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By now if you watch the news you've probably heard about the budget increase for the IRS that is built into the Inflation Reduction Act. We've seen a lot of concern about this act from clients and other small business owners.
The headlines about 87,000 new auditors and the increase in audits for lower-income taxpayers have people concerned. Let's break down the facts so we can understand the potential implications of the act and leave the politics behind for a minute:
IT and Customer Service
The IRS budget is not just going toward auditors. It's reported that the treasury plans on using a portion of the funds to improve technology - which was blamed when the IRS shredded 30 million informational returns from a pandemic backlog.
A portion of the new hires are supposed to be customer service and IT staff - not auditors. This should help address the inability of current staff to handle call volumes. Hopefully allowing the IRS to stop cutting off incoming callers daily when call volume becomes too large for them to handle. As the IRS operates now even the priority line for tax practitioners is shut down throughout the day when the call volume becomes too much for the IRS to handle. We're not even given the option to stay on hold or have a call back when staff is available.
Startling Job Listings
A job listing for IRS staff has been circulating on social media that contains requirements of the candidate being able to legally carry a firearm and be willing to use deadly force if necessary. This caused some questions about why the IRS would be recruiting for a position that requires the potential use of deadly force. A lot of people don't realize that this is not a listing for a typical IRS auditor, this is a listing for an agent in the criminal investigation unit of the IRS. These agents investigate criminal activity that are tied to tax fraud/evasion. Historically the IRS has been paramount in uncovering larger criminal activity such as drug trafficking - including Pablo Escobar and Al Capone. The agents placed on these cases naturally have to have a different skill set than agents auditing your regular small business. This listing does not point to a new more aggressive set of auditors for the IRS, this unit of the IRS has been around as have its armed agents.
The BIG Question - Will Audits Increase?
Finally the big issue/debate. There seems to be a lot of confusion on what hiring additional auditors would do in terms of targeting small businesses and lower-income taxpayers. We've seen claims that the increase in auditors will not result in an increased incidence of audits on low-income taxpayers. And we've seen claims that the increase in auditors is going to target low-income taxpayers. To understand the implications of adding more auditors we need to understand how the IRS actually selects returns for audits.
The IRS has a computer system that goes through the returns and identifies returns with a high chance of collecting more tax. The specific algorithms behind this system are not known - the IRS does not release information on this system. However, the IRS does claim that the auditing and collecting side of the IRS does base their decisions to pursue a return that has been flagged by this system on the amount of effort that the IRS staff will have to put forth and the amount of potential return for this effort. In other words, the IRS attempts to run this part of their agency as a business, it makes no sense to spend $1,000 to collect $100. So the IRS will target easily enforceable discrepancies and large amounts due over small amounts that would be hard to evaluate. Now the learning curve for some of these new auditors may make this concept a little foreign to them at first, but overall the IRS does not take heroic efforts to pursue small amounts of taxes owed, they won't show up on your doorstep if you owe $1,000, but if you fail to provide explanations on large discrepancies or claim credits you're not eligible for they will assess tax and levy assets. And this doesn't require a large amount of effort on the part of the IRS.
The IRS targets lower-income taxpayers at a higher rate than higher-income taxpayers and large businesses - this is a fact the IRS has verified. The IRS has admitted that because they do not have the expertise to audit higher-income taxpayers they target lower-income taxpayers at a higher rate. The audit rate for lower-income taxpayers is expected to go up with additional auditors. The Treasury has claimed that it will not go above the historic audit rate for lower-income taxpayers. It's important to note here that historic levels are higher than current levels - so the audit rate of lower-income taxpayers is expected to increase from the current audit rate - the Treasury has not denied this.
And this logically makes sense, a large influx of auditors will not be trained properly and will not possess the expertise to audit higher-income taxpayers who will have a team of accountants behind them. Although we can also expect the audit rate for higher-income taxpayers to increase due to the sheer increase in the volume of auditors it would be unrealistic to expect that only higher-income taxpayers will be targeted. There will be an increase across the board, and because business owners self-report their income they have historically had a higher audit rate than that of employees.
With this understanding what are some things that small business owners can do to prepare their companies for this increase in audit rates?
Ensure that you have properly kept books. Many small business owners try to DIY their bookkeeping or keep their books on a budget. I understand the desire to keep compliance costs here low, but there is a trade-off to this. The IRS knows that small businesses often have poor bookkeeping practices and therefore the chance for an auditor to collect additional tax is higher for small businesses. Clean this up now to help you more easily navigate an audit.
Keep your receipts. Oftentimes business owners do not realize that bank statements are not acceptable documentation for expenses in an audit. The actual receipts need to be saved to help substantiate the bookkeeping.
Pay attention to hot button issues, for example the IRS knows that S-Corporation owners frequently do not pay themselves reasonable compensation in an effort to reduce taxes. If you own an S-Corporation what substantiation do you have for your reasonable compensation? If you're audited you'll need to justify reasonable compensation calculations.
File and pay your payroll taxes and returns on time. Payroll taxes are not something the IRS is generally willing to negotiate on.
Concerned about the compliance of your small business and looking for a professional to take a look? We're currently running a small business compliance check for a discounted rate of $5,700. Additional rates for businesses with over $15 million in gross receipts, over 30 employees, and/or over 5 owners apply. We're happy to discuss your questions and needs - Support@MariettiAccountingServices.com.
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