Last, congressional oversight through TIGTA questioning and pressure on the IRS is working.

We may berate the IRS from time to time, but their response to the TIGTA reports has been nothing short of brilliant. In the past, audits were random or at best based upon computer guessing. Through the DIF selection system, 27% to 40% of the audits resulted in no change. What a waste of resources. Expect that to change in the future.

What’s the Nature of the Problem? 

The May 2020 TIGTA report estimates the average annual tax gap to be $441 billion. $39 billion of that or 9% is due to taxpayers who do not file. Further, high-income non-filers contribute to the majority of the non-filer tax gap.

How Did the IRS React? 

Strategically. Here are a few of their responses:

• They sent out teams to go door-to-door to face people who had not filed. And with COVID-19 around, most of these people are going to be at home! It’s brilliant. 

Thanks, Kim.

• Using soft notices saying: “We think there is a problem with your tax return, do you have an XYZ transaction?” If received, you should complete these notices as soon as possible. While not an audit, no response could trigger one.
  

• And their best response? The IRS formed super teams of teams to focus on the right things with the right people, sharing intelligence across the enterprise. That’s a lesson all businesses should take note of.

The designer of this IRS plan must have read General Stanley McChrystal’s book: ‘Team of Teams.’ McChrystal draws parallels between the IRS war on fraud and the Joint Special Operations Command (JSOC) in the war against Al Qaeda. The comparisons are striking.

Assembling the Super Team

There is a new Office of Fraud Enforcement to coordinate IRS Divisions. We will see new coordination between the operating divisions of the IRS. Key team members from each division are working with the Office of Fraud Enforcement.

 JSOC did the same. The JSOC invited the FBI, CIA, Interpol, and others to their daily Operations and Intelligence briefings. They also placed members of the JSOC task force within the FBI, CIA, etc. This tears down silos.

The IRS has used a wealth squad to drill into the intricate details of all aspects. Commissioner Rettig described this as “audits from hell." This squad focuses on the complete finances of the taxpayer and all entities. This includes partnerships, corporations, trusts, foundations, and more. Contrast that with the new teams that are a bit more strategic and you've got a scoped rifle versus a shotgun.

Imagine a super-team composed of representatives from each sector of the IRS all focused on high wealth and income issues. 

What Will the Super Team Accomplish?

They are using data analytics to focus on issues based upon risk. This should result in a dramatic reduction in the 27% to 40% of audits with no changes. The IRS super team is identifying the high probability issues. Straight out of Jim Collins' mouth.

That is where the soft notices come in. They focus on the issues. Example: The Tax Cuts and Jobs Act enacted the 20% qualified business income deduction. IRS is focusing on business restructurings to qualify for the deduction.

High Wealth Audits

These cases are now risk-assessed before the auditors go out in the field. They are still taking a holistic approach to look at the whole picture. But now they keep a database with probabilities of adjustments. And therein lies the power of the team.

Before opening an exam, the IRS does a risk assessment of the returns, K-1s, all in the background. If they decide to open, they will develop a case folder with returns and paperwork that the examiner will need along with focal issues. Traditionally, the examiner would ask for copies of all tax returns. Now, agents get the copies, why the case was selected, and the background issues to be examined.

Where Do High Wealth Audit Referrals Come From? 

• Any of the IRS business units

• A referral form on the IRS website

• Whistleblowers

• Issues that are driven by experience from other high wealth audits

• Referrals from technical specialists in international compliance. 

There appear to be few random audits these days. Instead, audits are selected for good reason. If you get a notice, know that it was not random and is not a fishing expedition. You need to identify the reason.

There are several hundred exams of high net worth and high income in the process. Equating to over 10 million in assets or income. Some of the issues will filter through to main street businesses in the form of soft notices or audits. These issues will further feed the new case selection procedures to better identify the low-hanging fruit.

Final Thoughts

Meet the new IRS. Sophisticated, strategic, risk-based audit strategies focused on target areas showing a significant risk. Now, imagine what could be if their budget increased.

What You Can Do

1. Always report all your income. No exceptions.

2. Timely file (extensions are ok) all tax returns.

3. Disclose items of risk or not clear on your tax return aiming to remove questions if someone looks at the item.

Be safe out there.

Shoutouts

Special thanks to the excellent attorneys at the tax controversy firm of Hochman Salkin Toscher Perez. They presented continuing education through Stratford Seminars. 

Current IRS Commissioner Charles Rettig was a partner of this firm before his appointment to the IRS. We are excited to see him excelling and celebrate his accomplishments.