What would a big expansion of the IRS in Inflation Reduction Act mean for taxpayers and for audits?

·6 min read

The Inflation Reduction Act covers a lot of ground. The Democrat-backed legislation includes provisions to lower prescription-drug costs for consumers, encourage more energy efficiency, impose a minimum tax on some corporations and more.

There’s also $79.6 billion in increased funding over several years for the Internal Revenue Service, largely to help the agency crack down on tax evaders. And that could revive awareness of and debate about the tax gap.

What is the tax gap?

The gap is the amount of taxes that are legally owed by but not collected from the public and businesses, largely owing to tax evasion. This shortfall adds to the nation's massive federal deficits. Closing the gap is a way to raise revenue without raising tax rates.

It’s difficult to say how large the gap is because the IRS itself hasn’t made an estimate for nearly a decade. The average gap from the latest IRS study, for tax years 2011 through 2013, showed a shortfall estimated at $441 billion annually. That declined to $381 billion after counting additional tax revenue that came in through late payments and IRS enforcement actions, including audits.

Stated differently, the IRS collects about 84 cents for each tax dollar owed, or 86 cents including late payments and enforcement actions.

The current gap in dollar terms is likely much higher now owing to inflation, an expanding economy, the emergence of hard-to-trace cryptocurrencies and other factors. Some estimates place it closer to $1 trillion annually.

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How important is compliance?

The IRS audits relatively few Americans each year, under 1%, so it’s important that the public voluntarily pays all or most of what they owe to fund government adequately.

“Small declines in compliance cost the nation billions of dollars in lost revenue and shift the tax burden away from those who don't pay their taxes onto those who pay their fair share on time, every year,” the agency said in a posting on its website.

However, the same IRS post doesn’t seem to view this as a particularly serious problem.

“In general, the tax-gap estimates dating back decades consistently show the United States enjoys a relatively high and stable voluntary tax compliance rate,” the IRS said.

Worth noting: Some people likely underpay taxes because they don’t understand all of the labyrinthine rules, rather than out of a deliberate desire to cheat.

“Noncompliance due to unintentional errors on the part of taxpayers is included in the tax gap but not considered tax evasion,” wrote Alex Muresianu, an analyst at the Tax Foundation, in a 2021 report.

At any rate, the U.S. doesn’t seem to be a tax-scofflaw haven like Italy, instead ranking closer to highly compliant nations such as Canada, Switzerland, Luxembourg and New Zealand, according to one study cited by Muresianu that tracked the tax gap as a percentage of Gross Domestic Product.

How might the IRS use this funding?

Audits and other enforcement efforts would get the lion's share of new funding from the legislation, $45.6 billion of the additional $79.6 billion through 2031, but other areas would see gains, too.

About $25.3 billion would go to operational support (information technology, security, rent and more) and $4.8 billion to modernize IRS business systems, which oversee the administration of taxpayer services, operations, cybersecurity and so on.

There's also a modest $3.2 billion to shore up the IRS' woeful taxpayer services. IRS representatives answered 59% of the phone calls they received in 2019, but that dropped to 18% this year, the Congressional Research Service noted. Unprocessed tax returns also are a problem.

Stated differently, funding would jump 69% for enforcement, 53% for operational support, 153% for business-services modernization — but just 9% for customer service.

Muresianu said that increase might not be enough to help the IRS interact much better with the public, especially if audits increase. "Taxpayer services should go hand in hand with enforcement," he said in an interview.

Tom Wheelwright, a certified public accountant and financial author in Chandler, said that even tax professionals often must wait hours to contact an IRS representative by phone, up from minutes in past years. He would like to see less money for enforcement and more for customer service and upgrading the IRS' antiquated technology systems.

"Why don't they solve the customer-service problem before they go after more customers?" he asked.

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Should you worry more about audits?

The answers to the question of whether this all means more audits for average taxpayers fall along party lines. Some Republicans predict the expanded funding will turn the IRS into an aggressive, audit-heavy agency. Democrats view the increased funding as an opportunity to give the IRS adequate resources to enforce the tax code while improving customer service and bringing the agency's computer systems into the 21st century.

Enforcement activity likely would target wealthy taxpayers.

"They really would be looking at large corporations and individuals earning $400,000 or more a year," said Lisa Featherngill, national director of wealth planning at Comerica Bank. "They'd also be looking for unreported income," such as that from cryptocurrency-trading profits.

Wheelwright warns small business owners to be wary. He already describes the IRS as a "bully" in some cases by sometimes disallowing legitimate business deductions, effectively forcing taxpayers who object to take their grievances to court. Hiring more auditors could make the agency more aggresive. He suggests that business owners save all receipts, keep good records and otherwise "cross all your t's and dot all your i's."

But Wheelwright doesn't think employees who earn wages that are subject to tax-withholding and third-party reporting should be concerned about a spike in audits if earning less than $400,000 a year.

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Any other costs for taxpayers?

Still, merely the public perception of a more vigilant IRS could have a deterrence effect. "More people would follow the rules," Muresianu predicted.

Featherngill suggests that taxpayers might want to think twice before making aggressive use of deductions or other tax-shaving opportunities. "Over the last several years, the public has known the IRS has been short on resources, especially for audits," she said.

Wheelwright puts it more bluntly: "Because people haven't been audited, some have gotten lazy," he said.

Even if most Americans don't face a materially higher audit risk, they still might wind up facing higher costs. Taxpayers might opt to pay professional return preparers more to avoid errors, or they might forgo legitimate benefits out of fear of making a mistake, Muresianu said. Some might feel compelled to spend more time and effort compliling their own returns.

Wheelwright said small business owners, in particular, should make sure they have good tax-preparation help. And they probably should plan on paying more for it at a time when many aging CPAs and other financial professionals are retiring anyway.

Reach the reporter at russ.wiles@arizonarepublic.com.

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This article originally appeared on Arizona Republic: How would billions more in IRS funding affect taxpayers, audits?