How Is The IRS Spending $80B In New Funding?

Now that the tax deadline has passed, have you ever paused for a moment to consider how all of the tax returns get processed? The Internal Revenue Service (IRS) is arguably one of the most loathed government agencies in the country. It is a mammoth organization consisting of over 79 thousand employees that are responsible for the collection of over $4.9 trillion in annual revenue from taxpayers. Recently, the government allocated $80 billion in new funding to the organization via the Inflation Reduction Act that became law in January of this year. With such a significant cash infusion, it begs the question: How will the IRS spend $80B in new funding? Spoiler alert: you’re probably not going to like the answer.

The Department of Treasury released its plan in late March on the use of the new funding for the IRS. The funds will be spent over the next decade and small business owners should pay close attention to where the IRS will focus their spending.

Growing the IRS Workforce

If you’ve ever had to correspond with the IRS, you know they are historically slow. Following the required government shutdowns and mandatory work-from-home requirements for government employees in 2020, the IRS experienced significant challenges in maintaining a workforce to support the agency. The National Taxpayer Advocate Annual Report to Congress for 2021 reported the IRS received a record 282 million calls that year. Of those calls, 32 million, or 11 percent, were answered by customer service representatives. In 2022, their answer rate improved slightly to 13 percent. IRS Commissioner Danny Werfel said that the agency had already hired 5,000 service representatives who had answered 1 million more calls than last filing season and reduced average wait times by about four minutes as of February 2023. This growth in the workforce is music to the ears of many taxpayers who have struggled to get assistance from the IRS to address time-sensitive issues.

Increasing the Number of IRS Audits

The other additions to the IRS workforce will likely not be celebrated by most taxpayers. The agency has announced plans to add a total of 8,700 auditors to its workforce by 2024. This growth in their workforce means a higher percentage of taxpayers will be subjected to an audit than in the past decade.

The agency has consistently stated that the new auditors will be focused on households and businesses earning more than $400,000 a year. In testimony before Congress, Werfel repeated a pledge from Treasury Secretary Janet Yellen that new auditors and enforcement initiatives at the IRS would be focused “exclusively” on wealthy people, partnerships, and corporations. This threshold puts small business owners who are taxed as S-corporations squarely in the crosshairs of the IRS. According to the IRS, S-corporations became the most common corporate entity type in 1997. For the past 25 years, entrepreneurs have chosen this entity type for its strategic tax benefits. S-corporations file a corporate tax return and are generally subject to the same legal protections as C-corporations, but their net profit is passed through to their shareholders and becomes a part of their household income. The combined profit from their small business along with other income including W-2 wages, puts a large percentage of small business owners over $400,000 in total income. The agency’s focus on this income level is described as an emphasis on the wealthy, but it creates a higher frequency of audits for small businesses.

Increasing the Collections by the IRS

The allocation of funds to more auditors results in more enforcement activity by the IRS. The justification for this significant increase in funding to the agency includes an expected return on investment (ROI). The Congressional Budget Office (CBO) reports an ROI ranging from 500 to 900 percent.

CBO’s estimate of revenues is based on the IRS’s projected returns on investment (ROIs) for spending on new enforcement initiatives. The IRS estimates those ROIs by calculating the expected revenues that would be raised from taxes, interest, and penalties as a result of the new initiatives and dividing them by their additional cost. (The agency has provided ROIs over the past five years as part of its budget justification.) The IRS’s ROIs ramp up over three years as staff become trained and fully productive, arrive at the peak level, and then stay there.

Once again this is not good news for taxpayers. It’s historically proven that when the IRS increases its audits, it is successful in recouping millions of dollars from taxpayers. Now, more than ever, small business owners will need to be diligent to limit their audit risk and protect themselves from the IRS.

Don’t Overreact, Instead Be Proactive

While the planned use for the IRS’s new funding is not good news for small businesses, being armed with this information, you can be proactive in limiting your risk for audit. Even with an increase in their workforce, the IRS can’t afford to audit a high percentage of tax returns. The agency uses an algorithm to screen for potential red flags in a filed return to identify underpayments to the IRS and increase tax revenue. Last year, only 0.38 percent of tax returns were audited by the IRS, according to a recent report using IRS data from Syracuse University’s Transactional Records Access Clearinghouse. It’s predicted this rate could double with the resources provided by new spending, however, your risk still remains under 1 percent. Given these statistics, your risk of audit still remains low.

Plus, with the expected increase in audits, you can proactively prevent some of those red flags that may trigger an audit before you submit your return. For a business owner, the majority of IRS audits are triggered by suspected underreporting of income. Specifically, underreported Form 1099 income tops the list as a red flag for the IRS. Business owners can receive four different Form 1099s including:

• 1099-C – Cancellation of Debt
• 1099-K – Merchant Card and Third-Party Network Payments
• 1099-CAP – Changes in Corporate Control and Capital Structure
• 1099-MISC – Miscellaneous Income

Each of these forms will be provided to you and also filed with the IRS. If the amounts attributable to these 1099s are not accurately reported in your tax return, your audit risk increases. Be proactive in gathering all of your 1099 forms, and compile them with your other income sources to avoid unnecessary audit risk due to underreporting income.

Protect yourself from the IRS

Needless to say, learning the IRS is dedicating more money and human resources to enforcement activities is bound to raise the eyebrows of taxpayers. Gaining awareness of the agency’s plans, and being armed with the right information to protect yourself will ensure you make the right moves for this tax season and beyond.