IRS revenue agents are now spending substantially more of their time on corporate audits that produce no revenue for the government than they did in the recent past, according to agency data obtained under the Freedom of Information Act by the Transactional Records Access Clearinghouse (TRAC).
The year-to-year growth in nonproductive audit time — defined by the IRS as face-to-face examination hours that produced what it calls "no change" results — occurred for corporations in every asset class (see Figure 1).
The forty percent (40%) increase in the number of corporate audit hours that bore no fruit is troubling primarily because the misdirection of the agency's enforcement resources ultimately could weaken the long term interest of corporations in paying their taxes.
But IRS data tracking the outcomes by corporate size raise more focused concerns. One key finding was that the relative growth in these unproductive hours tended to rise as the size of the corporations increased. In the last five years, for example, the nonproductive audit time for the largest corporations — those with assets of $250 million or above — has more than doubled. See Figure 1 and supporting table.
Although audit dollar recommendations for the largest corporations increased substantially from fiscal years 2001 to 2005, they declined by about 15 percent, from $30.1 billion in 2005 to $25.5 billion last year, a drop of $4.6 billion in potential audit revenue. See Table 1. It should be recalled that historically the largest corporations produce the lion's share of all audit dollars.
The pattern of nonproductive auditor time increasing with the larger corporations is also puzzling. This is because the bigger the institution the more likely that the sheer volume and complexity of its business transactions will result in misreporting errors.
Explaining the Changes
The data presented in this analysis are not available in the IRS's annual report and the information about the across-the-board growth in the agency's nonproductive corporate audits has not been publicly discussed by the agency or Commissioner Mark W. Everson.
Instead, Everson has repeatedly emphasized his interest in effectively marshalling the powers of the IRS to assure that all American taxpayers, including corporations, pay their fair share of federal taxes. During a March 20 hearing before the House Ways and Means Oversight Subcommittee, for example, the commissioner said that improving corporate compliance is "a top priority of mine...." And, talking from his position as the head of one of America's largest enforcement agencies, he added that "we are doing our level best to improve compliance here."
As part of his prepared testimony during that same subcommittee hearing, the commissioner reported that "IRS enforcement efforts have increased in virtually every area." Concerning the agency's specific programs regarding corporations, Everson emphasized how the number of these audits have substantially increased and did not touch on the quality questions that have emerged from the internal administrative data analyzed by TRAC.
But the quality of the corporate audits has become an issue for the IRS in the last few months. In a meeting with the American Institute of Certified Public Accountants last fall, Deborah Nolan, Commissioner of the IRS's Large and Mid-Size Business Division, defended the agency's audit policies. According to Tax Notes, a leading trade publication, Nolan told the accountants that the service's emphasis on speeding up the audits — what she called the "currency and cycle time" effort — had been done "in a smart way, and all of our statistical indicators indicate that our agents made very sound decisions."
Some within the ranks of the IRS disagree with this judgment. On March 20, for example, The New York Times published an article which said that more than a dozen revenue agents — all speaking anonymously — had told the reporter that they had been pressured by their managers to close cases too quickly and that this could result in the loss of billions of dollars in unpaid taxes.
And in March 29 testimony before the House Appropriations Committee on Financial Services and General Government, Colleen M. Kelley, President of the National Treasury Employees Union, agreed. She said the pressure on the auditors that had been reported by the Times was not new, going back to a 2002 IRS policy called the Limited Issue Focused Examination (LIFE) process.
Kelley told the subcommittee that the union had "heard directly from a number of our members about the detrimental effect this policy has had not just on efforts to ensure corporations are in full compliance, but also how this misguided policy is damaging employee morale."
The goal of improving the effectiveness and fairness of the IRS is an extraordinarily challenging job and measuring the extent to which these efforts are achieved is difficult. On the efficiency side, for example, the commissioner has claimed many times that the increase in enforcement revenues collected by the IRS between FY 2002 and FY 2006 is one of the "most obvious measures" supporting his assessment about the agency's improving enforcement effort. But the Government Accountability Office, in its April report on the IRS, was less confident. The GAO acknowledged the recent increases in revenue collected as a result of the agency's enforcement programs. It added, however, that "enforcement continues to be included on our list of high-risk federal programs." The reason, according to the GAO, is the massive and persistent gap between federal taxes owed and federal taxes paid. According to the latest official estimate this so called "tax gap" is estimated to be over $300 billion.
Corporate Audits: Key Numbers
As noted above, the IRS data analyzed by TRAC indicates that the agency's overall effort to assure corporate compliance with the nation's tax laws and regulations is deteriorating. For example:
The agency data showing the growth in non-productive corporate audit hours is worrisome on a number of grounds.
The poor targeting suggested by these increases indicates the IRS is wasting more and more of the time of its revenue agents during a period when, because of limited resources, the agency is auditing many fewer corporate returns than it did only a decade ago. In fact, the overall corporate audit rate in 2006 (1.2%) was only half what it was in 1996 (2.4%).
In addition to documenting the growing number of missed opportunities to identity corporations who are not abiding by the tax laws, however, poor targeting also means that more and more taxpayers are unnecessarily burdened with the expense and bother of unneeded audits.
And, to the extent that superficial audits don't find errors, the core purpose of the overall program to deter corporate misreporting is undermined.
A wide range of tax experts, including the IRS Oversight Review Board, have expressed concerns that should the American people become convinced that taxpayers in general are not meeting their lawful obligations. That perception could result in a serious deterioration of the whole tax system.
IRS Commissioner Mark W. Everson made this point several years ago in a speech at the National Press Club in which he quoted Mortimer Caplin, the head of the IRS under John F. Kennedy. "Large and continued avoidance of taxes on the part of some has a steadily demoralizing effect on the compliance of others." Caplin said. Echoing the same concern, Everson then cited what he said had been described as a "culture of greed" that was "allowing large numbers of taxpayers to believe they really need not pay their full share." A key aspect of this drift, he continued, was that the accounting and legal professions "were tolerating an unprecedented and sad decline in professional ethics on the part of too many of their most respected members."
Individual Taxpayers and Correspondence Audits
For individual taxpayers, the reality is that the correspondence audit has become dominant and the long-dreaded face-to-face audit is disappearing from the American scene. In FY 2006, for example, more than three out of every four (77%) IRS tax audits were by correspondence.
Even this figure masks the real truth: when it reorganized five years ago, the IRS eliminated face-to-face audits for most taxpayers — even those at the top of the income ladder. This is because the IRS division set up to handle ordinary taxpayers, the Wage and Investment (W&I) Division, only does correspondence audits. It has no field auditors!
Those taxpayers who report business-type transactions — self-employment income on a Schedule C (business) or Schedule F (farm), file a Schedule E (supplemental income and loss) or Form 2106 (employee business expense) — still face traditional audits since only these taxpayers are handled by the Small Business and Self-Employed (SBSE) Division. But even for SBSE audits, last year most (60%) were by correspondence.
In addition, correspondence audits in the last few years have become the primary vehicle which generate additional recommended taxes from individual taxpayers. In fact, in FY 2006, 58% of the additional taxes recommended after the audits of individual taxpayers — some $7.6 billion — were from correspondence audits. Five years ago, only $1.3 billion were from correspondence. See Figure 3 and supporting table.
A key reason for this growth in revenue was a dramatic change in the IRS's enforcement strategy. Five years ago, partly because of a Congressional mandate, 61% of all correspondence audits focused on taxpayers with $25,000 or less in positive income and who had filed a short form. (Most of these audits were aimed at those reporting the earned income tax credit.) The startling result: the rate of IRS audits for poor people was higher than for high income taxpayers.
By FY 2006, correspondence audits for the low income group had been sharply reduced. Only 15% of correspondence audits still focused on these same low income taxpayers. Correspondence audits for higher income taxpayers more than tripled from levels five years earlier. One result: the additional taxes and penalties recommended by the IRS as result of correspondence audits has surged. Recommended additional taxes from taxpayers with income of $100,000 or more soared to over $4.5 billion from correspondence audits alone.
Note: The Treasury Inspector General for Tax Administration (TIGTA) recently issued a cautionary finding ("While Examinations of High-Income Taxpayers Have Increased, the Impact on Compliance May Be Limited") concerning the meaningfulness of such dollar figures. If the IRS receives no response to its "correspondence audit" including where its letter is returned because of an incorrect address, the taxpayer is presumed to owe the additional tax. This tended to inflate the numbers over what the IRS ultimately assessed or collected.
At the same time, in contrast with the IRS's declining ability to focus its auditors on those corporate returns most needing attention, the accuracy of the agency's targeting of correspondence audits for individual taxpayers, except for returns with farm income, has been showing small but systematic improvement for every examination class. Overall, 83 percent of all correspondence audits last year resulted in recommended tax change, up from 81 percent in FY 2001. See Figure 4 and supporting table.
For taxpayers with $100,000 or more total gross receipts from a business, improvements were more dramatic. In FY 2001, only 65 percent of correspondence audits resulted in a tax change. Last year, it was 88 percent. In terms of improvement in productive audits, this translates to a rate of improvement of 36 percent.
Targeting of correspondence audits for high income taxpayers with salary and investment income also improved in several ways. Last year 76 percent of correspondence audits resulted in a tax change, up from 65% in 2001 — a relative rate of improvement of 17 percent. The increase in the average tax adjustment recommended per audit was more dramatic — from $4,567 in FY 2001 to $31,912 last year.
Correspondence audits also take little time to complete. Last year, correspondence audits took on average only 1.4 auditor hours each, making them very cost effective.
Despite being cost effective and despite the clear improvements the IRS has made in this program, this enforcement technique is not a panacea. By its very nature, correspondence audits only can spot the problems evident from the information submitted by the taxpayers in their returns or from third-party information provided by employers, banks and other sources. As a result, other serious sources of tax under-reporting can escape detection.
Thus, while the value of correspondence audits is clear, face-to-face audits must continue to play a significant role to help ensure all — including taxpayers that happen to derive substantial income from sources not subject to information reporting — pay their proper share. Current IRS policies which eliminate face-to-face audits for large segments of taxpayers could prove in the end a risky strategy.