When the Inflation Reduction Act of 2022 (IRA 2022) was passed in August 2022, the majority of the additional $80 billion in IRS funding was earmarked for increased IRS enforcement to close the ever-growing annual tax gap. IRA 2022 funding has been reduced to $57.8 billion, but $24 billion is still set for increased IRS enforcement.
The tax gap, as of 2021, was $688 billion a year. The biggest area of non-compliance is underreporting – that is, taxpayers filing inaccurate tax returns. Underreporting accounts for $542 billion, or 79%, of the tax gap each year. The IRS combats underreporting non-compliance mostly with audits and income matching notices (known as CP2000 notices where the IRS compares information returns such as Forms W-2 and 1099 and compares them to your filed tax return for underreporting).
The rationale for the IRA 2022 additional IRS funding was that there was a clear return-on-investment for funding the IRS to modernize and to increase enforcement of the tax laws. In February 2024, the IRS provided updated data that showed it can substantially reduce the tax gap by collecting an additional $851 billion over 10 years (2023-2032) with the additional IRA 2022 funding. In short, IRA 2022 funding is a good investment for the US Treasury.
To get to the projected gains from enforcement, the IRS must target the areas with the greatest non-compliance. To that end, the IRS has announced that they will mainly target the most complex taxpayers in an effort to close the tax gap. These targets include wealthy individual taxpayers, complex partnerships, and large corporations. It also includes targeting certain transactions such as offshore arrangements and cryptocurrency non-compliance.
With additional funding, the IRS must reverse years of degrading compliance enforcement. IRS audit rates have plummeted in the last 12 years due to decreased IRS resources. The limited IRS resources in the past 12 years have not been used to audit taxpayers- as evidenced by the decreasing IRS audit rates.
In 2023, on average, approximately 1 out of every 312 taxpayers were audited by the IRS.
Two Obstacles to Closing the Tax Gap
The IRS has been explicit in its early strategy and targets to close the tax gap: audit the wealthy and the complex. US Treasury data supports targeting wealthy – with the Top 10% income earners accounting for almost 2/3rds of the underreporting tax gap. But, like the overall audit rate, the audit rates for the wealthy and large corporations have also plummeted since 2010.
To this end, the IRS auditing function (IRS calls its audit function the “Examination” function) needs to be rebuilt after 12 years of gradual losses to its ability to audit complex taxpayers. The IRS targets require the IRS to greatly increase the number of its “revenue agents” to do complex audits. Revenue agents have the background, education, and training and are the only IRS personnel qualified to the most complicated of audits, including high-income, corporations, employment, and other specialty tax areas such as pension plans and trusts. In short, they are accountants with accounting degrees and/or specialized tax knowledge, capable of auditing the most complex taxpayers.
The first obstacle to the IRS strategy of increasing its ability to do complex audits is the inability to hire enough revenue agents. As of 10/3/2023, the IRS had 8,559 revenue agents and planned to hire 5,814 new revenue agents. Net of attrition, the IRS planned to increase its revenue agents by 4,704 or by 55%.
This is a VERY heavy lift for any tax provider – including the IRS. Many accounting firms have had great difficulty in hiring accountants to grow their firms. The IRS is no different.
As of 3/31/2024, the IRS did not increase the number of revenue agents. In fact, the number of revenue agents were reduced to 8,317 – a decrease of 3%. This is clearly going in the wrong direction if the IRS plans to close the tax gap. The IRS restated its hiring goals as of 1/27/2024. The IRS still plans to hire 4,663 new revenue agents and increase its rolls by 4,041 by 9/30/2024 (the IRS’ fiscal year end).
Even this new goal will be an extremely heavy lift for the IRS – as it would be for most accounting and tax firms. The IRS must compete with private accounting firms and industry for a limited supply of accountants.
If the hiring conundrum was not a big enough obstacle, there is a second obstacle that may delay IRS compliance efforts for years: the Employee Retention Credit.
The Employee Retention Credit (ERC) has been a headache for the IRS since Congress passed it during the early days of the pandemic. The ERC provides eligible employers with a lucrative refundable tax credit if they had employees and were affected by the COVID-19 pandemic. However, the IRS believes that many of these applications are not correct – and may even be fraudulent. The big problem is that, as of June 2024, there are 1.4 million outstanding ERC claims and growing that have gone unpaid – and the IRS believes that approximately 80% are questionable AND require more attention. 80% of these credits is over 1 million claims—and growing.
The ERC obstacle is linked to the “revenue agent” hiring conundrum. The IRS must decide on each of the ERC claims and there appears to be 3 options within the IRS’ authority: allow the ERC claim, disallow the ERC claim without audit, or audit the claim for accuracy.
The IRS appears not to be inclined to summarily allow the questionable claims. They have sent some taxpayers notices of claim disallowance (IRS Letter 105C) without an audit or request for more information. But most of the ERC claims appear to warrant an “audit” according to the IRS before they are allowed. This means the IRS must audit the purported around 1 million questionable ERC claims before they are paid. ERC claims are “employment tax” audits – and must be done by IRS revenue agents who are trained in employment tax rules and procedures. Very few IRS revenue agents (likely in the hundreds, not thousands) are “employment tax agents.” Even if the entire current revenue agent personnel dropped all of their current audits and were trained and assigned to ERC employment tax audits, it would take at least 7 years to audit and complete the current ERC inventory (note, as a rough comparison, in 2023, around 8,000-9,000 IRS revenue agents and office auditors could complete 132,587 office and field examinations. 1 million audits would take 7-8 years to complete if ALL of the current office and field audit resources were used only on ERC audits).
In short, the IRS cannot audit their way out of the ERC issue. They have tried to reduce the obvious erroneous claims by providing voluntary withdrawal programs asking taxpayers to withdraw their claims. But, as of June 2024, the IRS only received 4,800 withdrawals. The IRS claims that “thousands of audits” are underway. The “thousands” would only be a small “tip of the iceberg” given that the current questionable ERC claims count is at 1 million, and ERC claims are growing by 17,000 a week according to the IRS.
Using the limited IRS audit resources to expand ERC audits will hinder the IRS’ ability to target existing identified non-compliance areas. Reallocating the limited revenue agents to audit ERC claims instead of auditing the wealthy and complex may defer most of the published enforcement benefits of IRA 2022.
What’s Next?
IRA 2022 funding has given the IRS unprecedented funding to close the tax gap. The data shows that to close the tax gap the IRS needs to focus on underreporting by increasing audits in areas of significant non-compliance that has been diminishing for over a decade.
To meet the return-on-investment goals and projections that were most of the basis for the added funding, the IRS must solve two critical issues: hiring revenue agents and getting the ERC claims behind them. The ability to increase complex audits will be hindered until both obstacles are resolved.
To increase their audit capacity, the IRS may have to think “outside-the-box.” The IRS may have to move away from its traditional methods of auditing tax returns and processing claims to overcome these obstacles. The IRS could relook at the way it does audits to increase the audit rate. For example, the IRS could look to improve revenue agent capacity by supporting its revenue agents with administrative personnel that could help them with many administrative tasks involved in audits. The IRS has used audit aides and tax examiners in the past in its team audits and could extend learning and development opportunities to personnel that are not revenue agents.
The IRS could also innovate. With IRA 2022 funding, the IRS is already working on modernizing some of its case management systems. The IRS could accelerate the use of technology solutions in its audit function. The IRS is already exploring using artificial intelligence in the audit selection process to focus its resources on the most non-compliant areas.
The ERC obstacle appears to be much more daunting for the IRS to solve. The IRS has already asked Congress for help with the ERC. However, little help appears to be on the way. Voluntary withdrawal and disclosure programs seem to have little effect on reducing the volume of unresolved ERC claims. The data shows that the IRS cannot use audits to resolve all the claims – there is simply not enough audit resources to resolve ERC through audits. More delays from the IRS may lead to even more resource issues as taxpayers may clog the courts with ERC claim for refund suits. A flood of claim for refund suits will fall back on IRS audit and support resources to resolve- and further impede its ability to increase audit coverage on IRS targeted areas of non-compliance. As of the IRS press release on June 20, 2024, the IRS has not found a workable solution. The IRS will likely need legislative help or it must concede on many of the claims to reduce the volume of claims.
IRS officials have their work cut out for them. If they do not resolve the hiring and ERC obstacles, the US Treasury may not see the benefits of the IRA 2022 funding.