Amid the coronavirus pandemic, the IRS failed to process around 8 million paper returns by the end of 2020. Recently, the agency has signaled "swift and aggressive action" now that the Inflation Reduction Act has boosted the IRS' resources following more than a decade of budget cuts. (Photo by Alex Goodlett for The Washington Post via Getty Images)
has boosted the agency's resources following more than a decade of budget cuts. Among these action plans is the combination of AI and new accountants to expand the agency's large corporate compliance, or LCC, program, which uses data analytics to identify large companies for audit.These cuts had prompted the IRS to switch from continuous audits to issue-based examinations beginning in 2017 under the agency's Large Business and International Division. Specialists say LB&I will likely now use AI to sharpen its focus on new potential issues with companies that aren't strangers to examinations while expanding the audit scope to include businesses that may have been under the radar for a while.
The IRS will be going through masses of data it has on companies, including tax return information and publicly available financial data such as U.S. Securities and Exchange Commission filings, according to Robert Kovacev, a member of Miller & Chevalier Chtd. The recent announcement, with its emphasis on data analytics, is saying the agency will be launching audits based on whatever anomaly its algorithm finds, he said.
"I think a lot of large businesses that haven't been audited in a long time will receive audit notices seemingly out of the blue," Kovacev said. "Those are likely to be technology-driven."
The IRS on Oct. 20 announced its plans to expand the LCC program, which includes corporate taxpayers with average assets of more than $24 billion and average taxable income of approximately $526 million per year. As new accountants join the agency in early 2024, LB&I intends to start an additional 60 audits of the largest businesses using a combination of AI and subject matter expertise in areas such as cross-border issues and corporate transactions, according to the announcement.
The IRS cited new resources under the Inflation Reduction Act, which increased the agency's funding by almost $80 billion, with nearly $46 billion earmarked for enforcement. About $20 billion of that total increase was subsequently clawed back under an agreement reached this year by President Joe Biden and then-House Speaker Kevin McCarthy, R-Calif.
As part of the announcement, the agency noted that prior to the Inflation Reduction Act, more than a decade of budget cuts prevented the IRS "from keeping pace with the increasingly complicated set of tools that the wealthiest taxpayers use to hide their income and evade paying their share."
Budget cuts were at the center of a 2015 announcement about a change in audit approaches from LB&I, which is responsible for examining companies with assets of more than $10 million. The division said at the time that it was moving toward issue-based examinations instead of the old approach of placing large multinational businesses under continuous audit by a rolling team of examiners.
LB&I in 2017 launched its first round of compliance campaigns, which highlighted an array of corporate transactions that the agency saw as red flags, including maneuvers to repatriate foreign earnings tax-free. The agency also created the LCC program as part of its shift away from continuous audits to risk-based exams.
When the IRS switched to issue-focused examinations and algorithms to target companies, it was "haphazard," according to Kevin Spencer, a partner at McDermott Will & Emery LLP. But with AI and updated technology, the agency is going to be able to take advantage of more efficient computer audit techniques, he said.
The IRS will likely use its computer systems to look for changes, such as if a company takes a much larger depreciation expense deduction in one year compared to previous years, according to Spencer. If there are multiple risk factors, the agency might open up an audit of that company and focus its attention on issues that the computer flagged, he said.
"That's kind of what they're doing now, but my guess is they're going to be able to be much more robust," he said.
Similarly, Covington & Burling LLP partner Kevin Otero said companies that may not have gotten caught within the audit selection analysis for a few years could now be examined. In addition, companies that have been examined may be looked at in a different way based on specific issues that the IRS chooses to focus on, he said.
These new examinations may be "more efficient in some ways, and in other respects more burdensome, depending on what the issue is and what the analytics show to the IRS," he said.
Vivek Patel, a partner at Baker McKenzie, noted that the agency's announcement suggests the approach is a combination of AI and subject matter expertise. The key is for corporate taxpayers to remain vigilant and make sure that's what actually happens in practice, and that there isn't an overreliance on the program itself, he said.
"AI is a tool, so it could help the IRS in getting through a more complicated audit or determining where it wants to focus resources, but it can't replace the job of the agent," Patel said.
As for specific issues the IRS may focus on, the agency's announcement also outlined a transfer pricing initiative that will focus on large foreign-owned corporations.
According to the announcement, the agency is "increasing compliance efforts" of U.S. subsidiaries of foreign corporations that distribute goods in the U.S. and underreport their taxable U.S. profits. As part of this initiative, the agency said it would send so-called compliance alerts to approximately 150 subsidiaries.
A spokesperson for the IRS told Law360 that the alerts will be sent this month to these subsidiaries, which share a common denominator of income reported over multiple years indicating that the pricing of their intercompany transactions may not comply with U.S. rules.
"We are asking all of these companies to review their transfer pricing, amend their tax returns where necessary, and, in what our data suggest to be the most glaring cases, provide additional information about their transfer pricing to the IRS," the spokesperson said.
As Otero saw it, the compliance alerts will allow corporate taxpayers to be on notice about what the agency is doing, and if they should perhaps double back and consider any tax return filings.
"It's a way for the IRS to increase companies' awareness of issues and perhaps get voluntary compliance that would save the service from having to engage in direct scrutiny or devote substantial resources in situations where otherwise a soft approach would work," he said.
In general, practitioners say the agency's recent announcement is a message for large companies to ensure that they're able to substantiate their tax decisions — perhaps with a level of detail that some corporations haven't consistently applied over the last several years.
According to Miller & Chevalier's Kovacev, it's fair to say that some businesses "have become complacent" over the past decade, and haven't paid enough attention to the possibility of an audit and having to prepare for that audit.
"This announcement tells those businesses they need to ensure that they have substantiation for their tax positions, and they are ready in advance to defend any positions on their tax returns," he said. "Otherwise, they may find themselves playing catch-up late in the game after they receive an audit notice from the IRS."
In a similar vein, Spencer said corporate taxpayers should be proactive in realizing "the new paradigm" that the IRS is working under, including targeting aberrations in a company's tax profile. A company should not put its "head in the sand" waiting for the agency to swoop in, he said.
Spencer added, "I think that maybe we're seeing the end of the audit lottery, where people just hope that they can escape being recognized."
--Editing by Tim Ruel and Roy LeBlanc.
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