The IRS’s Plan To Enhance Compliance

The Internal Revenue Code is predicated on a system of “voluntary compliance.” Historically, the Internal Revenue Service and the Tax Division of the Department of Justice have encouraged “voluntary compliance” through civil and criminal enforcement programs, and have publicized those efforts in the weeks leading up to April 15 (a/k/a “Tax Day”).

For years, however, the IRS has operated under significant budgetary constraints, which have resulted in a substantial reduction of the Service’s workforce. According to the IRS’s 2022 Data Book, on September 30, 2022 (i.e., the last day of fiscal 2022), the IRS had a total of 84,553 employees, which included 16,158 customer service representatives, 8,307 revenue agents (who conduct civil audits), and 2,074 special agents (who conduct criminal investigations). This reflects considerable attrition over the last dozen years: on September 30, 2010, the Service had a total of 94,346 employees, including 21,057 customer service representatives, 14,588 revenue agents, and 2,751 special agents.

Unsurprisingly, the decline in personnel has resulted in a substantial drop in civil and criminal enforcement activity. The 2022 Data Book reports that as of September 30, 2022, the IRS had audited 0.2% of the approximately 164.5 million individual income tax returns filed during calendar 2020. By contrast, tables included in the 2020 Data Book disclose that 1.0% of the 143.1 million individual income tax returns filed in 2010 were audited. Data relating to criminal investigations tells a similar story: during fiscal 2010, IRS-CI opened a total of 4,706 investigations and referred 3,034 matters for prosecution; by fiscal 2022, those figures had plummeted to 2,558 criminal investigations initiated and 1,837 referrals for prosecution.

The decline in enforcement activity almost certainly contributed to an increase in the “tax gap,” which attempts to measure the difference between taxes that are owed and taxes that are paid voluntarily and on time. Last fall, the IRS estimated that the annual gross tax gap had risen from $438 billion for 2011-2013 to $496 billion for 2014-2016.

In an effort to reverse these trends, last August, when Congress passed the Inflation Reduction Act of 2022 (the “IRA”), it included almost $80 billion in additional funding for the IRS over the next ten years. While the Congressional Research Service noted that $45.6 billion of these funds were to be devoted to tax enforcement, $25.3 billion for operating expenses, and $3.2 billion to improve taxpayer services, the details regarding how the funds would be spent were left to the IRS. Earlier this month newly confirmed IRS Commissioner Danny Werfel issued the long-awaited Inflation Reduction Act Strategic Operating Plan (the “Plan”), which describes how the Service proposes to spend its new funding. The 150-page Plan identifies five objectives for transforming the IRS through both enhanced customer service and increased enforcement targeted at “taxpayers with complex tax filings and high-dollar noncompliance.”

The first two objectives identified in the Plan are aimed at increasing compliance by “mak[ing] it easier for taxpayers to meet their tax responsibilities and receive tax incentives for which they are eligible” and “dedicat[ing] more resources to helping taxpayers get it right the first time.” In this regard, the Plan proposes to improve customer service by hiring more employees who will be available to answer taxpayer questions as early as this year. More importantly, the Plan envisions updating the IRS’s antiquated technology and anticipates that technological improvements will enable taxpayers to “access [ ] their relevant account data, as well as information to help them meet their tax obligations,” “identify credits and deductions for which they are eligible,” “understand and claim appropriate credits and deductions,” and experience “real-time status updates on returns, refunds, and other IRS processes and decisions.” The IRS expects that by providing these services through updated technology and systems, more IRS employees will be available to focus on complex tax filings that require individual attention.

After describing the initiatives aimed at improving customer service, the Plan recognizes that “[e]ven with improved taxpayer service, some taxpayers will not comply” and acknowledges that “[t]he rising breadth and complexity of tax administration, coupled with the sophisticated ways that some taxpayers attempt to evade tax, have outpaced [the IRS’s] resources and ability to monitor compliance and close the gap between taxes owed and collected.” In remarks accompanying the release of the Plan, Commissioner Werfel explained that the long-term reduction in staffing and resources negatively affected the IRS’s ability to maintain sufficient audit coverage of wealthy individuals, large corporations and big partnerships. Noting the exponential increase in returns filed by these groups as well as the complexity of their returns, Commissioner Werfel further emphasized that “it makes sense to focus [the Service’s initial IRA] implementation efforts exclusively on increasing our capacity to assess compliance of high-income and high-wealth individuals, complex partnerships, and large corporations.”

Perhaps in response to concerns raised by some politicians and commentators that the IRS would use the funds allocated under the IRA to hire gun-toting agents who would hound ordinary Americans, Secretary Yellen committed “that audit rates will not rise relative to recent years for households making under $400,000 annually.” This commitment is reflected in the Plan and Commissioner Werfel has made clear that the IRS will use the funds devoted to increasing enforcement to hire accountants, attorneys, and data scientists who will focus on high-net-worth individuals, large corporations, complex partnerships, and other groups that historically have had low audit rates relative to other groups due to the greater complexity of their filings.

The Plan envisions that “the first wave” of new enforcement personnel will be hired and onboarded this fiscal year and that, during fiscal 2024, the IRS will develop proposals to change its organizational structure and establish a “[c]entralized compliance planning and strategy function” aimed at “identify[ing] potential high-risk compliance cases using existing systems and analytics.” Ultimately, the Plan envisions “enforcement and risk identification through better use of data analytics, technology, and centralized operations” and “increas[ing] the expertise and capacity necessary to examine highly complex returns and issues more effectively.”

While the Plan reflects an ambitious effort to reform the IRS, it depends on executing a fifth initiative: “[a]ttract[ing], retain[ing], and empower[ing] a highly skilled, diverse workforce and develop[ing] a culture that is better equipped to deliver results for taxpayers.” It remains to be seen whether the Service will, in fact, be able to hire, onboard, and train personnel with the qualifications necessary to examine the most complex tax returns. Indeed, as I previously noted (here and here), between the need to take experienced agents offline to train new hires and the likelihood that attrition will outstrip new hires, it is questionable whether the advances envisioned through new hires will be realized within the time frame anticipated in the Plan.

Finally, the Plan is contingent on Congress not cutting the IRS’s annual budget. In a memorandum to Secretary Yellen that accompanied the Plan, Commissioner Werfel warned that “[a]ny reduction in annual discretionary funds – including not providing for inflationary increases to maintain current levels – will require IRA funding to be shifted to general operations,” which will undermine “the service, technology, and compliance initiatives envisioned to transform the IRS.” In light of recent history, it is hard to be optimistic that the incremental $80 billion provided for under the IRA will, in fact, remain sacrosanct, especially as House Speaker Kevin McCarthy has pledged to cut IRS funding. If past is prologue and Congress reverts to cutting the IRS’s budget as it did last fiscal year, Commissioner Werfel may well need to come up with a “Plan B”.

To read more from Jeremy H. Temkin, please visit www.maglaw.com. Emily Smit, an associate at the firm, assisted in the preparation of this blog.