IRS urged to overhaul its examination function

The Internal Revenue Service needs to develop a more coordinated approach to its tax examination function, according to a new report, as the agency comes under fire from various quarters for its tax audit and enforcement efforts.

A report released Monday by the Treasury Inspector General for Tax Administration found the IRS doesn't have a multiyear Examination Strategic Plan for allocating resources across its entire examination function. The report noted that the IRS's four business operating divisions — Wage and Investment, Small Business/ Self-Employed, Large Business and International, and Tax Exempt and Government Entities — each cover different segments of taxpayers and do different types of examinations, including full tax audits. 

The report comes at a time when the IRS has been under fire from Republicans in Congress who warn the agency will use much of the extra $80 billion in extra funding allocated over 10 years by last year's Inflation Reduction Act to increase tax audits. The IRS and Democrats have countered that the funding will mainly be used to improve taxpayer service, modernize aging computer systems, and beef up enforcement against large corporations and wealthy taxpayers. 

Andrew Harrer/Bloomberg

Sen. Mike Crapo, R-Idaho, the ranking Republican on the Senate Finance Committee, disputed those claims in an editorial for the Washington Examiner, writing, "Supporters claim the IRS will not use the $80 billion to hire 87,000 new employees, instead insisting hiring will mostly backfill employee retirements. In truth, the supersized funding will go toward significantly increasing the IRS's size, particularly on the enforcement front."

The IRS came under criticism after a study was released this month by researchers at Stanford University, the University of Michigan, the University of Chicago and the Treasury Department that found the IRS is more likely to audit Black taxpayers versus taxpayers of other races due to computer algorithms and disparities in the rate of claiming the Earned Income Tax Credit (see story).

This week's TIGTA report found the IRS needs to be doing more on the strategic planning side to ensure its examinations are dedicating the appropriate amount of resources. The IRS does have a general five-year strategic plan with broad goals for the agency, but the strategic plan lacks the kinds of details needed for compliance functions, such as examination, to most effectively allocate resources. 

"Creating a multiyear, comprehensive Examination Strategic Plan would provide IRS management with clear direction on how to allocate examination resources," said the report. "In addition, the IRS does not have a coordinated approach for developing an annual enterprise-wide examination workplan that considers the various strategic and operational risks of all the examination functions. Examination management from the four business operating divisions independently develop their annual workplans to determine how to allocate resources in their own work areas. The IRS would also benefit from having an annual enterprise-wide examination workplan. This would help to ensure a consistent, strategic approach and transparency for allocating resources in the examination areas with the most significant needs."

The report found the IRS doesn't use estimates of the tax gap to determine where its examination function should allocate resources in its work planning. IRS management informed TIGTA that ongoing research on complex areas of noncompliance and planned future changes to the tax gap methodology should make the gap more useful for informing resource allocation decisions through enterprise examination planning.

The report includes a table showing that the Earned Income Tax Credit ranks at the top for underreporting, especially for taxpayers whose incomes fall below $200,000 per year, which is one reason why the IRS has been pursuing EITC claims much more frequently than those of wealthier taxpayers.

TIGTA recommended that the IRS should:

• Consider adopting a multiyear, comprehensive Examination Strategic Plan;
• Establish a documented annual enterprise-wide examination planning process;
• Set up a process to use tax gap data annually to identify opportunities to better align resources that more effectively narrow the net gap; and,
• Develop a tool to consider risk and other relevant variables to inform examination resource allocation decisions, then expand its use to include examination workstreams from all divisions. 

IRS officials agreed with all four of the report's recommendations. 
"Establishing a multiyear strategic plan may provide the IRS with a more coordinated and cohesive approach to resource allocation and examination efforts," wrote Melanie Krause, acting deputy commissioner for services and enforcement at the IRS, in response to the report. "However, such a plan will need to be informed by corresponding considerations such as recruiting, hiring, training and staffing needs in areas of competing priority. Further, a multiyear strategic plan will require agility to address new and emerging issues, legislative changes, shifts in priorities and resources."

She noted that recent discussions of audits of high-income taxpayers and syndicated conservation easement transactions are two examples of areas where the IRS's ability to flexibly respond to areas of interest is critical to meeting its strategic priorities. 

Those strategic priorities may well shift in the near future, as the Senate Finance Committee prepares to hold a confirmation hearing on Wednesday for a new IRS commissioner, Daniel Werfel.

"The next commissioner of internal revenue will see the Internal Revenue Service through a transformative time," said Chad Hooper, executive director of the Professional Managers Association, a group representing managers at the IRS and other parts of the federal government, in a statement Monday ahead of Werfel's confirmation hearing. "The American people are demanding better customer service and better tax processing from the IRS. Last year, Congress finally gave the IRS the opportunity to meet those demands through the Inflation Reduction Act. The next five years will be critical for shaping the IRS's future and managing the proper spending of the $80 billion Congress has committed to the IRS over the next ten years. The IRS has a long way to go, and strong, stable leadership will be critical for making the vision of the IRA a reality."