While President Biden has had to scale back some of his ambitions for the proposed Build Back Better Act, one item has remained intact — $80 billion in funding for the IRS. The funding is part of the administration’s plan to increase federal tax revenue by ramping up compliance. Intensified enforcement of tax laws could have significant repercussions for both individuals and businesses.

Shifting Landscape

The IRS lost more than 33,000 full-time positions from 2010 to 2020. Though the size of its workforce has grown since 2019, it remains below 2010 levels. The reduction in staff has led to a decrease in audit activity. The audit rate for higher-income taxpayers fell for higher-income taxpayers from 2010 to 2018, according to the Congressional Budget Office.

Biden’s proposal would return audit rates to 2010 levels. The rate would climb for all taxpayers, but IRS resources would focus primarily on enforcement activity aimed at high-wealth individuals, large corporations and partnerships. IRS officials hope that boosting the number of audits will, in turn, improve compliance and help close the tax gap.

Audit Triggers

The IRS already has reallocated substantial audit resources and technology to more closely scrutinize high-income taxpayers. Potential areas of interest for individuals and businesses include:

Pass-through entities. High-income taxpayers who own so-called “pass-through” entities — such as sole proprietorships, partnerships, limited liability companies and S corporations — are at-risk for audit. One particular hot spot is the qualified business income (QBI) deduction.

Tax Cuts and Jobs Act (TCJA) compliance. The QBI deduction is just one provision of the TCJA that could garner IRS attention for businesses and individuals. The IRS has moved from implementation of the sweeping tax law passed in late 2017 to enforcement. For example, it has launched the “Section 965 Campaign” targeting taxpayers with ownership in specified foreign corporations who may have failed to report related income.

Overseas activity. The IRS also recently instituted a program to examine compliance with respect to the timely and accurate filing of information returns reporting ownership of and transactions with foreign trusts. Offshore bank accounts and foreign transactions are less likely to fly under the IRS’s radar, too.

Cryptocurrency. The recently enacted Infrastructure Investment and Jobs Act includes new reporting requirements for transactions involving digital assets. Between those requirements and the IRS’s existing Virtual Currency Compliance Campaign, it seems clear that the agency is intent on cracking down in this area.

Best Defense

IRS audits generally look back three tax years. But they may go back as far as six years under certain circumstances — and no time limitation applies to penalties for fraud. If you receive a dreaded letter from the IRS, don’t panic; many inquiries end without incident. But, when problems are found, an audit can result in higher tax bills, fines, penalties and even criminal prosecution.

The most effective weapon against such consequences comes down to thorough recordkeeping. Individuals and businesses should maintain clear, contemporaneous documentation of items reported on their tax returns, such as invoices, canceled checks and receipts. It’s also advisable for businesses to undergo independent financial statement audits on a regular basis to ensure that all the numbers reconcile with the amounts reports on their tax returns.

When the Tax Man Comes

If you receive an inquiry from the IRS, there’s no need to go it alone. Our tax specialists can help represent you in an audit, especially if you file multiple, complicated tax returns. Contact us for further guidance what the IRS is looking for and on how to avoid unwanted attention from the IRS.