Tax practitioners are facing an increase in compliance efforts and controversies not only in the U.S. but worldwide, according to observers.
“It started several years ago, and then slowed down because of COVID,” said Sharon Katz-Pearlman, head of global tax dispute resolution and controversy at KPMG International, and the national principal-in-charge of its Tax Dispute Resolution Network.
“As we begin to emerge from COVID and return to a more normal environment, we’re beginning to see an increase in controversies and a more aggressive landscape for taxpayers,” she said. “And it’s not just in the U.S., it’s everywhere.”
In January 2017, the IRS began a new approach to examination, identifying campaign issues to target that they think have potential for noncompliance. “They consider it a ‘living, breathing’ list, adding and then removing or retiring various issues,” Katz-Pearlman added. “A lot of issues on the list are those they think have the potential for adjustments. For example, the Code Section 965 Tax [which requires U.S. shareholder to pay a transition tax on the untamed foreign earnings of certain specified foreign corporations as if those, earnings had been repatriated to the U.S.] is a very active campaign impacting a lot of taxpayers.”
“The TCJA campaign is another active campaign, and it’s very unusual, because there’s no single defined issue,” she said. “They designated partnerships as an area that needs increased focus. There’s been an ongoing consensus at the IRS and more broadly that they don’t audit enough partnerships. As a result, they have increased resources in that area. The new audit regime put forward by the Bipartisan Budget Act has started, and now they have additional resources.”
The IRS high-wealth initiative, which targets very wealthy individuals, is a focus around the world — not just in the U.S., according to Katz-Pearlman. “Other countries have a similar focus area,” she said. “And the Treasury Inspector General for Tax Administration recently issued a report indicating that enforcement efforts aimed at high-wealth taxpayers were not as robust as they should be. So that’s going to generate additional inquiries.”
The ‘Wealth Squad’
Steve Jager, a tax partner at CPA firm Fineman West, agreed: “The Global High-Wealth Group, also known as the ‘Wealth Squad,’ seeks to identify high-net-worth individuals. It uses whistle-blower type information, and gets many of its leads from data scientists. The IRS has invested time and money to develop data analytic tools. They employ an army of data scientists who create algorithms to ferret out corroborating documentation.”
“For example, when a taxpayer wants to increase their credit line, they fill out financial statements for the bank,” he explained. “Before data analytics, that information would stay in the bank files and require a lot of bad luck for the taxpayer if the application were to be discovered by the IRS and matched with the taxpayer’s tax returns. But now with algorithms they’re able to discover if a taxpayer filled out a loan application that indicates different income than what is being reported on their tax return. That’s a very powerful tool.”
“I’ve been cautioning my clients that if they’re filling out credit information and are asked for their income, they should be reasonably close to what’s verifiable on the tax return,” he said. “That’s the scary element of the Wealth Squad — they have access to all the information they weren’t able to use before. But their real power is through data analytics, which gives them the ability to unravel extremely complicated situations.”
For example, the taxpayer might be involved in a series of entities that prior to data analytics were not detectable by the IRS. “Instead of auditing the four corners of an individual tax return, they pull together all the entities that were uncovered. Every entity with the person’s name attached will get on the list, including S corporations, trusts, foundations, partnerships, and any entity that might serve to bury their income. It’s important that people tell a consistent story between entities,” Jager concluded.
Where the money is
The first target for the IRS is high-income, high-net-worth non-filers, according to Marty Davidoff, partner-in-charge of the national tax controversy practice at Top 100 Firm Prager Metis. “Biden’s budget adds $1.2 billion, most of which will go to increased enforcement. This is right. We have a commissioner who is appropriately looking toward the right audience of people.”
“But what we’re seeing day to day is that IRS penalties are being less forgiving on abatement,” Davidoff warned. “For example, a taxpayer’s 2018 return was filed and fully paid in May 2019. He received an $8,000 penalty because the CPA who prepared the return failed to press the button requesting an extension. The CPA even texted the client that, ‘We got your extension done.’ He — the CPA — wrote a seven-page letter to the IRS explaining the matter but the IRS would not waive the penalty for something that’s inadvertent.”
“When a CPA tells the client that the extension is being filed, what is the client supposed to do — go to his computer and look? These are people who really don’t owe any money but are being hit with assessments,” he continued. “They haven’t been ‘bad actors,’ but they get stuck in a fairly rigid system. They’re paying all their taxes and not intentionally doing anything wrong.”
Davidoff has recently dealt with four different cases of taxpayers who don’t owe any money but will have to go to Tax Court.
One case involved a woman who was estranged from her husband, who had sold his mother’s home after his mother died for $665,000. The attorney issued a Form 1099-S, “Proceeds from Real Estate Transactions,” but made a “decimal point” mistake, reporting that the house was sold for $6.65 million. The taxpayer didn’t report the sale on her return, because she didn’t even know the house had been sold, and she missed the filing date for a petition to the Tax Court. “The taxpayer doesn’t know where her husband is,” Davidoff added. “Meanwhile, the IRS thinks she owes them $3 million in tax, interest and penalties. There’s no easy way to get into the IRS to fix this. It’s not a fault of the IRS itself — the leadership is doing the best they can with the budget they have.”
“There are generally more audits of wealthy people, and traditionally more audits of Schedule C or smaller businesses,” according to Robbin Caruso, partner and co-leader of the national tax controversy practice at Prager Metis. “It’s more typical to see audits of Schedule C taxpayers than partnerships or S corporations. They can be as simple as a matching notice. For example, they didn’t include income reported on a 1099-INT. Or they might have sold stock and failed to report it. “
“If the taxpayer receives a matching notice for a capital transaction, the IRS may not know the basis but will assume the entire proceeds are a gain unless the taxpayer can demonstrate otherwise,” said Caruso. “That’s why it’s important to address notices from the IRS immediately.”
The whole COVID environment has had an impact on the economies and budgets of countries, Katz-Pearlman observed. “Revenue authorities have a job to do, and that is to determine where additional revenue is. There is a valid concern that revenue authorities might take a more pointed view because there is a need for additional revenue, and this is one way that they could recoup some of the tax revenue loss due to COVID.”
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