IRS Enforcement and Funding: Understanding the Impact of Increased Resources on Audits and Compliance

The Internal Revenue Service (IRS) has long been the primary agency responsible for administering the U.S. federal tax system, ensuring compliance, and enforcing tax laws. In recent years, however, the agency has faced significant challenges due to budget cuts, reduced staffing, and an increasing workload. Recognizing the need to bolster the IRS’s capabilities, the U.S. government has recently approved substantial funding increases aimed at enhancing the agency’s enforcement capacity and improving overall tax compliance. In this article, we’ll explore the reasons behind the increased funding, its expected impact on audits and compliance, and what taxpayers can do to prepare for this new era of heightened IRS scrutiny.

The Background: Why Increased Funding for the IRS?

For years, the IRS has struggled with reduced budgets, resulting in a decline in its ability to effectively enforce tax laws and provide adequate service to taxpayers. Between 2010 and 2020, the agency’s budget was cut by nearly 20% in inflation-adjusted dollars, leading to a significant decrease in staff, including a 30% reduction in enforcement personnel. These cuts have had several consequences:

(A) Reduced Audit Rates: Audit rates, particularly for high-income individuals and large corporations, have plummeted. This has raised concerns about the agency’s ability to deter tax evasion and ensure that all taxpayers pay their fair share.

(B) Outdated Technology and Systems: The IRS’s technology infrastructure is outdated, making it difficult to efficiently process returns, detect fraud, and provide timely service to taxpayers.

(C) Growing Tax Gap: The tax gap—the difference between the taxes owed and those actually collected—has been estimated at nearly $500 billion annually. This gap represents a significant loss of revenue that could be used to fund public services and reduce the federal deficit.

Recognizing these issues, the Biden administration and Congress have prioritized increasing the IRS’s budget as part of broader efforts to improve tax compliance and reduce the tax gap.

The New Funding Boost: What It Means for the IRS

The Inflation Reduction Act of 2022, along with other legislative measures, has allocated nearly $80 billion in additional funding to the IRS over the next decade. This funding is intended to address several key areas:

(A) Enhanced Enforcement: A significant portion of the new funding—approximately $45 billion—is earmarked for enforcement activities. This includes hiring new auditors, upgrading technology, and expanding resources to target high-income individuals, large corporations, and complex financial structures that are often used to evade taxes.

(B) Improved Customer Service: Around $3 billion will be used to improve taxpayer services, including reducing wait times, expanding online services, and providing more assistance to taxpayers seeking to comply with tax laws.

(C) Modernization of Technology: Another $5 billion is allocated for modernizing the IRS’s outdated technology infrastructure. This investment aims to improve the efficiency of processing returns, detecting fraud, and managing taxpayer accounts.

(D) Operational Support: The remaining funds will support various operational needs, including training new staff, maintaining facilities, and supporting ongoing programs.

Impact on Audits: What to Expect

With the increased funding and resources, the IRS is expected to significantly ramp up its audit and enforcement activities. Here’s what taxpayers can expect:

1. Increased Audit Rates for High-Income Individuals and Large Corporations

The IRS has made it clear that it will focus its enhanced enforcement efforts on high-income individuals and large corporations, which are often the most complex and challenging to audit. Audit rates for individuals earning over $400,000 per year and large businesses are expected to increase substantially. This focus aims to address concerns that these groups have not been audited at rates proportional to their potential for tax evasion.

2. More Attention to Complex Financial Structures

The IRS plans to invest in training and hiring specialists who can better understand and investigate complex financial structures, such as partnerships, trusts, and foreign assets. These areas have historically been under-audited due to their complexity and the lack of specialized IRS personnel.

3. Expanded Use of Data Analytics and Technology

With new funding for technology, the IRS will likely expand its use of data analytics and artificial intelligence to identify potential audit targets. By analyzing large datasets, the agency can more effectively detect anomalies and patterns indicative of tax evasion or underreporting.

4. Focus on Cryptocurrency and Digital Assets

Given the rapid growth of the cryptocurrency market, the IRS has signaled its intent to increase enforcement in this area. The agency has already begun issuing guidance on the reporting of digital assets and is expected to conduct more audits related to cryptocurrency transactions and holdings.

Impact on Tax Compliance: What It Means for Taxpayers

The increased enforcement efforts are expected to have a significant impact on tax compliance across the board. Here are some of the potential implications for taxpayers:

1. Greater Scrutiny of Tax Returns

Taxpayers, particularly those in higher income brackets, should be prepared for increased scrutiny of their tax returns. This means that deductions, credits, and income reported on tax returns will be subject to more rigorous examination. It is crucial for taxpayers to ensure that their returns are accurate and that they have proper documentation to support their claims.

2. Heightened Focus on Tax Planning Strategies

Tax planning strategies that are perceived as aggressive or abusive will likely come under increased scrutiny. This includes the use of offshore accounts, complex business structures, and certain tax shelters. Taxpayers engaging in such strategies should be prepared to justify their positions and may want to reconsider their use in light of the new enforcement environment.

3. Increased Compliance Costs

With the heightened focus on enforcement, taxpayers may face increased compliance costs. This includes the need for more thorough record-keeping, potential legal and accounting fees, and the cost of defending against audits. Taxpayers, particularly businesses, may need to invest in more robust tax compliance systems and processes.

4. Greater Emphasis on Voluntary Compliance

The IRS’s increased enforcement efforts are intended to promote voluntary compliance by deterring tax evasion and increasing the perceived risk of audit. Taxpayers who have previously taken a more relaxed approach to compliance may be incentivized to adopt a more conservative and compliant stance.

Preparing for Increased IRS Scrutiny: Tips for Taxpayers

Given the upcoming changes, taxpayers can take several proactive steps to prepare for increased IRS scrutiny:

1. Review and Correct Past Returns

Taxpayers should consider reviewing their past tax returns for any potential errors or omissions. If discrepancies are found, filing amended returns or taking advantage of the IRS’s voluntary disclosure programs can help mitigate penalties and interest.

2. Maintain Comprehensive Documentation

Proper documentation is key to substantiating deductions, credits, and other positions taken on tax returns. Taxpayers should ensure that they keep detailed records of income, expenses, and any supporting documents that may be required in the event of an audit.

3. Consult with a Tax Professional

For individuals and businesses with complex financial situations, consulting with a tax professional can provide valuable guidance on compliance and audit risk. A qualified tax advisor can help identify potential issues and develop strategies to address them.

4. Avoid Aggressive Tax Positions

Taxpayers should be cautious about taking aggressive tax positions that could draw the attention of the IRS. Consulting with a tax professional before implementing such strategies can help assess the risk and determine the best course of action.

5. Stay Informed

Keeping up with changes in tax law and IRS guidance is essential for remaining compliant. Taxpayers should stay informed about new developments and consider adjusting their tax strategies as needed.

The Future of IRS Enforcement

The increased funding for the IRS marks a significant shift in the agency’s capabilities and focus. While the initial ramp-up may take time as the agency hires and trains new staff, taxpayers can expect a more robust and proactive IRS in the coming years. Several trends are likely to shape the future of IRS enforcement:

1. Continued Focus on High-Income Individuals and Corporations

The IRS will likely continue to prioritize audits of high-income individuals and large corporations, as these groups represent a significant portion of the tax gap. This focus aligns with the administration’s goal of ensuring that all taxpayers pay their fair share.

2. Increased Use of Technology and Data Analytics

As the IRS modernizes its technology infrastructure, it will become more adept at using data analytics to identify non-compliance and target audits more effectively. This technological investment is expected to improve the agency’s efficiency and effectiveness.

3. Expansion of International Cooperation

Given the global nature of many tax evasion schemes, the IRS is expected to increase its cooperation with international tax authorities. This includes information-sharing agreements and joint efforts to combat offshore tax evasion.

4. Enhanced Enforcement of Cryptocurrency Reporting

With the rise of digital assets, the IRS will continue to focus on ensuring compliance in the cryptocurrency space. This will likely involve increased guidance, reporting requirements, and targeted audits of cryptocurrency transactions and holdings.

The significant funding increase for the IRS represents a turning point in the agency’s ability to enforce tax laws and promote compliance. While the increased scrutiny may pose challenges for taxpayers, it also underscores the importance of accurate and transparent tax reporting. By taking proactive steps to review past returns, maintain comprehensive records, and consult with tax professionals, taxpayers can better navigate the evolving enforcement landscape and minimize the risk of audits and penalties.

As the IRS strengthens its enforcement capabilities and modernizes its operations, taxpayers should be prepared for a new era of accountability and compliance. Staying informed and adopting best practices will be essential for successfully navigating this changing environment.