A fragile lifeline for the IRS

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I have no great love of the Internal Revenue Service, but the current criticisms from people like Iowa Senator Chuck Grassley, who is trying to convince people that that 87,000 IRS agents are headed to Iowa carrying high-lethality weapons have zero basis in reality. Grassley needs to be retired by the voters. However, I am going to tell you how the IRS really works. At any rate, my story will be more accurate than Grassley’s.

First, I need to share about the cagey long-time corporate controller I worked with for several years. Our closely-held company had been sold to a much bigger holding company headquartered far from his operation, and the new owners demanded some stiff profitability goals annually. Like many businesses, he knew he could bury a lot of managerial mistakes in excess inventory. His strategy was to wait to write off a lot of obsolete inventory until we would have the inevitable bad year, thus boosting annual “accounting profits” and managerial bonuses in the good years. In a bad year, when there were no bonuses to be had by any creative way to account for the year, he would then pull out all that dead inventory, sometimes literally caked with dust, and destroy it, now making it a really bad year from an accounting point of view.  Freed from that dead inventory, we were now more likely to show greater accounting profits in future years. It was classic joke about accounting profit in real practice: “How much do you want it to be?”

The problem was the auditors. He hated them snooping around in his inventory transactions, or worse yet, spending time in the warehouse. However, because we were a “backwater” for this big international corporation, the major CPA firm auditing our books did not send their best to our location, instead staffing multiple trainee CPAs on the team. The outside auditors kept this group’s budgeted hours low, and their “overnights” few, in order to maximize auditor profit. The wise old controller would intentionally “salt the books” with some small, obvious but complex mis-booked transactions throughout the year. This would force the auditors to spend their limited hours tracking down and correcting his “errors.” This left no time in the audit budget to do the hard, and literally dirty, work of auditing obsolete inventory, where the big money was.

Here is how Congress intentionally does this with the IRS:

First, realize that the bipartisan House and Senate committee members responsible for taxation legislation all get big contributions from tax policy lobbyists. These contributions are followed by lobbyist-written language intended to be inserted by a “friendly” congressman into the annual tax legislation. The changes almost always make some income rule, deduction, or tax credit more complicated, with more exceptions, requiring more lines on the tax forms, or even special forms. And the changes “coincidentally” always work to the advantage of at least one big client paying the lobbyist.

For instance, the trade association representing my industry hired a well-connected lobbyist who would brag at the annual meetings that he controlled the fate of just one line on corporate tax forms that was worth millions of dollars to the members of the trade association. Multiply that by all the lobbyists and all the trade associations in Washington. THAT is how tax law is made.

Meanwhile at the IRS:

The second lobbyist strategy is to keep staffing budgets at the IRS low and pay under-market. Every one of those lobbyist-written tax code changes can likely be exploited for maximum gain and minimum tax due. You do not want anyone working at the IRS long enough to get expertise in your provision of the tax code. Lobbyists want to make the rule so complex that any case initiated against a client will take months-to-years of collective agent time to bring to completion, and still have enough wiggle room that even experienced agents will probably lose their case. Big tax cases are hard to document, lengthy, and expensive to prosecute.

On the other hand, you can train rookie workers in a high-turnover IRS to audit the Earned Income Tax Credit in a day or two. This part of the code is only used by the poorest Americans, and they are usually tripped up by missing a W2 or 1099 documentation of income, often because this same group of taxpayers tends to move and change employers frequently. The eligibility of the taxpayer’s children, an important part of the calculation, is often uncertain, due to residency, custody or child support agreements, thus making this a primary cause of computation error. The IRS literally knows more about their income and qualification for the credit than the taxpayer does, but it doesn’t tell them until the return is rejected or adjusted, or the audit letter comes. It is literally a form of entrapment. And all for peanuts gained in revenues, but with a high “success” rate for the auditors.

In short, because they are so easy to audit by inexperienced agents, poor people are far more likely to be audited than the fat cats massaging away millions of dollars of taxes due. Of course this reversal of moral priorities could be aided by hiring more qualified agents and paying them better, which is the intent of the recently-signed Inflation Reduction Act. 50,000 IRS agents are reportedly likely to retire over the next five years, and this is where the bulk Grassley’s feared 87,000 personnel are accounted for (and almost all unarmed, Chuck).

Money is also to be directed at updating the long-obsolete COBOL programs that drive the IRS computer systems. I was writing COBOL programs on my first job over 50 years ago. But for extensive usage still by the federal government, COBOL is pretty much a dead computer language.

But the longer-term solution requires more:

Free File. My IRS-fix priority list is topped by scrapping the current “Free File” system intentionally hobbled by H&R Block, TurboTax and their competitors. 70% of taxpayers could use this system, but only 3% do. I have experimented with it and the barriers to even finding the “free path” are daunting. TurboTax wants to sell you something, not give you a free tax return, even if your taxes are basic.

Past changes to the deductibility of house mortgage interest and charitable contributions have simplified greatly the returns of many taxpayers, even those making over $100,000 in family income. For most of us, we have just W2 or 1099 income. We can deduct next to nothing anymore past the standard deduction, and so we pay tax on that net amount. Much of the rest of the return has become a fruitless but complex hassle for millions of Americans. So much more could be simplified, obviating the need for paying someone to do your taxes for you.

Millions of tax filers today would already be best served by being sent pre-filled forms directly or online from the IRS, telling them what the IRS already knows based on past returns, W2s, and 1099s issued. The taxpayer could then submit that return or modify it, preferably online directly to the IRS, not using some “partner site.” This would literally eliminate millions of audits of low-income taxpayers caused by mistakes and missing information rather than an intent to deceive. Fortunately, the Inflation Reduction Act has allocated $15 million to investigate an improved free e-file system. Look for a strong-arm attempt by the tax preparation firms to kneecap this effort, however, as they have already for Free File.

Sunset of special-interest provisions. As I have earlier noted, almost every change to the tax code, of which there are hundreds annually, requires “warm bodies” at the IRS to implement and audit. Most of these provisions were intentionally inserted favor some constituent business or rich person, and each modification provides opportunities for creative tax consultants to construct new loopholes. My longstanding position is that the only feasible way out of this mess is a mass “sunsetting” of any tax provisions that favor, say, only one in 10,000 taxpayers (pick your favorite ratio here; the IRS has the necessary data). These rules could be handed over to a bipartisan commission to determine whether they should be retained, but the base assumption should be that they would all die in three years. Estimates are that there is up to $500 billion per year of collectable tax to be had in these special interest “tax expenditures.”

The basic principle being violated by these special-interest rules is that my income should be treated like your income. We are equal citizens. In the current system, low-wage workers are taxed from the first dollar, first to pay for my Social Security (just as I paid for my parents’ Social Security — “trust funds” are an accounting fiction, paper handcuffs self-applied to Congress and easily bypassed), and then are taxed on their labor income. Meanwhile, people living off inheritances from their parents in lobbyist-dominated businesses, such as real estate, farming, and private equity, can shelter huge portions of that income from ever being taxed at the nominal rates. And they quickly reach an income cap ending their payment of Social Security taxes. The injustice is naked.

WGPD Tax Code

The Daily podcast from the New York Times recently ran an excellent story on “the tax loophole that would not die,” the carried interest provision used by private equity managers. I find it fascinating how many low-income Republicans have been fooled into thinking that they should be paying higher tax rates (and sometimes higher taxes) than rich people.

Improved minimum tax. A major positive step in the Inflation Reduction Act is the imposition of a minimum tax of 15% on corporations. What makes this most significant is that the definition of “income” is not my old controller’s fiddled numbers, which is how most corporations determine this fiction called “taxable income.” Rather the minimum is based on what is called GAAP income (Generally Accepted Accounting Principles), the same income that they report to their shareholders under the rules of the Financial Accounting Standards Board (FASB).

The Trump Corporation is currently in court for playing an especially aggressive version of a game played by virtually all sizable corporations. They want to show their best performance to their owners, and so FASB rules regulate the audits required to come up with that income number, especially to make sure it is not overstated, which is the natural inclination for managers seeking performance bonuses. On the other hand, these same managers want “taxable income,” the number reported to the IRS that few shareholders actually see, as low as possible. This is the primary impetus for the current congressional tax code revision process that I described earlier. I have long advocated getting taxable corporate income much closer to FASB income under that same philosophy. Business income is business income, whether you are a mom-and-pop LLC or ExxonMobil.

Keeping taxable income and GAAP income the same, one with natural pressure to understate and the other to overstate, gets us far closer to the “taxable truth” than where we are currently. But corporate tax reform has a long way to go, and it should start with the same “sunsetting” I have proposed for personal taxes.

The Inflation Reduction Act is a start on tax reform, but it is swimming against a very strong tide. If you want to see true bipartisanship in Washington DC, you will find it on these tax legislation committees in Congress. These are not “campaign contributions” that they are receiving. This is “bribery,” and we need to start calling it that.

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3 thoughts on “A fragile lifeline for the IRS

  1. Lisa

    Great post – very educational. In addition to TurboTax, H&R Block et al, would imagine that accounting firms and associated trade associations are also lobbying to keep the complexities in the tax code?
    Certainly not in the same league as your story, but it reminds me of the time I took an intro to accounting seminar for small businesses from a local accountant, an older gentleman. Everything seemed fine, until the session in which he advised us that the best way to get info on our competitors was to go out the night before trash collection day, and conduct our “market research” in their dumpsters and trash cans. Options like shredding were not commonly available at that time. Yes, trash is considered “abandoned property”, but something about his advice felt, well, a bit dirty and unethical. But I did learn something – from that day forward, my trash cans go out the day of trash collection, not the night before, and anything I wouldn’t want falling in the wrong hands gets shredded.

  2. Linda DeBarthe

    Your research is always impressive. Thanks for these great class examples!
    I just saw that the Treasury has promised that the extra $80 billion will NOT result in increased audit rates for small businesses or individuals with income < $400,000. Of course that's just a promise, not part of the law, but at least there's an intention.

  3. Pingback: How Republicans are more shrewd than Democrats on tax policy – When God Plays Dice

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