For the past five years, taxpayers and their tax professionals have been hearing news about a downsized IRS–-mired in budget cuts, cutting resources, and reducing audits and compliance activities.
But what most people don't realize is that the IRS's main priority is still compliance–-and that its mantra is enforcing the tax laws. Here are 10 facts that show why tax compliance and enforcement is and will be an IRS priority for years to come.
1. The tax gap is almost as much as the budget deficit.
Every year, people in the United States who don't file a return, underpay their taxes, and underreport their income cost the government about $458 billion, according to IRS estimates. This difference between the amount of taxes that taxpayers owe and the amount of taxes that the IRS collects is called the tax gap. Add to the tax gap the cost of international noncompliance, which represents between $43 billion and $123 billion a year. In total, these numbers are close to last year's budget deficit of $587 billion.
Based on the last IRS study for 2010, taxpayers comply with their filing and payment responsibilities about 82% of the time. This is called the voluntary compliance rate. Every 1% increase in the voluntary compliance rate adds about $25 billion to the U.S. Treasury. Reaching 100% compliance is impossible without placing a substantial burden on taxpayers, but the IRS makes a clear case for increasing its enforcement resources to close the tax gap. In its current strategic plan, the IRS has set a target for 86% voluntary compliance for 2017.
While the IRS has mostly experienced budget cuts in recent years, it plans to realign its resources with a Future State Initiative. This plan will modernize IRS service to taxpayers through electronic tools, such as an online account for balance inquiries where taxpayers can look up their tax due, including penalties and interest. By modernizing its service tools, the IRS can accomplish two critical goals:
- Provide better service to taxpayers who voluntarily comply with their obligations.
- Make more efficient use of scarce resources to better focus compliance efforts.
2. The IRS spends the most on enforcement.
Congress divides the IRS's $11.2 billion budget among five areas. Historically, the largest portion of its budget has been devoted to enforcing tax laws (39%). Congress typically appropriates smaller amounts to operations support (30%), taxpayer services (19%), other services/support (10%), and business systems modernization (2%). Translation: Congress has traditionally seen enforcement and tax compliance as the IRS's most important functions, as evidenced by the numbers.
3. The IRS is doing more with less.
Five straight years of IRS budget cuts haven't diminished enforcement revenue. For the past five years, revenue collected through IRS enforcement was between $50 billion and $57 billion. In 2015, it was $54.2 billion.
4. The IRS knows that 7.5 million people don't file their required returns every year.
The IRS receives 2.6 billion information statements every year (such as Forms W-2 and 1099). Because of this information tracking, the IRS knows that about 7.5 million people who receive one of these statements don't file their returns.
What the IRS doesn't know is the number of people who are effectively "off the grid" and who don't receive Forms W-2 or 1099s. They are commonly cash-based workers and small businesses. Recent studies may renew IRS interest in finding these nonfilers.
5. Nineteen million individuals and businesses owe $391 billion to the IRS.
Managing accounts receivable from 19 million taxpayers is a big effort. The IRS is actively pursuing payment from one-third of the population that owes taxes and hasn't paid. Another one-third is in an arrangement with the IRS to pay or defer payment. And the IRS is not pursuing the remaining third.
The IRS isn't going to stop collecting taxes. In fact, with more electronic features such as DirectPay, the Online Payment Arrangement tool, and the "balance due" online look-up tool, the IRS is more active than ever in using technology and alternative means to collect tax liabilities, including the recent reintroduction of third-party tax collectors after Congress enacted legislation requiring it.
6. The IRS audits only 0.8% of returns, but that doesn't include automated information-matching.
In 2015, the IRS conducted 1.3 million audits. Three out of four audits were correspondence audits, which are conducted by mail and are less intrusive than IRS office and field audits. The IRS focuses its mail audits mainly on protecting refunds for refundable credits, such as the earned income tax credit and the additional child tax credit. Overall, IRS audits are rare; the Service audits less than 1% of returns.
But for taxpayers, that number isn't always comforting. That's because of another IRS program—the automated underreporter program (also called Notice CP2000, Automated Underreporter notice), which looks and feels much like an audit. The IRS sends CP2000 notices to question tax returns that don't match income information the IRS has on file. Taxpayers should always respond to these notices within the time provided in the letter, and, if the information the IRS is reporting is incorrect, notify the Service of that fact.
Although CP2000s are not technically audits, the consequences feel the same to clients: more tax assessments and penalties for underreporting income. This program is popular at the IRS, because it reaches taxpayers with an automated, less costly approach. The IRS sent 1.1 million CP2000 notices in 2001 and increased that number to the program's height of 4.7 million notices in 2011.
In the future, rather than relying on expensive audits, the IRS will most likely increase its use of automated information-matching programs to compel taxpayers to report all of their income.
7. Twenty-four million Forms 1040 don't report all information statements on the return.
Back to CP2000s again. When the IRS analyzes tax returns against the 2.6 billion information statements it has on file, the IRS finds more than 24 million returns that don't report all income.
Because of resource constraints, the IRS limits CP2000 inquiries to the returns with the highest potential adjustments. In 2015, the IRS sent only 3.7 million CP2000 notices (out of 24 million mismatches). The IRS has also tried "soft notice" programs (using CP 2057, which instructs taxpayers who may have underreported income to file amended returns) in the past to prompt taxpayers to correct their returns. Future electronic accounts can enable the IRS to prompt and allow taxpayers to quickly correct their returns. This is the ultimate "soft compliance" solution.
Practice tip: Taxpayers and their advisers should make sure to report all Forms W-2 and 1099 to avoid IRS scrutiny. If you have a client with many information statements, consider ordering an IRS wage and income transcript in May of each year and matching it to the filed return. If you find unreported income, file an amended return before the IRS issues a CP2000 notice with potential accuracy penalties (20% addition to tax).
8. The IRS sends six times more notices per year than it did in 2001.
Considering that the IRS workforce has decreased 33% since 1995–-the kinder, gentler IRS realized long ago that it is cost-effective to contact more taxpayers through notices, rather than expensive, time-consuming audits. Mail audits take the IRS about one hour to complete, compared with 22 hours for a field audit.
This strategy of using mail audits more than field audits has propped up the IRS audit rate. In 1995, almost half of all audits were office and field exams. Now, the IRS conducts three out of four audits by mail. The IRS is not close to the number of audits it conducted in 1995 (2.1 million). But, in 2015, the IRS used its mail audit program to examine almost one million tax returns.
9. The IRS issues 40 million penalties to 27 million taxpayers every year.
The IRS uses penalties to enforce noncompliance. For individuals, the most common penalties are:
- Failure to pay (56%)
- Estimated tax (30%)
- Failure to file (10%)
Although the accuracy-related penalty isn't one of the most common (only 2%), it demonstrates an important fact: During the past 10 years, the IRS has increased its use of individual accuracy-related penalties by 948%. This shows how serious the IRS is about enforcing underreporting on tax returns.
10. Schedule C filers underreport their income by 57%.
This statistic worries the IRS. The 28 million small businesses in the United States—and especially those with cash-intensive operations—contribute the most to the tax gap every year. With IRS field audit resources on the decline for the past five years, the IRS is doing its best to contact more of these businesses through automated matching, including information from third-party payment processors, with Form 1099-K, Payment Card and Third-party Network Transactions. If the IRS gets any increased enforcement budget, the IRS will likely invest in small business audits first.
You can help your clients with IRS enforcement actions
Don't let the decreasing IRS budget and audit rate fool you. In the near future, the IRS will continue to improve its capabilities to contact more taxpayers to try to close the tax gap and increase compliance.
How can you help your clients? You can be there when they need you. About 57% of taxpayers use a tax professional each year to file. Each year, taxpayers file only about 3.6 million third-party authorizations (Forms 2848, Power of Attorney and Declaration of Representative, 8821, Tax Information Authorization, or 8655, Reporting Agent Authorization), authorizing their tax professionals to communicate with the IRS or solve other issues on their behalf. With 192 million individual, business, and specialty tax returns filed annually, there's ample opportunity for tax professionals to better help clients all year long.
Tax professionals shouldn't let their guard down. Clients still need you after they file, because the IRS is still very much in the compliance business, as the 10 facts above demonstrate.
Jim Buttonow, CPA/CITP, directs tax practice and procedure product development for H&R Block. He has more than 28 years of experience in IRS practice and procedure. To comment on this article, contact Chris Baysden, senior manager of newsletters at the AICPA.