After a decade of budget cuts and watching audit rates of wealthy taxpayers decline due to fiscal constraints, the IRS announced earlier this year its plans to establish a special unit to focus on large or complex pass-through entities.
IRS Commissioner Daniel Werfel says the goal is to “disrupt efforts by certain large partnerships to use pass-throughs to intentionally shield income to avoid paying the taxes they owe,” and to “end the era of historically low error rates for wealthy and large entities while making sure middle- and low-income filers continue to see no change in audit rates for years to come.”
The Need for Change
The need for the special unit is clear. IRS data released for the tax years 2012 – 2020 shows the Service examined 0.3 percent of the partnership returns filed for tax year 2012 but less than .05 percent for 2020.The IRS audited .4 percent of the S Corporation returns filed for 2012 while auditing less than .05 percent of such returns for tax year 2020.
On October 12, 2023, the IRS published its new tax gap projections for tax years 2020 and 2021, showing the projected gross tax gap increased to $688 billion in tax year 2021, a significant increase from previous estimates. According to Commissioner Werfel, this jump underscores the importance of increased IRS compliance efforts in key areas such as high-income individuals, partnerships, and corporations.
Focus on Pass-Through Entities
The upcoming special pass-through unit will zero in on large or complex pass-through entities, including partnerships and S-corporations. These entities, not subject to corporate income tax, pass their income through to individual or corporate owners, who are then taxed at their respective income tax rates. Given the complexity of these structures, they have become popular among higher-income groups, necessitating increased scrutiny.
Location and Staffing of the New Unit
The new unit will find its home within the IRS’s Large Business and International (LB&I) division in New York. Staffed with a diverse group of personnel, including LB&I agents, employees from the Small Business/Self-Employed division, and new hires. In conjunction with the establishment of the pass-through unit, the IRS recently announced it is embarking on a larger transformation, opening more than 3,700 positions nationwide to bolster enforcement efforts.
Data Analytics as a Game Changer
In an effort to avoid unnecessary “no-change” audits that burden taxpayers, the new unit will harness the power of data analytics. As the IRS must currently sift through vast amounts of taxpayer data to select returns for examination, data analytics will play a crucial role in identifying returns most likely to contain reporting errors. This strategic use of technology will enable the IRS to detect tax cheating, identify emerging compliance threats, and improve case selection.
As the IRS adapts to the changing landscape of tax compliance, the establishment of the specialized pass-through unit represents a significant step toward holding high-income entities accountable.