The IRS Picks On the Little Guy

Tax audits of big companies have declined as the Internal Revenue Service shifts its attention to smaller businesses.
Marie LeoneApril 28, 2010

The Internal Revenue Service has cut the amount of time it spends auditing large companies by a third since 2005, while reducing the number of large companies audited by 22%, according to a new study. In fact, last year the IRS audited only one in four corporate returns reporting assets of $250 million or more, says the study, which was conducted by the Transactional Records Access Clearinghouse (TRAC), a research organization sponsored by Syracuse University.

While IRS audits of large companies dropped by 1,000 to 3,675 between 2005 and 2009, audit rates fell even faster, says TRAC (see chart below). In 2005 the agency audited 43 out of every 100 big-company returns, but by 2009 the audit rate had fallen to 25 out of every 100. The downward trend isn’t new: 20 years ago, two out of every three large corporations were audited by the IRS.

What’s more, TRAC data shows that large-company audits declined even as the number of IRS revenue agents grew, jumping by 6% since 2005, to about 13,000. (Some of those agents likely were temporarily reassigned to handle tax issues associated with last year’s economic stimulus bill.)

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The recent cutbacks were made despite evidence that IRS audits of big companies uncover the largest dollar amounts of tax underreporting. For instance, viewed on an hourly basis, audits of large companies exposed $9,354 of underreported taxes per auditor hour in 2009, while audits of small and midsize companies revealed only $1,025 per hour. Meanwhile, collection of underpaid taxes has decreased by 2% since 2005, dropping to $17.4 billion.

One reason for the audit drop may be a “perverse quota system,” say the study’s authors. The TRAC report explains that the IRS regularly establishes monthly audit goals for revenue agents as a way of measuring performance. The goals may be a factor in determining which companies to audit, says TRAC, noting that auditors and their managers may look less productive if they focus on more time-consuming audits.

The IRS declined to comment on the TRAC study. However, an IRS press statement summing up the 2007 fiscal year noted that the agency had audited partnership and S corporation returns, reflecting that the agency was placing “more emphasis in the growing area of these flow-through returns.” The IRS said that while audits of large corporations were down, it had increased its focus on midmarket corporations, those with assets between $10 million and $50 million. “In times of flat budgets, the agency cannot increase activity across the board but must address the areas where there is growth and potential risk,” noted the press statement. (Flat budgets may not be a concern for long: the 2010 omnibus spending bill signed into law by President Obama included $12.2 billion for the IRS, which plans to spend a record $5.5 billion this year on enforcement efforts.)

IRS Big Audits

Why is the IRS ramping up audits of smaller companies? One reason is “the drumbeat regarding the ‘tax gap,’” the difference between taxes owed and actually collected, says Dean Zerbe, national managing director of tax consultancy Alliantgroup. “The IRS has stated repeatedly that smaller businesses are the core of the tax-gap problem,” he says. Alvin Rabushka, a senior fellow at Stanford University’s Hoover Institute, puts the size of the gap at $400 billion and rising.

While Zerbe says it is “difficult” to speculate on the decline in large-company audits, he points out that sustention rates (the ratio of agreed-on and upheld tax deficiencies to proposed tax deficiencies) may have something to do with the shift. Historically, sustention rates pertaining to large companies have been very low, says Zerbe. While the IRS may seek a high dollar amount based on underreported taxes, “the number drops like a stone” when the case gets to court and wends its way through the appeals process, he says.

Smaller companies also see the amount of tax they owe reduced in court, but “not nearly as dramatically,” notes Zerbe. That’s because they may not have the resources to challenge the IRS and are therefore more likely to settle. As a result, the IRS may see a better “bang for the buck” pursuing smaller companies, says Zerbe.

But targeting smaller companies may be bad for the economy on the whole, since audits consume the time and attention of business owners, adds Zerbe. “While politicians in Washington love to give speeches touting how small businesses are the engines for job growth, revving up IRS audits of small business is like putting sugar in the gas tank,” he says.



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