How the IRS is changing tax enforcement

The Internal Revenue Service (IRS) tax enforcement continues to increase using targeted audit approaches. The IRS will deploy resources towards examinations of high-income and high-net wealth individuals, large corporations and complex partnerships. In addition, the agency plans to acquire improved technology, automation and other tools aimed at greater efficiency, and continues to apply data analytics in operational management and selection of compliance cases.

This article describes some of the more notable changes to tax enforcement by the IRS during the last year as outlined in their Strategic Operating Plan.

Use of IRA funding

The IRS is in the early stages of deploying some of the $80 billion allocated to the agency by the Inflation Reduction Act (IRA). While it is unlikely that the agency will receive the full amount of the IRA funding, even receiving a significant percentage of that amount would materially change how the agency is able to employ technology, recruit more experienced agents, and proactively target areas of perceived tax noncompliance. It is expected that some of the agency funding will also allow the agency to better process correspondence and reduce response times to basic inquires.

Some of the early efforts of the funding have become evident in the field. Certain collection alternative requests, such as offer in compromises, are being processed in weeks as opposed to months and many field agents have completed comprehensive trainings at higher levels prior to being assigned technical topics.

CPAR rollout

The IRS has significantly increased the number of partnership audits under the Bipartisan Budget Act of 2015 (BBA) centralized partnership audit regime (CPAR). The CPAR audit regime shifts significant burdens to taxpayers instead of the IRS. If the IRS determines that there was an understatement of a partnership tax item at the entity level, the agency does not need to make a corresponding assessment on the partner’s individual return. Instead the IRS is allowed to assess an underpayment at the entity level calculated using the maximum individual rate. It then becomes the responsibility of the partnership to substantiate a lower applicable rate and decide whether the entity should pay the tax or if it should push out the adjustment to the individual partners.

With the shifting of this administrative burden, the IRS has been much more willing to audit and adjust partnership items. Recent areas of emphasis during CPAR audits include basis recalculations, depreciation adjustments and recapture, purchase price allocations, debt issues, and substantial economic effect of allocations.

The IRS has recently announced that they are going to expand the CPAR audits to the largest partnerships and that as part of this compliance campaign, they would be leveraging the latest technology (including artificial intelligence) to identify areas of noncompliance.

Implementation of AI in audits

Beyond these announcements, we have already started to see the impacts of artificial intelligence (AI). While the mechanics of the technology are not clearly explained to practitioners, the effects of the technology have been felt in recent months. In certain complex situations, the IRS has been better prepared and has more fully identified potential issues earlier in the selection process than they would have in the past. It is suspected that the AI programs have been able to compare large data sets of returns that share similar characteristics. For example, a tiered partnership that invests in real estate can be compared to other tiered real estate partnerships to see if the recapture falls outside of the expected range. That data is then turned into targeted audits.

The end result is that audits are likely going to become more targeted, and that while mathematical inconsistencies can be explained, taxpayers will face an uphill battle. Auditors are going to have pointed questions earlier in the exam process, to which taxpayers will have to respond. It is also more likely that once an apparent discrepancy or area of potential noncompliance is identified, it will be more difficult to demonstrate that the return was correct (because an auditor who is assigned a particular issue will default to the belief that the IRS AI is more likely to be correct than the taxpayer).

ERC audits

The employee retention credit has emerged as a hotbed of potential fraud and IRS enforcement has followed suit. The IRS believes that many of the amended employment tax returns filed in 2023 claiming the employee retention credit were fraudulent. Employee retention credit audits are demanding because the IRS does not have much information with regards to the taxpayer who claimed the credit when a file is assigned for audit. The first document request from the auditor requires the taxpayer to demonstrate that they are eligible for the credit, as well as provide all the substantiation for the credit. How the taxpayer learned about the credit, and who did the calculations for the credit, are central discussion points and it is likely that many taxpayers who relied on questionable promotors are going to find themselves ineligible for the credit and subject to penalties for not doing basic due diligence as to the legal requirements for claiming the credit. For more information on how the IRS is handling ERC audits, please see our Sept. 19, 2023 tax alert on the IRS Halts Processing of New ERC Claims and our Aug. 2, 2023 tax alert, IRS Intensifies Efforts to Combat ERC Fraud as well as our article So you’ve been selected for an ERC audit, here’s what to expect.

Ongoing battles over foreign information return penalties

Foreign information returns continue to be a point of litigation. During the past year, the IRS suffered significant enforcement setbacks in this area. The Supreme Court held in Bittner v United States that nonwillful Report of Foreign Bank and Financial Accounts (FBAR) violations were subject to a $10,000 per report penalty rather than a $10,000 per account penalty. Of potentially greater significance in this area is the Farhy v Commissioner tax court case. In Farhy, the Tax Court held that the IRS lacked the authority to immediately assess certain penalties for failure to file a Form 5471, Information Return of U.S. Persons with Respect to Certain Foreign Corporations. These (and similar) international information penalties (for example, Form 5472, Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business, and Form 8938, Statement of Foreign Financial Assets) had been widely assessed via an automated system whenever a taxpayer filed a late return. For a Form 5471, this was due to an untimely reporting of ownership of a foreign corporation. While the ultimate resolution of Farhy is uncertain because the IRS has appealed the decision, a taxpayer victory would limit the ability of the IRS to assess one of practitioners' most feared penalties.

Conclusion

2023 has been a transformative year at the IRS. For the first time in decades, the agency received significant funding via the IRA. This funding has led to unprecedented investment in technology, personnel, and enforcement. Concurrently, CPAR is a significant legislative development that became functionally relevant in 2023. The above-described issues will continue to evolve in 2024 and beyond.

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.