Earlier this month, the IRS announced that it will begin using AI to identify tax returns for examination and audits. This is, as the agency wrote in its announcement, part of an effort to shift attention toward high-earners, large corporations and complex partnerships. Among other changes, the agency will use “improved technology as well as Artificial Intelligence that will help IRS compliance teams better detect tax cheating, identify emerging compliance threats and improve case selection tools.”
Longtime critics of the IRS pushed back almost immediately. Among others, Grover Norquist, founder of Americans for Tax Reform and general opponent of income taxation, argued in the New York Times that the IRS “has a history of blaming its problems with enforcing the tax code on its algorithms [and] employing artificial intelligence was just another way for the IRS to separate itself from future accusations of political bias or inequitable enforcement practices.”
The tax agency, on the other hand, has announced its AI push as part of a program of fairness and cracking down on tax cheats.
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IRS Aims to Bridge the Gap on Audit Disparities
Audits of wealthy taxpayers, large companies and large partnerships fell considerably over the past 20 years, coinciding with a roughly 25% budget cut over the same time. The agency has cited budgetary restrictions as a reason for the shift.
But in 2022, Congress authorized $80 billion in new funding for the IRS. The agency has used much of that money to hire more experienced agents who can handle the complexities and pushback involved with auditing wealthy taxpayers, companies and partnerships. This is particularly valuable for auditing partnerships, a growing category of tax filers that are particularly time consuming to audit.
Next generation AI will help the tax agency work with larger files more quickly, which will make it easier to conduct an initial review. However, selecting a file for review has never been the IRS’ main difficulty. For years the bottleneck has been a lack of personnel and resources to pursue that review and audit once the system raised a red flag. Hiring new, more experienced staff is the bigger change, one which has allowed the IRS to identify 75 of the largest partnerships in the nation with a combined $10 billion in assets for audit.
While it’s unclear exactly how the AI will be implemented, it’s clear that the agency intends to improve results and accuracy of audits. The IRS has announced that it intends to step up tax enforcement on files worth more than $400,000, and particularly on partnerships. A faster system will let the agency do that better, but the real difference is that now there will be more accountants and lawyers behind the scenes using it. They are the ones who will conduct the audit, and they’ll do so the same way that they always do: Patiently, thoroughly and (usually) successfully.
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IRS Use of Data and Automation
Despite hype and criticism, the reality is that the IRS has long relied on automation to select files for audit.
In most cases the IRS selects files for examination based on a computer screening. (Occasionally there will be exceptions, such as when the IRS receives a recommendation for audit from third parties.) The agency’s system compares a tax return against a base set of norms, looking for patterns and flags that correlate with known tax problems. For example, the system might flag round numbers, unusually large refundable credits or expense claims unusual for a given category of business. It particularly flags any relationship between a tax return and other audit targets, and returns that don’t match information provided by third parties such as bank statements or employers.
The system then scores each tax return based on how many issues it raises and pulls files with a high enough score.
Once a file has been selected it is then reviewed by IRS agents in person. They determine whether the tax return represents material misconduct, good faith or de minimis error, or if it just appears mistaken. For example, say a taxpayer organized their income differently than their bank and employer statements reflected. The system would likely flag this for an audit based on information matching, but a human review would determine that the taxpayer accurately represented all of their income.
If the IRS agent decides that the file requires further investigation, it will typically proceed to an audit.
Tax Planning Tips
- Audits are an essential part of the tax system. They collect underpaid taxes and incentivize the voluntary compliance system. But how, exactly, do they work?
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