Investor Alert

June 19, 2020, 3:03 p.m. EDT

The Tax Audit Paradox

Early in his career as a tax specialist at Fiduciary Trust Company, Craig Richards spent a lot of time working with clients to get through rigorous in-person audits by the Internal Revenue Service. “We were located down at the World Trade Center then, and the IRS office was up the street—I was there quite a bit,” says Richards, a managing director and director of tax services at the firm.

Times have changed.

Deep, invasive audits have declined sharply over the past decade—even for wealthy families—as the IRS’ budget has been steadily chiseled, squeezing resources and staff. Between 2010 and 2018, the agency’s funding fell by about 20%, and the overall audit rate for individual tax returns dropped 47% from 1.1% to 0.6%, according to the Tax Policy Center. For the wealthiest group—those with $10 million or more in income—the audit rate fell 64% from 18.4% to 6.7%.

But don’t get complacent. Audit numbers are down, but technology has vastly improved the IRS’ ability to ferret out tax cheats or errors in returns, says Shannon Smith , a partner and tax attorney at Withersworldwide. And for wealthy taxpayers, the agency is focusing resources in areas where it believes it will get the best return on efforts.

In March, the IRS announced it was extending the tax filing deadline to July 15 because of the Covid-19 crisis. But it noted: “Field revenue officers will continue to pursue high-income nonfilers and perform other similar activities where warranted.”

It’s no surprise the IRS doesn’t want to let up pressure. The total tax gap—estimated taxes owed, but unpaid—was $600 billion in the last fiscal year, according to the Brookings Institution. That’s 60% of the U.S. military budget. Past studies show that high-income taxpayers account for about two-thirds of the problem.

Topic-Specific Crackdowns

To maximize results on compliance efforts among the wealthy, the IRS flexes its muscles on particular trouble spots.

The most notable recent example is the crackdown on taxpayers who fail to report foreign income. Between 2009 and 2018, it offered voluntary compliance periods during which taxpayers were promised no criminal charges if they came clean. Around 54,000 taxpayers came forward, paying $11.1 billion.

Recent efforts have homed in on crypto-currency trading and micro-captive insurance. Last year, the IRS sent compliance notices to 10,000 taxpayers—likely surprising many who believed their trades were opaque.

Technology Picks Up Some Slack

Tax underpayments are often found these days through data mining technology—systems that access data, then match the data to tax returns. The systems flag a return if, say, the capital gains reported on a stock sale doesn’t match the gains reported by the brokerage firm that processed the transaction. The data matching often finds discrepancies, generates a notice to a taxpayer to pay to square up their affairs.

Battling a compliance problem with too few resources, the IRS caught a break with the Tax Cuts and Jobs Act, which went into effect in 2018 and tightened the screws on deductions, reducing the possibility to manipulate tax bills.

For example, deductions for property taxes and state and local income taxes are capped at $10,000 under the law. “The IRS doesn’t have to sort out whether a property tax deduction matches all real estate taxes for all of someone’s properties—you only get to claim $10,000,” Richards says.

But it’s a small victory given the massive task of putting the tax act into effect.

The challenge to do more with less is ongoing and massive. Unscrupulous taxpayers may see this as an opportunity to stay under the radar. Think again. A frustrated, resource-starved agency is unlikely to be in a compromising mood with taxpayers in its crosshairs.

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