Is the IRS Auditing the Right Parties?

This article was picked up by the AICPA and shared via the CPA Letter Daily on November 24, 2015. The soundbite commentary from the CPA Letter Daily stated:

IRS audits should target wealthier taxpayers, report says:

The IRS is reconsidering its approach to audits following a report by the Treasury Inspector General for Tax Administration. The report found that the agency spends more time auditing people who make between $200,000 and $399,999 than people who make $5 million or more. However, audits of the wealthier group yield much higher revenue per hour.

USA Today (11/20), The Wall Street Journal (tiered subscription model) (11/22)

Here is the original The Treasury Inspector General for Tax Administration (TIGTA) report that is being referred to by the CPA Letter Daily. The executive summary states,

TIGTA recommended that the IRS:

1. Reevaluate the income thresholds in its High-Income and High-Wealth strategy;
2. Conduct a cost/benefit analysis of the GHW Industry’s outsourcing initiative;
3. Explore system modifications needed to systemically quantify GHW Industry enterprise case examination results;
4. Ensure that its management reports accurately reflect that there currently is no audit quality measure for the GHW Industry;
5. Establish a permanent ongoing quality review system; and
6. Require quality reviews of closed GHW Industry examination cases.

 

The IRS agreed with four of the six recommendations. However, the IRS does not agree that its decision to outsource GHW Industry enterprise cases requires a cost/benefit analysis and is not planning to explore system modifications needed to better quantify enterprise case examination results. TIGTA believes that both the cost/benefit analysis and better information on examination results would improve program decisions.

It is important for the IRS and for us as taxpayers to be careful here. We tend to measure that which is easy to measure and we tend to work towards desired results. Note that since the Restructuring Reform Act of 1998 IRS employees are not evaluated on dollars collected or adjusted per return or on dollars per hour. That has been a good thing for taxpayers. No rewards or bonuses are offered directly or indirectly based on dollars or dollars per hour. However, these numbers are accumulated at a national level to report to Congress.

In the article it is suggested the average dollars per hour adjustment for those with incomes between $200,000 and $399,999 per year were $605 dollars per hour. By comparison auditing those with incomes over $5 M has resulted in $4,545 dollars per hour. Therefore the knee jerk reaction is to say the IRS should audit more of those folks making over $5 M a year. Anyone can see that, or can they? Recall that the average is the sum of the total divided by the total number of observations. In my experience working in research for nearly 4 years at the IRS that a few sensational cases with much lower quantity can significantly skew the average and I suspect that is exactly what happened here. I suspect a few sensational audits have resulted in a high mean (average). The question is what is the median? Understanding both is important. The data presented in the report does not provide this information to us.

I think it is important to get behind the numbers. I also think it is important to ask the right questions. Rather than a simplistic $/hour metric and “bringing in revenue” on the 0.86% of returns audited, shouldn’t the real question be “what is the impact on voluntary compliance as a result of targeted audits and the compliance rate of individuals?”

Figure 2 on page 11 of the TIGTA report in part indicates the audit percentages as follows:

Figure 3 points out that the percentage of high income closures is continuing to increase every year for the 5 years presented. It strikes me that these percentages are fairly high percentages.

I also have a concern regarding the IRS making $/hour a metric that may have implications for auditors. Go back and read why the Pension Protection Act of 1998 was implemented to prevent IRS employees from becoming oriented towards meeting these types of metrics at the expense of bullying taxpayers. Do we really want the IRS to go down that road again? I don’t think so. Beware of simple solutions to complex problems.

Finally I am asking us to step back for a minute and look at what these numbers tell us. The higher graded agents that audit individuals might be a GS 12. Taking a GS 12 step 5 (mid-range of steps from 1 to 10) with a salary of $71,736 per year ($32.60 per hour) and comparing that to bringing in $605 per hour for those individuals making between $200,000 and $399,999 for a ratio of 18.5 dollars of return for dollar invested, or bringing in $4,505 per hour for those individuals making over $5 M for a ratio of 138 dollars of return for dollar invested, wouldn’t you think it would be a good idea to hire some more auditors? At the same time those in Congress have continued to cut the IRS budget with targeted budget cuts that continue to reduce enforcement. This makes no budget sense to me. Why didn’t TIGTA report on that? I can tell you why. Congress did not ask that question. TIGTA reports on what Congress requests. Congress did not ask the question, but TIGTA reported on the information so a simple calculation can be made by a lay person like me. If you were in business, wouldn’t you ask the question? I know I do relative to where I spend my time.

I would propose that Congress is not asking the right questions, TIGTA is not exploring more fully what is behind the numbers they are reporting on, and good law abiding taxpayers like us are paying our fair share by complying with the tax laws while others are not.

There is a lot of room for improvement. It helps to define the problem up front. I would propose the problem is what can the IRS do to improve voluntary compliance and what evidence does the IRS have to answer that question. That should drive who to audit. Secondly, Congress should look at the big picture of the overall numbers at the agency and get behind those numbers. Who would not see the reason to add more auditors when the auditors can bring in 19 to 1 on the low end and 138 to 1 on the high end for those that are not complying with our tax laws?