Symposium | Rebuilding Enforcement

Tax Enforcement: Let the IRS Do Its Job

By Brian Galle

Tagged equalityIRSTaxes

Money would solve a lot of problems for the IRS. As widely reported, the IRS budget has been slashed in recent years, even as the sophistication and international scope of tax-planning by businesses and the very wealthy has grown considerably. In response, IRS has shifted enforcement resources to target those taxpayers who are unlikely to engage in lengthy disputes, leaving richer taxpayers undisturbed. For example, in 2018, IRS conducted less than half as many compliance audits of small businesses—a notorious area of low compliance—as it had in 2014. Meanwhile, IRS cannot afford to pursue profitable investments in IT infrastructure, and soon may have to dramatically cut its national research program, the source for the algorithms that help it detect fraud and abuse.

Obviously Congress should remedy this situation as soon as possible, but in the meanwhile there are significant steps IRS and other executive actors can take to improve the fairness, efficacy, and legitimacy of the tax system. Some of these steps are straightforward. It is absurd, for instance, that some of America’s poorest areas are its most intensively audited. Similarly, IRS should withdraw or revise known money-losing regulations, such as old guidance on the taxation of private equity and recent rules on multinational corporations. More subtly, but of no less importance, we need to revisit the ways in which IRS is accountable to the public and other government actors for its decisions, undoing a current divide in which determinations that lose money are much easier to enact, and less transparent, than those that raise it. And we need more targeted solutions to some of the more obscure but problematic areas of the IRS portfolio, including its oversight of political activity and of certain forms of complex small businesses.
First, the IRS should dramatically scale back its audits of low-wage earned income tax credit (EITC) recipients and reallocate those efforts to where the money is: small businesses, the self-employed, and the very wealthy. It makes no sense to expend so much effort trying to take back money from households whose earnings are just a shade farther from the poverty line than those officially targeted by EITC.

IRS and Treasury could also work together to roll back past regulatory mistakes that have made it easy for the wealthiest taxpayers to escape paying their fair share (tax regulations are usually co-written by IRS and Treasury, and formally issued through the Treasury Department). Many readers will have heard of the “carried-interest loophole,” the provision that allows private equity managers to pay tax at a bit more than half the rate of other top-bracket workers. A 1993 IRS ruling is the keystone of this position. Less familiar are a set of rulings dealing with family businesses, trusts, and the estate and gift tax. In combination, these allow for the very wealthiest families to escape a large fraction of their estate-tax bills. Equally misguided are regulations issued over the last few years implementing the 2017 tax legislation, most of which are far more generous to taxpayers than budget scorers projected.

The Obama Administration was reportedly reluctant to take administrative steps to reform carried interest in part because of the budget scoring consequences; that is, because of congressional rules that effectively require new sources of revenue whenever Congress wants to spend new money. But that consideration is unlikely to be important in the next Senate. Since allowing Congress to close the loophole would have generated a positive revenue score, Treasury seems to have concluded it would be better to save carried interest as a “pay for” to cover other costly legislative priorities. That never happened, and so perhaps one lesson learned is that it’s better to simply collect tax revenues whenever we can. More importantly, revenue scores are significant mostly due to filibuster rules in the Senate that allow budget-friendly legislation to pass with 51 rather than 60 votes. Whichever party retains power, the filibuster and its 60-vote threshold look increasingly under threat. Next year’s Treasury should not skimp on key reforms in order to create pay-fors that might turn out to be worthless.

Reform IRS Administrative Law

Deeper structural reforms are necessary to avoid repeating these kinds of giveaways in the future. Modern administrative law has evolved to systematically disfavor revenue, and that evolution has accelerated with recent developments that should be reversed. Some of these steps will require congressional authorization, but again, others are already within the control of the executive.

For one, rules for when IRS decisions can be reviewed in court may tilt the regulatory scales in favor of tax cuts and against a sound budget. Briefly, this is because the U.S. Supreme Court has said that, for the most part, no one has “standing,” or a right to bring a court challenge, to complain about anyone else’s tax treatment. Only taxpayers who are directly and adversely affected by IRS or Treasury decisions can have their day in court. Are you mad that the President (reportedly) took a $70,000 deduction for hair styling? Too bad: Twitter is your only outlet for complaints on that matter.

This rule necessarily shapes IRS incentives and behavior. Agencies build careful administrative records, meticulously responding to every public comment, in large measure in order to survive judicial review. If rules that give away money cannot be reviewed, while rules that demand payment can, then it is systematically more difficult for the IRS  to take actions that raise funds. Especially to a resource-strapped agency like IRS, that difference in time and effort can be crucial. Thus, judicial review and its absence tend to close off avenues of public participation and to favor giveaways to private interests.

Further steepening this tilt against revenue collection are a growing set of procedural obstacles to tax rulemaking. The Trump Administration revoked important portions of Treasury’s longstanding exemption from Office of Management and Budget (OMB) review of tax rules. Courts are cutting back on the traditional deference IRS received. And a pending Supreme Court case under the obscure “Anti-Injunction Act” threatens to allow lawsuits to block the IRS from rules that raise revenue, before those rules are even enforced. All these add to the obstacles IRS must overcome to raise money, further encouraging it instead to do nothing or to simply give away the store.

Probably the best corrective would be comprehensive legislation to encourage review of giveaways and remove barriers to revenue-raising regulation. But a Biden Administration could reinstate the OMB exemption of revenue-raising tax rules, while retaining review of rules that could not be reviewed in court. IRS could voluntarily subject itself to internal review of possible giveaways, either through its Inspector General or the existing Office of Appeals, which currently hears disputes between individual taxpayers and line auditors. It might also publicly report major individual decisions in favor of taxpayers, perhaps using an anonymized system similar to its existing “private letter” rulings.

Deep Cuts: Politics and Partnerships

These existing failings—lack of resources and an inclination to accede to taxpayers at the expense of the public’s interest—have been especially evident in two small but important units. These units oversee charities (and other tax-exempts, such as 501(c)(4)s and business leagues) as well as partnerships. IRS has seemingly abandoned efforts to reject new applicants for charitable status, or to police political activity by tax-exempt entities. Its task on the latter front has been complicated by a series of congressional budget riders, which have blocked the agency from finalizing regulations that might limit political expenditures by “dark money” (c)(4) organizations. IRS should be allowed to do its job, and the new administration should be sure to install personnel who understand that the IRS charity unit serves as a de factoregulator of politics, higher education, and the hospital sector.

Partnerships are a poorly understood area that can serve as a playground for rich people’s tax lawyers. For tax purposes, a “partnership” is a non-corporate business entity, often complex in its ownership structure, which is subject to a unique set of tax rules. Most private equity firms, for example, are taxed as partnerships. Planners can build dense networks of interrelated partnerships that make auditing, and even basic data collection, an impossible chore. We simply don’t know the extent of wealth and tax minimization represented by modern partnerships.

In addition to substantive reforms to partnership tax law, a possible response on the administrative side could be a “know your partner” regulation, inspired by New York’s efforts to shut down shell-company ownership of that state’s real estate (and akin to some proposed federal disclosure rules for LLCs). That is, IRS could use its existing authority to set reporting obligations to require partnerships to disclose enough information to make it possible to know who a partnership’s ultimate owners are, and to effectively audit the entities. For instance, each partnership could be required to provide a visual representation of its organizational structure and owners. Each partnership—perhaps excepting publicly-held partnerships—could also be obliged to report the real humans or publicly-held entities who are the ultimate owners of the partnership and its related entities, along with the total capital and tax obligations that flowed to each owner from anywhere in the organizational structure.

Without question, the IRS has struggled in recent years to fulfill its mission. Like many agencies, it is mostly staffed with skilled and dedicated public servants who want to do their job and do it well. But Congress, courts, and deep-pocketed taxpayers have made the agency’s task a significant challenge. With a handful of reforms—and of course more money—we can turn that around.

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Brian Galle is a professor of law at Georgetown University Law Center. He has also been a prosecutor in the Criminal Appeals & Tax Enforcement Policy Section of the Tax Division of the U.S. Department of Justice, and a visiting scholar at the Urban/Brookings Tax Policy Center. Follow him on Twitter @BDGesq.

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