Tax Refund

The veil has lifted (at least partway) on the administration’s two-year-old pledge that the IRS would not use its $80 billion budget boost to increase audits on small businesses and taxpayers with incomes below $400,000 a year relative to “historical” levels. In a Senate Finance Committee hearing on April 19th, IRS Commissioner Danny Werfel explained that the pledge applies to taxpayers with “total positive income” in excess of $400,000, and the “historical level” means the audit rate on 2018 tax returns.

Still, questions remain regarding who will be in the expanded audit pool.

Evolution of a pledge

The president, like many of his rivals for the Democratic nomination, ran on a promise to increase tax compliance among high-income earners. A few months after his inauguration, the Treasury Department released a 24-page compliance agenda stating that audits wouldn’t increase for taxpayers with income below $400,000 relative to “recent” levels. Later, “recent” was replaced with “historical,” and “small businesses” were added to the taxpayers protected from new audits.

The $400,000 threshold was a bow to the President’s promise not to raise taxes on taxpayers below that level. The rest of the sentence gave the Treasury and the IRS some wiggle room to figure out how to make good on that pledge. The Commissioner’s testimony narrows, but does not close, the wiggle room.

What is income?

The tax code contains many definitions of income. Adopting “total positive income” increases the risk of audit for a larger share of the wealthy population by more than most other measures of income, such as adjusted gross income. It’s the sum of income before losses and deductions. In a simple example, a real estate magnate with gross receipts of $1 million and losses of $601,000 would be in the pool of audit candidates. So would a business partner who makes $500,000 but claims deductions in excess of $100,000.

Besides widening the audit pool, using positive income as the trigger also reduces evasion opportunities. That real estate magnate couldn’t lower his audit risk by overstating losses. But there may still be an escape hatch. A taxpayer—say a self-employed lawyer who underreports her earnings but claims no losses—might evade scrutiny by the IRS under a literal interpretation of Werfel’s testimony.

What are historic levels of audits?

I was surprised by the selection of the audit rate on 2018 tax returns as the historical level.

One reason was that much analysis by the administration and others (me, included) highlighted the reduction in the IRS’s resources since 2010. I figured the plan would be to increase audit rates to at least the level for 2010 tax returns—0.9 percent for returns with positive income below $500,000. (The public data doesn’t include a category for taxpayers with income under $400,000, so the under $500,000 category is serving as a proxy.)

But another reason is that the 2018 audit rate reflects unusual circumstances—not just the big cutbacks in the IRS from 2010 but also the pandemic. The combination of those two factors probably contributed to an audit rate of 0.3 percent for the under-$500,000 group

Why does the pandemic affect the 2018 audit rate? Audits don’t begin until after the return is due or filed, and any additional taxes must be assessed within three years of that date. Thus, the 2018 audit rate encompasses audits occurring during the first couple of years of the pandemic, when everything slowed down at the IRS and elsewhere. And because of the three-year statute of limitations, the IRS doesn’t yet have complete audit data for tax returns filed in later years.

That’s lucky for most taxpayers, though Werfel has a reasonable explanation for using the especially low 2018 rate. Over the next several years, the IRS will be focusing on beefing up its staff and technology to tackle the complicated returns of the wealthy and big businesses. Werfel opened the possibility that the IRS would revisit that audit rate some years down the road but doubted that the threshold would rise to “any historical average” for a long time.

What’s a small business?

Werfel wasn’t asked, and so we still don’t know how small a business would have to be to avoid a higher risk of audits. Werfel did deliver a message to “mom-and-pop stores, clothing stores, and auto-repair shops” not to worry.

Has the pledge boxed in the IRS?

Will the pledge improve compliance among the taxpayers with income above $400,000 without also reducing compliance by those with lower incomes? A lot depends on the quality of the IRS’s enforcement tools. Perhaps investments in data analytics and machine learning will enable the IRS to better detect taxpayers who underreport income to be below the $400,000 threshold. And maybe the IRS will be able to rely more on tools other than audits (say, notices for mismatches between amounts on tax returns and 1099s) to prevent noncompliance by taxpayers with income below $400,000.

But in the meantime, some wealthy taxpayers with substantial underreporting of income may fly under the IRS’s radar, casting doubt on the IRS’s ability to implement the pledge.

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