IRS sets its sights on tax avoidance by the super-rich and corporations

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In 2010, Forbes magazine counted 403 billionaires in the US on its annual rich list. This year, there were 735, a four-fifths increase. Yet the number of inspectors employed by the Internal Revenue Service to audit complex tax returns — the kind filed by the ultra-wealthy and corporations — has fallen by almost half over the same period to around 2,600. In the cat-and-mouse game of US tax compliance, the mice have had the run of the place.

The “defund the IRS” strategy pursued by Republicans in Congress over more than a decade has had damaging effects on two fronts: most obviously, on the agency’s customer service, which accountants during tax season will tell you is appalling, but also on its ability to conduct complex audits.

However this ought to change with an infusion of new funding for the IRS, totalling $80bn over the next decade, thanks to the Inflation Reduction Act signed by President Joe Biden last year. That compares with a $14.3bn annual budget last year. The cat just got a lot of cream.

More than half the money has been earmarked for enforcement and, if there was any doubt about the agency’s game plan, it was dispelled with the publication in April of a new operating strategy and the installation of a feisty new commissioner, Danny Werfel — a high-flying bureaucrat under previous administrations who has been called back from the private sector after a stint as a management consultant.

“We will focus the IRA enforcement resources on hiring the accountants, attorneys, engineers, economists and data scientists needed to pursue high-income and high-wealth individuals, complex partnerships, and large corporations that are not paying the taxes they owe,” Werfel said on publication of the new strategy.

In 2019, the IRS said, just 0.7 per cent of taxpayers earning $1mn or more were subject to an audit, a figure that had slumped from 7.2 per cent in 2011. It simply hasn’t had enough people with the level of expertise required to go in and root out dubious tax accounting, let alone to fight with the battalion of advisers and attorneys that the rich inevitably bring to bear when they are challenged.

And the quantity and length of tax returns has only increased while the cat has been sleeping. The ballooning number of partnerships, used by small and not-so-small business owners and investors to avoid the double taxation associated with traditional corporations, is one area where the IRS has fallen far behind.

Audits matter. They extract more money to fund the federal government, limiting the need to increase taxes on everyone. In the fiscal year ended September 2022, the 708,309 audits that the IRS did finish resulted in $30.2bn in recommended additional tax. The $80bn in the Inflation Reduction Act for the IRS is not spending, it is investment. It will result in an extra $180bn in tax income over the decade, the Congressional Budget Office has forecast, defraying the cost of the green energy subsidies that were the centrepiece of the legislation.

Werfel signalled that audit rates will bounce back closer to historical levels, and the approach this time round will be significantly more sophisticated. His list of hiring targets hints at why. The engineers and data scientists that he wants to bring into the agency — and the $12.4bn of the $80bn allocated specifically to IT — should lift an effort to use machine learning and AI to detect patterns of tax evasion and fraud.

The IRS has built tools to link the different participants in business deals, for example, to see if they were used to dodge taxes, but it has previously had to lean on expensive outside vendors — such as Palantir — for assistance in fraud detection. Better centralised tools should also help focus audits on cases where recoveries of unpaid taxes are likely to be highest.

The step change in audit rates won’t happen overnight. Hiring and training the required numbers of inspectors will take several years. And while, all else being equal, the Inflation Reduction Act may end up doubling the IRS’s workforce, it is hardly the last word on money matters.

Wealthy taxpayers and their accountants have been playing fast and loose with the tax code, because they know they have little chance of being caught

Defunding the IRS has always been a way of defunding the government by stealth, which is why Republicans look set to continue to try to trim the agency’s sails. Revoking most of the additional funding is on a list of demands made by the Republican-led House of Representatives in talks on raising the federal debt ceiling. And there will always be haggling over the rest of the IRS budget, where annual increases could be held below the rate of inflation, at the very least.

But this is more likely to curtail customer service improvements for everyone than deter the IRS leadership from targeting tax avoidance by the wealthy.

The agency says that audit rates have “declined to levels that erode voluntary compliance”, which is a polite way of saying that wealthy taxpayers and their accountants have been playing fast and loose with the tax code, because they know they have little chance of being caught. That no longer looks a safe bet. The cat is no longer away, and the mice would be wise to play nice.

Stephen Foley is the US accounting editor. Follow him on Twitter @StephenFoley

This article is part of FT Wealth, a section providing in-depth coverage of philanthropy, entrepreneurs, family offices, as well as alternative and impact investment