In April 2023, the IRS received $80 Billion in a new budget as part of the Inflation Reduction Act. Recently, the agency revealed they’ll use some of those funds to hire thousands of agents to audit the filings of wealthy individuals and corporations to close “the tax gap.”
Let’s look closer at where these funds will go and what implications the changes may have for taxpayers and business owners.
Table of Contents
How Will the IRS Use the $80 Billion?
The agency released a breakdown of where they intend to spend the funds:
Roughly half will increase the frequency and depth of tax audits of high-net-worth (HNW) individuals to lower the deficit by eliminating accidental and intentional underpayment.
Additionally, the funding will be used to modernize and improve the customer service experience of all tax filers who interact with the IRS.
Who Will This Impact?
The IRS will only increase audit frequency for individuals or legal entities reporting over $400,000 in income annually. In 2020, only ~5% of individual income tax returns filed exceeded that threshold.
Everyone below $400,000 annually is at no greater risk of being audited than before.
“I’ve directed that enforcement resources will not be used to raise audit rates for households making under $400,000 a year relative to historical levels.”Treasury Secretary Janet Yellen, September 15, 2022
What Is the Tax Gap?
The tax gap is the difference between the total tax owed to the IRS if everyone paid what they were meant to pay and what is collected.
There are several reasons for the tax gap, from things as innocuous as accounting errors to more nefarious actions like tax fraud or tax evasion.
The IRS is targeting HNW individuals and businesses because this group of taxpayers is responsible for a disproportionate amount of the tax gap, according to public finance researchers Johns and Slemrod.
However, even though the IRS has significantly increased its budget, there are still limited resources. The IRS will focus on tax returns with the most significant impact. This doesn’t necessarily mean that those who are not HNW individuals will be excluded or ignored from additional IRS attention and scrutiny.
For example, indinero clients are mostly C-corporations with tax credits in research and development (R&D) and employee retention tax credits (ERTC). It’s worth noting that the IRS creates these and other credits to incentivize businesses to pursue activities that help the American economy. If our clients meet the eligibility criteria, they can claim these tax credits. The expertise of our accounting and tax teams can ensure that clients maintain accurate and well-documented records of their activities, expenses, and compliance with the respective tax credit requirements. This documentation will help support their claims in case of any IRS scrutiny.
|Income Percentile||Proportion of Tax Gap|
|0 through 95%||49%|
|95 through 100%||51%|
Source: University of Chicago
The rate of improper reporting is consistent across income groups, but because HNWs earn the lion’s share of income, they also pay the lion’s share of tax. When they make reporting errors, their contributions to the tax gap add up quickly.
Though the IRS received significant funds, they still need more resources to address the tax gap. Going forward, they’ll focus on tax returns likely to have the biggest impact.
“The IRS will closely examine credits like the R&D tax credit, which I call ‘Free Money,’ and focus on rule changes like the 2022 modifications to IRC 174 that can greatly affect a client’s taxes. To navigate these complex issues, you need an expert accounting and tax team like Indinero.”Brian Miller, Tax Director
How Will the IRS Increase Enforcement?
The $80B funding increase represents an over 50% jump in IRS resources. They’ll be using $47.4B to:
- Improve data analytics technology for flagging potentially incorrect returns
- Hire additional agents to process audits
- Focus on partnerships, large corporations, and HNW estate transfers
- Focus on corporate credits such as the R&D tax credit, Earned Income Tax Credits
- The enforcement will also focus on areas where the Internal Revenue Code (IRC) changed, such as IRC Section 174, which beginning in 2022, requires businesses to capitalize their expenses related to research and development and amortize them over 5 or 15 years rather than expensing in the year occurred.
|(Warning) The IRS Charges Fees for Underpayment |
The IRS looks for tax returns with significant underpayment, either from negligence or accident. The penalties and interest can be as high as 20% of the underpayment. You can learn more about the penalties here.
What Can HNW Taxpayers Do?
First, it’s wise to review any tax returns that fall under the IRS’ statute of limitations, which in most cases is about three years from the date a return was due. However, there are some exceptions to that rule:
- The statute of limitations only begins once a tax return is filed. If you never filed a return, the IRS could audit you for that year, no matter how long ago.
- The IRS stipulates that audits can go as far back as six years if they identify a “substantial error” in a tax return.
Books going back that far must be accurate to protect yourself. Proper documentation of all tax deductions and expenses and avoiding the commingling of personal and business funds are the two most important things to the IRS.
Why Is This Happening?
In a word: Understaffing.
Between 2010 and 2020, the IRS employed ~95,000 full-time workers. As of the passage of the Inflation Reduction Act, that number had fallen to ~80,000 despite the number of filers continuing to grow with the population.
Consequently, according to IRS Commissioner Danny Werfel, the agency reported abysmal customer service statics in 2022: There was an average 27-minute wait for people who called the IRS for help, and just 17% of phone calls were answered.
On top of this, HNW filings are particularly complex. Per its April 2023 press release, the IRS has just 2,600 employees managing 30,000 HNW individuals, 60,000 corporations, and 300,000 partnership filings.
Due to that imbalance, the IRS collects only 85% of taxes due annually. The missing 15% is the “tax gap,” which amounts to ~$500B annually. That’s a lot of money to be leaving on the table for the IRS, especially while we run the deficits we do.
When Is This Happening?
Support staff have already been hired and are reducing wait times this tax season. Commissioner Werfel reported that ~85% of calls are being answered in 2023, compared to ~17% in April 2022.
Audit data for 2023 still needs to be published. That said, the IRS reported the following audit frequencies broken down by income ranges: For earners above $400,000 per year, these frequencies are set to increase dramatically, while those below will stay the same.
|Annual Income ($)||Audit Rate (%)|
|1 – 25,000||0.4|
|25,000 – 50,000||0.2|
|50,000 – 75,000||0.2|
|75,000 – 100,000||0.2|
|100,000 – 200,000||0.2|
|200,000 – 500,000||0.2|
|500,000 – 1,000,000||0.6|
|1,000,000 – 5,000,000||1.3|
|5,000,000 – 10,000,000||2.0|
Audit frequency is about to be increased for HNW individuals and their companies. If you earn over $400,000, keeping your books organized and accurate is more important than ever.
To proactively protect yourself, contact an indinero business tax services professional today.