What it's like to be audited by the bigger, better-funded IRS. 'They are pushing harder now.'

Andrew Keshner

The Internal Revenue Service is showing more 'swagger' in audits of rich taxpayers, says one lawyer with ultra-wealthy clients

Anyone on the receiving end of an IRS audit will say there's never a good time to open up the books for Uncle Sam's revenue agents.

That's never felt more true, say people who've witnessed the Internal Revenue Service in action recently.

IRS auditors have more questions, more staff and are acting more assertive, according to lawyers and accountants who advise very upscale clients on taxes.

In 2022's Inflation Reduction Act, the IRS landed billions of dollars in funding over a decade to make sure rich households, partnerships and corporations were paying all of their owed taxes. The funding was intended to revive sagging audit rates at an agency that's been slowly sapped of money and people over the past decade.

Since then, the agency has been publicizing its efforts to collect back taxes from delinquent millionaires and to rake in tax returns that millionaires failed to file.

The IRS has also talked about combing through corporate-jet records and using artificial intelligence to spot tax returns worth scrutiny. Most recently, the agency announced an effort to stop a "shell game" that large, complex partnerships allegedly use to churn up tax deductions.

Now, tax professionals are seeing that talk turn into action.

"Right after the Inflation Reduction Act was passed, I started seeing increased swagger, for lack of a better word. For a while, it seemed like just swagger," said Robert Kovacev, a member at the law firm Miller & Chevalier. His clients include corporations, partnerships and ultrarich families worth between millions and billions of dollars.

"For the first time really now, I'm starting to see the effects of the funding," he told MarketWatch.

The "swagger" that Kovacev sees now is displayed in the extra questions he has to field from the IRS, increasingly on topics that weren't part of an audit's starting scope.

Before the Inflation Reduction Act, Kovacev said the IRS was already viewing high-net-worth families as economic "enterprises" with a sprawling financial footprint where tax noncompliance could sprout in all sorts of ways.

A family's trusts, companies, partnership interests and charitable-giving tactics might all be places where auditors could poke and prod. "But without the resources they needed, there was only so much they could do," he said.

Now he sees IRS agents ready to veer farther and farther from the audit's beginning focus. "It was kind of rare if you had an exam team color outside of the lines," Kovacev said. "You can't make that assumption anymore."

IRS agents combing through a massive tax return have "an infinite number of avenues [they] can follow, but can't follow all of them," Kovacev noted. "Sometimes you find things worth exploring, but you let go. They are starting not to let those go so quickly."

IRS auditors are digging deeper

Niles Elber, a member at law firm Caplin & Drysdale, said IRS auditors seem willing to dig deeper these days. "I might describe it as eagerness," he said. There are millions of dollars hanging in the balance in the tax cases he handles.

"I've been doing this a long time now," Elber said. "When I first started, the agents I worked with usually concentrated on the most important things or the most important issues, usually with the most significant financial impact. And other things that were less significant were pushed by the wayside as a means of economizing. I'm not sure I see that now. Now, we're going to drill down on everything."

The IRS isn't 'outgunned' anymore

After years of budget cuts and shrinking staff, the IRS had been falling behind on its high-level enforcement, IRS Commissioner Danny Werfel said at a recent tax conference. In 2021, his predecessor, Charles Rettig, said the agency was getting "out-gunned."

That's changing now, but it's "a long process," Werfel said.

"[W]e have to have the patience to be playing the long game," according to Werfel, who occasionally refers to complex audits as a chess game.

"So many of the taxpayers at this end of the spectrum are doing the right thing and playing by the rules. But there are a material number of taxpayers that are not," he said.

Republicans fear the IRS will run roughshod over taxpayers

While debates heat up on the future of tax laws and tax revenue to fill a gaping federal budget deficit, it's important to understand what the IRS is doing to try to extract more money through existing laws. It's also important to remember that a stronger audit flex from a more muscular IRS has its critics.

The Inflation Reduction Act passed in a Democratic-controlled Congress without any Republican votes in support. The law awarded $80 billion to the IRS over a decade to replenish its ranks and upgrade operations. More than half of the sum was earmarked for tighter tax enforcement.

The IRS plans to boost audits on taxpayers worth at least $400,000 under a Treasury Department directive that came days before President Joe Biden signed the bill into law. Below the $400,000 mark, the IRS will not use the extra funding to increase audit rates from historical levels, the directive said. Specifically, the benchmark is the audit rates on 2018 returns, Werfel has said.

The enforcement money has been a flash point for Republicans, who have successfully negotiated just over $20 billion out of the Inflation Reduction Act funding.

Republicans say they don't want an IRS that runs roughshod over taxpayers. Many aren't convinced that the agency really will confine its attention to wealthier earners. Democrats counter that Republicans just want to take the heat off well-heeled tax cheats.

The fight over the IRS budget continues, with House Republicans looking to reduce enforcement-related money in the upcoming budget year.

'The breeze before the storm'

With the IRS stepping up enforcement on upper-income taxpayers, Michael Sardar, a partner handling tax disputes at the law firm Kostelanetz, is already getting calls from crypto investors who may have underreported their gains to the IRS, longtime nonfilers (meaning people who have repeatedly failed to file tax returns) and others worried they might be in the agency's crosshairs.

They're asking how to get their taxes in order and come clean with the tax agency before IRS notices arrive and make their tax situation worse, he said.

It's not quite right to call this period "the calm before the storm," according to Sardar. There's a better way to describe the moment, he said: "The breeze before the storm."

More IRS staff means more questions to answer during audits

What does that storm feel like to the people who are either getting audited, or are worried about it?

Around the Inflation Reduction Act's passage, one assertion from GOP critics was that the IRS would be hiring a new phalanx of aggressive auditors. Overall, the agency now has nearly 90,000 full-time equivalent employees, up from 79,000 in fiscal year 2022, thanks to the new funding. Almost 9,100 of those are revenue agents - the employees who conduct audits.

The plan is to bring the IRS's head count for its entire staff to 102,500 in fiscal year 2029, Werfel said last month, noting that's still under the IRS's head count in the late 1980s and early 1990s. The agency's hiring goal "should lay to rest any lingering myth about a super-sized IRS," he said at the time.

Still, a common refrain about high-end IRS audits these days is that there are more people involved - and having more people means answering more questions.

Elber used to work with one or two IRS agents during an audit, with one being the lead agent and the other serving as a specialist or supervisor.

Now, the exam teams can have up to eight people, he said. He's also noticed a new feature: recurring conference calls for updates on the audit. "Across the board, they are pushing hard now. They are moving cases along with deliberate speed," Elber said.

Once a tax return is filed, the IRS says it generally has three years to assess extra tax. It may go back further if auditors uncover a glaring error, but it says it typically doesn't look back any further than six years. The exam concludes with an IRS recommendation on how much more money the taxpayer owes the government.

The agency may not necessarily suggest an adjustment, but says it tries to minimize these "no-change" audits that bog down taxpayers who have followed the rules.

If the IRS and the taxpayer can't agree on the size of the extra bill, the process can move to the IRS Independent Office of Appeals or an array of federal courts.

IRS is reaching for new audit goals

The tax agency is trying to make 2026 a milestone. When tax returns are filed for that year, the IRS wants to be auditing 16.5% of households with a total positive income of at least $10 million, up from 11%.

In 2020, the Trump administration's Treasury Department directed the IRS to audit at least 8% of taxpayers worth $10 million. The IRS kept up with that goal in returns filed for 2018, 2019 and 2020, a recent Treasury watchdog report found.

But the IRS said it isn't following the 2020 directive anymore because it views the goal as out of date, the Treasury Inspector General for Tax Administration report said.

When it comes to corporate income-tax returns filed for 2026, the IRS plans to examine more than 22% of tax returns for corporations with assets of at least $250 million.

By then, it plans to audit 1% of partnership returns with at least $10 million in assets. The IRS already said it's launching 76 audits of lucrative partnerships, including certain law firms, hedge funds and real-estate investment trusts.

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07-08-24 1125ET

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