The year is 2010. Toy Story 3 tops the box office, the New Orleans Saints are Super Bowl Champions, and President Obama signs into law the Patient Protection and Affordable Care Act. That same year, the Internal Revenue Service (“IRS”) had a whopping $13.75 billion budget.[i]
Fast forward to 2018. The IRS budget has been slashed by approximately $2 billion, revenue from audits has decreased an estimated $3.2 billion, and the Patriots have won ten Super Bowls in what seems like five years.[ii] Other than the Patriots unprecedented rise to stardom, the real question is: How does the IRS collect more revenue, process more returns, and increase the level of taxpayer compliance with a significantly smaller budget?
The answer? The internet, automated adjustments of tax returns, and a refined audit selection process.
The Current Process
When an individual or tax preparer hits the submit button on an income tax return, it is transmitted to the IRS and instantly subjected to an automated review process.[iii] This automated review identifies mathematical errors and compares the individual’s tax return with information that has already been submitted to the IRS or Social Security Administration. [iv] This quick and seamless process collected approximately $6.8 billion in 2016 through the automatic correction of taxpayer’s returns.[v]
The IRS’s analysis of an income tax return does not end after the automated review is finished. Next, the IRS determines whether or not your tax return should be selected for an audit.
To identify and create efficient methods for the selection of tax returns for audit, the IRS created the Taxpayer Compliance Measurement Program (“TCMP”) in 1964.[vi] The TCMP selected thousands of income tax returns each year and audited them line by line to determine inaccurate entries.[vii] As a result of the TCMP audits, inaccurate entries on tax returns were identified and analyzed to determine their relative frequency. Thereafter, the IRS developed a discriminant index function, or DIF score, for each income tax return.[viii] After each return is assigned a DIF score, a national range is established. The higher the DIF score when compared to the national range, the more likely it is that an audit would result in an adjustment.
As the IRS soon discovered, TCMP was costly to maintain, required intrusive contact with taxpayers, and mandated long and extensive audits. As a result, the IRS created the National Research Program (“NRP”) in 2002.[ix] The NRP’s goal was to develop a new methodology to select tax returns for audit, while developing a less intrusive means by which to do so.[x] This methodology included comparing income tax returns with information the IRS already had available. [xi] But what information does the IRS already have available?
Does the IRS have the right to third party information?
Generally, the IRS is entitled to any information that may be relevant to determining a tax liability. [xii] Fortunately for taxpayers, 26 U.S.C. (“I.R.C.”) § 7602 and 6103 prevent the IRS from obtaining and disseminating confidential taxpayer information.
- I.R.C. § 7602
I.R.C. § 7602(c)(1) provides that “an officer or employee of the Internal Revenue Service may not contact any person other than the taxpayer with respect to the determination or collection of the tax liability of such taxpayer without providing reasonable notice in advance to the taxpayer that contacts with persons other than the taxpayer may be made.”
Section 7602 affords the taxpayer with the opportunity to provide information prior to the IRS reaching out to a third party. Unfortunately, section 7602 does not prevent the IRS from contacting the third party. [xiii]
- I.R.C. § 6103
I.R.C. § 6103 provides safeguards to protect the confidentiality of a taxpayer’s return. [xiv] However, numerous exceptions to the release of confidential taxpayer information are also delineated in the statute. For example, confidential taxpayer information can be disclosed to state agencies, the Social Security Administration, and other federal agencies without taxpayer approval or knowledge. [xv] Meaning, there is a safeguard in place to protect the confidential information of taxpayers, but it is often limited.
The Future of the IRS
Moving forward, it is likely the IRS will leverage information already warehoused by internet conglomerates such as Amazon, Google, and Apple to further enhance the automated corrections of tax returns and further refine the audit selection process. This will likely have a large effect on small businesses and non-filers.
To provide an example: Taxpayer A regularly purchases widgets for her business from Amazon. Thereafter, Amazon creates an internal document which details the dollar amount of Taxpayer A’s widget purchases, the date and time of each purchase, and where the item was shipped. The IRS requests this internal document from Amazon to verify Taxpayer A’s cost of goods sold and thereafter adjusts the amount claimed, if necessary. All of this occurs automatically and without Taxpayer A’s knowledge or approval.
The scenario outlined above may seem distant, but the automated correction process the IRS currently utilizes has already been enhanced as it relates to health insurance benefits (Form 1095-B), mortgage payments (Form 1098), and retirement benefits (Form 5498). Leveraging the information described above will also help the IRS further refine their audit selection process by increasing the accuracy of a tax return’s DIF score through the aggregation of vast quantities of taxpayer data.
However, should the IRS have the right to this information? On one hand, the information is absolutely relevant in determining whether the taxpayer is accurately reporting their tax returns. On the other hand, this seems to be a fairly intrusive process that will not only track an individual taxpayer’s internet activity, but will also house a wide array of information that is completely irrelevant to tax administration.
The IRS faces a constricting budget, a smaller workforce, and an uphill battle in coping with the ever changing tax landscape. However, the solution is clear. Leverage the internet to automatically correct tax returns and simultaneously enhance the accuracy of DIF scores to refine the audit selection process. The only question that remains is whether taxpayers can successfully advocate for their rights and keep that information out of the hands of the IRS.
[i] Bryce Covert, In Defense of the Much Maligned IRS, The Nation (April 8, 2019), https://www.thenation.com/article/internal-revenue-service-irs-budget-cuts/
[iii] Caroline Rule, BNA Tax Management Portfolio 623-3rd: IRS Procedures; Examinations and Appeals, Section IB (2013). See also, Hatfield, Taxation and Surveillance: An Agenda, 17 Yale J.T. & Tech 219 (2015).
[v] IRS Data Book 2016, www.irs.gov/pub/irs-soi/16databk.pdf. See also Kimberly A. Houser and Debra Sanders, The Use of Big Data Analytics by the IRS: What Tax Practitioners Need to Know, Journal of Taxation, Feb. 2018 at 6.
[vi] Amber Torrey, The Discriminant Analysis Used by the IRS to Predict Profitable Individual Tax Return Audits, April 2008.
[viii] Id at 3.
[ix] Id at 5.
[x] Id at 5.
[xi] Id at 6.
[xii] I.R.C. Section 7602 (The IRS may examine the books, papers, records, or other data which may be relevant or material in an inquiry). See also Kimberly A. Houser and Debra Sanders, The Use of Big Data Analytics by the IRS: What Tax Practitioners Need to Know, Journal of Taxation, Feb. 2018 at 6.
[xiii] Office of Chief Counsel Notice N(35)000-160, January 22 1999.
[xiv] I.R.C. Section 6103. See also Kimberly A. Houser and Debra Sanders, The Use of Big Data Analytics by the IRS: What Tax Practitioners Need to Know, Journal of Taxation, Feb. 2018 at 9.