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What the IRS Isn’t Telling You or Your Clients

May 18th 2018
CEO TaxAudit
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The true IRS audit rate is higher than you think. Every year the IRS tells Americans the audit rate in the U.S. is “low and getting lower,” but they’re not telling taxpayers the entire truth.

It is for this reason that your clients are showing up in your office under the impression that their chances of being audited are far lower than is true. The IRS claimed in their most recent published audit rate statement, the 2017 Internal Revenue Data Book, that the audit rate for fiscal year 2017 was a mere 0.5%. What the IRS fails to mention is their narrow definition of what constitutes an audit.

According to the IRS, roughly one million taxpayers are audited every year (aka a “real” audit). But as tax professionals, we know the IRS will never tell a taxpayer in a written notice that they are being “audited.” Instead, the IRS uses the word “examination.”

The reality is an “examination” is an audit. An examination includes three categories of IRS compliance: correspondence audits, office audits, and field audits. However, this way of classifying misrepresents the “true” audit rate because the rate cited by the IRS only includes activities which are on the decline, but not any of the other types of correspondence the IRS sends out that are not categorized as examinations.

If you include in the audit rate all of these other compliance activities like Automated Underreporter (AUR) notices, math error notices, and identity and wage verification notices, the number jumps up to roughly 6.3 percent, affecting 9.1 million taxpayers according to the most recent available data from 2016. Taxpayers need to know what the true audit rate is, so they don’t underestimate the likelihood of having an experience that feels just like being audited – and blame you.

This is something we have known for years, but haven’t seen concrete data released to the public until Nina Olson, Taxpayer Advocate at the IRS, released her annual report to Congress earlier this year. Now the fault doesn’t lie solely with the IRS – what you get out of the IRS is a direct result of how well they are funded.

In fiscal year 2017, for example, the agency spent $4.7 billion on enforcement activities. During that same period, $28.99 billion was assessed as a result of enforcement activities. This is a return of $6.16 for each dollar invested in enforcement. In other words, IRS enforcement is turning an 84 percent profit!

But despite the IRS being the only government agency capable of making a profit, it is currently understaffed and underfunded due to repeated budget cuts. In fact, the budget was effectively slashed again as part of the 2018 spending legislation passed in March.

Even though the IRS received a small increase, after reducing the additional funding to support the daunting number of additional tasks and changes resulting from the Tax Cut and Jobs Act of 2017, enforcement and customer service activities received less funding.

The result of these budget cuts is that the IRS is conducting fewer and fewer office and field audits, and instead relying greatly on compliance activities other than audits. Plus, face-to-face audits cost too much money.

In fiscal year 2017, the IRS audited almost 1.1 million tax returns, down from 1.7 million audits in fiscal year 2011. But if they had examined 500,000 more returns, the IRS would have assessed $13 billion, all for a nominal investment of $2 billion. To put it another way, our government threw away $11 billion, presumably to punish the IRS as the IRS is a popular target.

In fiscal year 2017, the IRS collected more than $3.4 trillion, while total operating costs were $11.5 billion. This is a collection cost of 3.4 percent, which is roughly the equivalent to the merchant discount fee on an AMEX charge.

American Express is a hugely profitable business, so what is Congress thinking? We are all afraid of being audited, but we are only hurting ourselves when we underfund the IRS. Tax law compliance is required for a voluntary tax system to be effective.

In her annual report, Olson lists the problem of “real” versus “unreal” audits as one of the “most serious problems encountered by taxpayers.” Not only does the IRS misrepresent audit rates, she says, but this approach to categorization also leads to false data that audit rates are declining, when in fact compliance activities overall have been increasing every year.

The IRS is, just like any other enterprise in the country, working towards automating as much as possible. This has resulted in a significant increase in “unreal” audits but their digital systems are so archaic and inefficient that the taxpaying public is made to suffer with extended response time and “unreal audits” that are based on incorrect or incomplete data.

The problem is not only that the IRS misrepresents audit rates. Due to the way the agency narrowly defines audits, the rights granted to taxpayers under examination are not extended to those who are called upon to respond to numerous other types of inquiries.

For “unreal audits,” certain rights, like appeals or protections against repeat examinations, are not available to these taxpayers by statute. Moreover, these “unreal audits” can and often do turn into “real audits,” while the category of the contact remains the same for statistical purposes and the associated rights are not extended.

Americans are already anxious enough when it comes to the IRS, with 47 percent stating they feel anxious when they receive any correspondence from the IRS according to a recent survey we conducted of roughly 2,500 taxpayers. In addition, our survey found 46 percent confessed to not knowing the difference between a notice from the IRS and an actual audit letter. With the lack of transparency from the IRS, it’s no wonder Americans are confused and anxious.

The introduction of the new tax law isn’t helping the confusion either with 77 percent of Americans confused by the new law. This is the most radical change we’ve seen to tax legislation in over 30 years. It’s likely that more taxpayers than ever will have mistakes on their tax returns in the coming years that will trigger some type of IRS contact.

The false sense of security the official IRS audit rates encourage, coupled with the fact that the IRS has plans to increase its automated compliance activities, means that many more of our clients will be blindsided by IRS letters and at risk of being deprived of their rights. As tax professionals under Circular 230 we must not, in evaluating a Federal tax matter, encourage a client to take a position based on the likelihood that they will not be audited on that matter.

We also need to be aware of the limits of our authority to represent taxpayers before the IRS. Currently, less than half of those who hold a PTIN are attorneys, CPAs or enrolled agents with the required authority. The IRS’s misleading audit information, audit categorization approach, and inability to extend the appropriate rights to nontraditional audit contacts needs to change.

The IRS needs to accurately report the audit rates to taxpayers so they know their risk, and we need to communicate those audit rates to our clients. And just as important, the IRS desperately needs to see an increase in funding because of so much money being lost by their chronic underfunding by Congress.

None of us can escape paying taxes no matter how much we wish we could.

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