The IRS made headlines last October when a report it submitted to Congress admitted that the agency targets the tax returns of the working poor at about the same rate as wealthy taxpayers.
Why? Because it’s “the most efficient use of available IRS examination resources.” In other words, it’s easier and cheaper than auditing the rich.
That’s a nice soundbite, but don’t be fooled. Because Congress has cut the IRS’s budget by a quarter in the last decade, audit rates are down across all income categories. And the agency has hardly forgotten about higher income taxpayers.
The IRS Is No Ordinary Creditor
The IRS estimates the difference between what Americans owe in federal taxes and what they pay is about $441 billion. This sum represents taxes assessed or otherwise calculated, but not collected. The enormous size of this purported "tax gap" is why Congress has given the IRS collection powers that are far stronger than those available to ordinary creditors.
To collect what it’s assessed, the IRS may, without a trial or judgment:
Seize your personal residence and auction it off, using the proceeds to pay the assessment. Property exempt from seizure under state laws, such as homestead statutes, isn't immune from IRS confiscation.
Seize your bank accounts, securities accounts, and property in your safety deposit box.
Garnish your salary, Social Security, and pension payments. A single parent with two children could be left with as little as $514.42 per week.
Order the State Department to revoke your passport if you owe more than $53,000 in delinquent taxes, interest, and penalties.
An uncollected tax assessment automatically imposes a lien against everything you own or acquire in the future. Your property is subject to seizure by "any means."
The Mind-Bending Complexity of the Tax Code
Except for the simplest tax returns, it’s often impossible to understand your actual obligations under the Tax Code. The code itself contains about three million words; more than five times as many as Leo Tolstoy’s mammoth War and Peace. A guidebook for practitioners, called the CCH Standard Federal Tax Reporter, is over 70,000 pages long.
But the biggest problem of the Tax Code isn't its length or complexity, but its inconsistency, unpredictability, and retroactive application. A great example is the Tax Cuts and Jobs Act, which President Trump signed into law at the end of 2017. The act imposed a repatriation tax on previously untaxed profits at a top rate of 15.5% for corporate shareholders in controlled foreign corporations; 17.5% for individual shareholders.
The law was intended to force multinational corporations to pay tax on trillions of dollars in untaxed profits they’d stashed offshore. But it also applies to individual Americans with profits sheltered in foreign corporations. For Americans living overseas, those savings can now be double taxed; first by the IRS and later by their adopted country.
A group of these overseas Americans are now suing the IRS for failing to review the regulations it issued to collect this tax for their impact on small businesses, as required under a 1980 law. In December, a judge rejected IRS efforts to get the case dismissed. That’s good news, but the fact that the lawsuit was necessary at all shows how the Tax Code and the IRS can trample small business owners.
Tax Audits: The Real Story
It’s true that nearly 40% of audits are of taxpayers claiming a tax break available only in lower tax brackets called the “earned income tax credit” (EITC). And it’s also true that the IRS audits taxpayers claiming the EITC at about the same rate as those in the top 1% by income.
But several IRS compliance initiatives still target higher income taxpayers. One focuses on S corporations – a popular choice for entrepreneurs to organize their businesses. (They’re a favorite of presidential candidate Joe Biden.) Another zeroes in on bogus captive insurance arrangements. A third is an ongoing campaign to enforce offshore tax compliance. The IRS has even announced it will conduct more unannounced personal visits to taxpayers who have “large balances due.”
And thanks to the IRS’s data processing capabilities, every tax return is subjected to computer scoring and compared to returns of people with similar income and occupations. That means the effective audit rate is 100%, not 0.59%. If the IRS’s software detects discrepancies that exceed predetermined variances, you’ll receive a computer-generated letter seeking an explanation. If you’re due a refund, the IRS can withhold it until you resolve the issue.
The letters are worded cryptically and may require you to cross-reference its statements with a list of possible explanations. But if you want to speak with an IRS employee for clarification, good luck: you might have to wait as long as three hours on the IRS’s telephone hotline before you reach a human agent.
Are You a Tax Criminal?
Every year, a few thousand Americans are indicted for criminal tax offenses: tax evasion, tax fraud, failure to file, or money laundering. More than 90% of IRS criminal prosecutions end in convictions or plea agreements.
Possible charges range from perjury or tax evasion to conspiracy and money laundering — all of which are felonies. If you willfully evade tax, you may be imprisoned up to five years, fined up to $100,000, or both. Your guilt need not be proven directly but may be inferred by the surrounding circumstances.
However, the Tax Code is so complex that the Supreme Court has carved out for it a rare exception to the legal maxim that “ignorance of the law is no excuse.” To be convicted of a tax crime, the government must prove that you “willfully” committed it. But to prevail with this defense, you must demonstrate you had a good-faith belief you weren’t violating the law. Most criminal defendants who assert this defense lose.
Don’t get caught in a war with the IRS. You’re unlikely to win. Protect yourself by hiring a qualified tax professional who can make certain you file all required forms and pay the correct tax. Keep records substantiating the income and deductions you claim on your tax returns and proof that you filed.
And if the IRS does come after you? Especially with budget cuts, it’s not omnipotent. Its employees have heavy workloads. Supervisors encourage auditors to close cases in the shortest amount of time possible. You and your tax advisors can that your advantage.
I discussed these strategies in more detail in an Alert published for members of our Nestmann Inner Circle Gold on “What to Do When the IRS Comes Calling.” To learn more about this service, click here.