Tax policy wonks rejoice, wealthy households cringe at IRS audit push

With the IRS ramping up audits and enforcement actions against wealthy tax dodgers, financial advisors, certified public accountants and other practitioners say clients should be on alert.

The stated focus on high net worth and ultrahigh net worth taxpayers, thanks to tens of billions of dollars in extra funding for enforcement efforts over the next decade, will pay off in the form of higher audit rates and revenue to the federal government if the IRS enhances its approach, according to a report released earlier this month by the Government Accountability Office, an independent watchdog agency that reports to Congress. For policy experts, the efforts represent a much-needed crackdown on an estimated "tax gap" of about $688 billion a year between the amount of revenue that should come to the government and its actual collections. To advisors and other tax professionals, the enforcement push and research display rising risk for clients.

"With much of the Tax Cuts and Jobs Act set to expire in 2026, accompanied by calls for tax reform and added IRS enforcement, we recommend that people check in regularly with their financial advisors and tax professionals," James Rabasca, a senior tax specialist with the Integrated Planning Group of Parsippany, New Jersey-based Summit Financial, said in an email. "Now, it is as important as ever to consult with qualified tax professionals to make informed planning decisions in an uncertain tax landscape that brings the prospect of additional changes and added scrutiny. Especially for wealthy taxpayers, it is reasonable to expect greater scrutiny, making it critical to stay informed of changing tax laws and seek multiple opinions on uncertain tax positions. Defending an audit can be very costly, so proper planning with tax professionals is vital."

While Rabasca said his firm has not witnessed a large spike in IRS inquiries in recent years, he noted that hiring and training new employees "takes time, as does implementing artificial intelligence to help identify returns and trends that warrant scrutiny."

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The sharpened lens on wealthy taxpayers has prompted a "migration toward more traditional ways of 'playing the game better' (i.e., traditional accepted tax planning) and even 'leaving the game' (migration to low-tax states and even expatriation)," according to David Lesperance, the founder of immigration tax and law advisory firm Lesperance & Associates.

"'Tax avoidance' is an inexact term in general parlance," he said in an email. "Strictly speaking, it does not include illegal tax evasion. Rather it includes tax planning which might be considered 'aggressive' and whose ultimate legality has not been tested. Previously some illegal tax evasion and aggressive tax planning had escaped detection or challenge because it was hidden in a web with more complexity than an under-resourced IRS was able to examine. However, with both funding and new data mining and AI assistance, those who engage in evasion will find themselves discovered. Those engaging in aggressive tax planning will find their structures challenged and possibly fail. In either case the financial and reputational cost of detection or failure is significant."

Across the world, Lesparance added, only "the Spanish have been as aggressive in enforcement as the IRS," which he said "is dealing with a much more complex set of tax laws and has a larger group of HNW taxpayers" to monitor.

Between 2017 and 2021, households with incomes of $400,000 or more have failed to file federal tax returns in more than 125,000 instances, the IRS said this week in announcing it would send mailings to those taxpayers. New IRS programs centering on taxpayers with at least $1 million in income and $250,000 in recognized tax debt have already recovered $520 million in revenue for the federal government, Commissioner Danny Werfel noted in Feb. 15 testimony before the U.S. House Ways and Means Committee. In addition, the agency has opened audits of 76 of partnerships that include "hedge funds, real estate investment partnerships, publicly traded partnerships, large law firms and other industries" and 60 other big corporations, he said. 

"That's half a billion dollars recovered from fewer than 1,000 millionaires and billionaires," Werfel said. "That is just the beginning: Our revenue officers continue to work on hundreds of these cases to recover more back taxes from delinquent high-wealth individuals. We are also closely examining potential noncompliance among the largest U.S. corporations and partnerships that were identified as higher risk for tax noncompliance with the help of new artificial intelligence tools."

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Tax wonks rejoicing

The strategy is earning praise from tax policy wonks who had called on the agency to alter its auditing and enforcement efforts for years. One dollar spent auditing the top 10% of the wealthiest households pays back $12 in additional revenue, according to a study by researchers from the Treasury Department, Harvard University and the University of Sydney cited earlier this week by the nonpartisan Brookings Institution in a "State of the IRS" blog post. The agency had previously deployed shrinking resources on the low- to moderate-income families that get the earned income tax credit, which disproportionately targeted Black households, authors Vanessa Williamson and Zach Benzaoui wrote.

"Auditing wealthy people is hard work, of course," they wrote. "It requires much more time and expertise to unravel the tax shenanigans of people who can afford the best lawyers and accountants that money can buy. But the payoff to auditing wealthy taxpayers is high."

The GAO report added to the documented case for boosting those audits, according to another blog earlier this month by Joe Hughes, a federal policy analyst with the nonprofit, nonpartisan Institute on Taxation and Economic Policy, who described the watchdog's findings as "astonishing." 

Between fiscal years 2012 to 2022, every audit of households with at least $10 million in income generated an average of $359,432 in unpaid taxes, the GAO said. When breaking that down by the hour using figures from the report's appendix, that comes down to $13,000 an hour. Before the enforcement initiatives under the 2022 Inflation Reduction Act, funding cuts to the IRS had pushed down audit rates from 7.2% of millionaires in 2011 to just 0.7% in 2019, Hughes noted.

"The hourly rate suggests the IRS could hire the most expensive tax accountants in the country and still come out positive," he wrote. "It is a return on investment that would leave Wall Street hedge fund managers drooling."

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Regardless, the GAO sent eight recommendations to the IRS to improve its audits of the wealthy, and the agency "fully agreed" with seven and "partially agreed" with one, according to the report. Because the IRS "does not yet have clear plans for certain aspects" of the probes of wealthy households' returns, the agency faces challenges stemming from its lack of comprehensive data about evasion, adequate evaluation of its selection of taxpayers for audits, intake of feedback from staff, assessment of hiring and training needs and the establishment of a centralized management system for the program, the report said. 

"By focusing on these areas, [the] IRS can better understand the types and prevalence of noncompliance on [high-income/high-wealth] returns, maintain accountability to meet its strategic objectives and vision and further its mission of fairly enforcing the tax law," according to the report.

The watchdog compiled the study through analysis of IRS data, as well as conducting focus-group discussions with auditors and their managers. The main difficulties of audits of wealthy taxpayers are: "balancing the number of audits with the scope and depth" of them; "finding noncompliance across many related entities"; "insufficient or untimely training"; "limited access to specialists"; "limits with technology to communicate" with the households; and "delays caused by taxpayers or their representatives," members of the focus groups said.

"Audit staff (auditors and managers) in all 10 of our discussion groups stated that auditing high-income/high-wealth (HI/HW) returns was challenging because these returns can include many related entities and complicated income flows, making it difficult to identify noncompliance," the report said. "According to one auditor: '[T]he characteristic of [HI/HW] exams, is massive tax returns with a considerable number of related entities, tiered entities, disregarded entities, all kinds and every complex maneuver that you can conceive of.'"

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Taxing implications

High net worth and ultrahigh net worth clients are watching developments like the IRS enforcement efforts closely, Lesperance said. A recent investigation by Democrats on the Senate Finance Committee into tax avoidance through the use of private placement life insurance and a U.S. Supreme Court case that may upend some lawmakers' plans to hit billionaires with extra duties could affect whether many wealthy Americans decide to leave the country, he said.

"The SCOTUS decision in the Moore case will have a significant impact on the number of wealthy Americans who actually depart," Lesparance said. "If the taxation of unrealized capital gains is found to be unconstitutional, then the expatriate 'exit tax' will disappear. This is the major barrier to expatriation. If it is found to be constitutional, then the specter of a future wealth tax will rear its head. When one looks at the egregious treatment of expatriates in the proposed Billionaire Tax Act, then you will also see a tsunami of expatriation by UHNW American taxpayers who want to pay the exit tax once and be done with the U.S. tax system."

Simply filing returns to the IRS is becoming more complicated, especially among those who may have to pay higher rates in line with President Joe Biden's campaign pledges and budgets seeking more taxes for those with at least $400,000 in income, Rabasca said. 

"Growing numbers of foreign and cryptocurrency transactions, plus tax reform and delayed Treasury regulations have made tax reporting increasingly complex over the past few years," he said. "A focus on expanding audits based upon income of $400,000 rather than specific areas of concern has caused some anxiety among clients, especially with the implementation of certain proposed regulations having been delayed (for example, concerning RMDs from inherited IRAs under the Secure Act). Our experience is that the vast majority of taxpayers look to properly report their taxes; their intent is to remain well within established law while seeking legitimate methods to reduce their tax bills."