Time To Gear Up For An IRS Exam

High income households will be facing two different IRS enforcement initiatives when the IRS reopens on July 15. First, the IRS announced an effort to get high-income non-filers to come in and file tax returns. Second, the IRS announced it is preparing to examine “several hundred” high-income households that have either a related pass-through entity (such as a partnership or an S-Corporation) or a private foundation in a coordinated examination effort. Both enforcement initiatives are being headed up by the Large Business and International (”LB&I”) Division of the IRS. LB&I routinely announces enforcement “campaigns.” Think of a war campaign, not a political campaign, because that is what it feels like for taxpayers who are in the crosshairs of an LB&I Campaign.

The IRS Plans to Audit High Income Earners and Private Foundations

In March of 2020, Treasury Secretary Steven Mnuchin reported in a Ways and Means Committee hearing that he directed IRS Commissioner Charles Rettig to increase funding so that the IRS can audit more high-income earners. The IRS is making good on that promise. On June 18, at the New York University Tax Controversy Forum, LB&I Division Commissioner Douglas O’Donnell announced that as soon as the IRS reopens on July 15, the IRS will open several hundred new audits involving high-income individuals, and letters will go out through September. The audits will focus on high-income individuals who have a connection with at least one pass-through entity such as a partnership or S-Corporation, or a connection with a private foundation. The IRS is using data analytics and cooperation across divisions to make these audits as effective as possible. The announcement calls to mind the IRS “Wealth Squad,” a group of examiners focused on conducting audits of high income earners, but this time they will be coordinating across departments.

And speaking of private foundations, the IRS is working to increase those audits on their own as well. IRS Tax-Exempt and Government Entities Division commissioner Tamera Ripperda has identified over 1,000 cases of private foundations that are connected to high income or high net worth individuals. The IRS is particularly interested in auditing whether those private foundations have engaged in prohibited “self-dealing,” such as making loans to a disqualified person.

Private foundations and high income earners should not sit idly by and wait to see if a letter from the IRS announcing an audit shows up in the mail when the IRS reopens on July 15. As with any complex tax situation, there are proactive steps taxpayers can take to “get ready” for an audit. The first and best step is to have an outside professional look for soft spots and advise on the possibility of proactively fixing the problem or other options.

Nathan Richmon’s article in Tax Notes (behind a paywall) has a great overview of the NYU Tax Controversy Forum discussion.

High Income Non-Filers

The Treasury General for Tax Administration, or TIGTA, issued a report on May 29, 2020 that was – simply put – staggering. “Intentional nonfiling of tax returns by those with significant financial resources and sophistication is a brazen form of noncompliance,” that resulted in an estimated $37 billion of unreported, unpaid federal income tax for years 2011 through 2013. Maybe you are reading this thinking about your own taxes and the refund you get every year. Don’t taxes get taken out of someone’s paycheck? Not always, and in particular high income individuals who are independent contractors and who own businesses do not have taxes withheld.

The chronic nonfilers who are the subject of the TIGTA report are not people who are having taxes withheld. They are individuals who owe a significant amount of tax.

Roughly 50% of the high income nonfilers owe more than $50,000 in unpaid federal income tax, and just under 2,000 owe over one million dollars in unpaid federal income tax. It is no surprise, then, that LB&I launched a “High Income Non-Filer” Campaign that will concentrate on bringing taxpayers who have not filed returns into compliance.

In general, taxpayers who do not file tax returns on time will be assessed a penalty of 5% of the tax due for each month the tax return is late, with a maximum of 25% penalty. There is also a late payment penalty, at a much-lower rate of .5% per month the return is late, with a cap of 25%. The lesson readers should take away is that even if you have no money to pay the taxes due: file the tax return on time, because the late filing penalty is much more onerous than the late payment penalty. (And in my experience it is much easier to establish reasonable cause for late payment than for late filing). If the failure to file is fraudulent, the penalty increases to 75% of the unpaid tax. And if the failure to file is “wilfull,” then it may arise to criminal failure to file, and may result in a felony conviction with five years in prison. The May 29 TIGTA report confirmed there are hundreds of active high income nonfiler cases being pursued by the IRS Criminal Investigation Division right now.

There are often good reasons why people can’t get taxes filed on time: death in the family, serious illness, loss of records. A tragic life event may happen in one year, and the late filing would likely be excused by the IRS for reasonable cause. The problem is that for many people, when taxes do not get filed on time, if a whole years goes by and the tax return still isn’t filed, it becomes almost impossible to get done. People wonder, if I didn’t file in 2018 can I file in 2019? Will the IRS wonder why I didn’t file last year? The next year goes by, and the next, and paralysis sets in.

No matter how good the reason for the first year of late filing that turns into nonfiling, as the years go by and the unpaid tax adds up, the problem is compounded. Anyone who has missing tax returns should talk to a tax professional sooner rather than later to get them filed as soon as possible. A qualified representative will be able to access IRS records to get as much income information as possible and, equally as importantly, determine if the IRS is already looking for past due tax returns. The LB&I campaign for Nonfilers combined with the results of the TIGTA report leave no doubt that time is running out to come into compliance voluntarily.

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