The IRS Says Audit Rates Increase as Income Rises and Offers Data and Explanations (11/8/20)

The IRS offers a web page titled “Audit Rates Increase as Income Rises” (Page Last Reviewed or Updated: 03-Nov-2020), here.  The web page provides tables with data drawn for the years 2013-2015 from the 2019 Databook, Table 17a, showing that the audit rates are significant for the no total positive income returns because of the high rate of refundable EITC errors.  For positive income returns, the audit rates range from less than 1% for $1-$25,000 of positive income and up to 12% in one year and 8% in the other two years for income up to and exceeding $10 million of positive income.  

The web page explains (excerpts):

Despite common misperceptions about IRS examination rates, the reality is that the likelihood of an audit significantly increases as income grows.

Taxpayers with incomes of $10 million and above had substantially higher audit rates than taxpayers in every other income category for each calendar year from 2010 through 2015. Those with incomes above $1 million also had higher exam rates than all other groups earning less.

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The typical audits for higher-income taxpayers involve at least three different tax years, often include related entities, and routinely take years to resolve. The highest income taxpayers face the most significant chance of an examination, and they face the most highly trained and experienced IRS agents and teams utilizing our most sophisticated tools and techniques.

One may ask, whether regardless of the audit rates, should the IRS simply audit fewer lower-income taxpayers receiving EITC? Here’s the challenge with doing that: Error rates on tax returns claiming EITC are around 50%, and the improper payment rate involving EITC claims is more than $17 billion each year. There are several factors behind why the improper payment rate is at that level – some of this is that, despite significant guidance provided by the IRS and others, people (including tax preparers) simply misunderstand the complex EITC rules, and others involve misreporting income. Each year, at the start of the tax filing season, IRS participates in EITC Awareness Day events throughout the country in an effort to increase participation by eligible people and enhance the rate of compliance.

The IRS fully appreciates the importance of the refundable EITC and the significant difference it makes for people. More than 25 million people claim EITC per year, generating more than $63 billion each year to people in need. This program lifts millions of Americans out of poverty, and the IRS is proud to work hard each year to raise awareness about the program since many, many people simply overlook claiming this important refundable credit that they are entitled to.

At the end of the day, the IRS strives to properly serve compliant taxpayers and uphold the nation’s tax laws, ranging from civil side audits and notices to criminal investigations in the most egregious cases. We face tough choices each year as far as where to deploy resources given the breadth of our responsibilities, but our choices are guided by fair and impartial audit plans throughout the process.

Peter Reilly on Real Estate Phantom Taxable Income Gaming the Audit Lottery (8/13/20)

Peter Reilly, a friend and frequent tax commenter, has this offering on his Forbes blog:  IRS Veteran Insists That IRS Is Missing Billions In Real Estate Gains (Forbes 8/11/20), here.  Basically, Peter deals with tools that the IRS has in its system that his informant asserts can locate large amounts of income that goes unreported through the phantom income that arises from real estate losses funded by nonrecourse debt.  I am not familiar with the IRS systems that could police the reporting of the income, but I do note (as does Peter) that there is a new IRS initiative for the partnership to report partner level basis.  See Notice 2020-43, here; see also Peter’s discussion on another blog Who Is IRS Aiming At In Recent Partnership Notice? (Your Tax Matters Partner 6/21/20), here.

Those who are partnership tax gurus will like Peter’s offerings and maybe even understand them.  As an aside, my practice over the recent years have not focused on partnership tax, so I am a bit long in the tooth on that.  (Except that I do cover the procedural aspects of the TEFRA and CPAR (often called BBA) regimes, and earlier in my private practice while substantially involved with real estate partnerships (and teaching Real Estate Taxation at UH Law School), I did have particular interest in partnership taxation originating from my handling of the appeal Diamond v. Commissioner, 492 F.2d 286 (7th Cir. 1974), here, a leading case in partnership taxation.  (The Diamond opinion was quite controversial, but in my mind just involved elemental tax principles correctly applied; but the real estate industry was quite powerful and managed to whittle away the results and essentially reverse through IRS administrative largesse, hence the carried interest notion, but I won't go off further on that rant here.)

Peter’s Forbes offering did cover some significant tax history related to Crane v. Commissioner, 331 U.S. 1, 14 n.37 (1947), here, and its tax infamous footnote 37. All tax students and practitioners should have at least a passing acquaintance with that footnote, said to be the most famous footnote in tax history.  Footnote 37 should also mitigate against the expression of apparent disdain for footnotes that Justice Scalia once made in oral argument (I cover Scalia’s statement in both editions of my book).  Footnote 37 said:

Obviously, if the value of the property is less than the amount of the mortgage, a mortgagor who is not personally liable cannot realize a benefit equal to the mortgage. Consequently, a different problem might be encountered where a mortgagor abandoned the property or transferred it subject to the mortgage without receiving boot. That is not this case.

That footnote spawned a myriad of offerings exploiting nonrecourse debt to generate deductions with the notion (or hope) that the taxpayer would not have to balance the books with so-called phantom taxable income at the end.  Those shelters proliferated particularly in the 1970s involving both real estate where lenders might make economic nonrecourse loans in the real world and in other contexts where the nonrecourse loan was basically phony (or magic).  The Supreme Court put an end to (or at least curbed somewhat) that magical thinking in Commissioner v. Tufts, 461 U.S. 300 (1983), here, requiring the taxpayer to include the amount of the nonrecourse debt in the amount realized part of the gain calculation upon foreclosure or deed in lieu of foreclosure, thus at least leaving the taxpayer with deferral and conversion shelter from playing the nonrecourse debt game.