Co-Author: Tomasz Dow
The Build Back Better Act is currently making its way through the legislative process, with the U.S. House of Representatives approving the legislation in November 2021. The legislation is now being considered in the U.S. Senate.
Among other provisions, including paid family leave and clean energy initiatives, the Build Back Better Act includes spending of about $79 billion over the next decade for the IRS to hire new agents, strengthen tax enforcement and expand audits.
Debate Over the Build Back Better Act's Impact on Tax Audits
In an eight-hour marathon speech on the eve of the House's vote on the legislation, House Minority Leader Kevin McCarthy (R-Cal.) raised alarm flags about the legislation being used as a tool to go after unsuspecting taxpayers.
“If you or your family spends $28 a day — prepare to be under constant audit by the IRS,” said McCarthy of California. He also said that the legislation would “grant the government access to spy on nearly every Americans' bank accounts.”
Conversely, Democrats and liberal analysts say that the legislation's increase in tax enforcement resources will help to reduce the “tax gap” — the difference between taxes owed and the amount of tax revenue actually collected. According to liberal think tank American Progress, research shows that “wealthy taxpayers are often able to avoid a large share of what they owe, with the top 5 percent of earners accounting for more than half of the tax gap.” The Treasury Department has estimated the “tax gap” to be around $600 billion annually.
American Progress says that the Build Back Better Act would “provide new resources for efforts that address this inequity, giving the IRS the capacity needed to tackle sophisticated tax evasion and targeting new efforts at high-income individuals and corporate taxpayers.”
What the Build Back Better Act Actually Says
PolitiFact, an independent fact-checking organization, found that the Build Back Better Act does not include the provisions or risks McCarthy has warned about. In fact, the legislation states that “no use of these funds is intended to increase taxes on any taxpayer with taxable income below $400,000.”
Additionally, PolitiFact notes that the Treasury Department wrote in May 2021 that Biden's “compliance proposals are designed to ameliorate existing inequities by focusing on high-end evasion. Audit rates will not rise relative to recent years for those with less than $400,000 in actual income.”
According to Michael Kaercher, a senior attorney advisor at the Tax Law Center at NYU Law, the increased IRS funding provisions in the legislation, along with other administrative documents, show that the goal of the Build Back Better Act isn't to target the middle class or poor Americans but to reduce tax evasion and non-compliance.
“This funding will likely increase audit rates, but those increases will be directed to large corporations and high-income filers,” Kaercher said.
What is the difference between monitoring and being audited?
Much of Rep. McCarthy's criticism hinges on the administration's previous plans to implement new regulations regarding the monitoring of bank accounts. But the bank monitoring provisions aren't in the current version of the Build Back Better Act
Erin Hatch, spokesperson for the House Ways and Means Committee, explains, “the bank reporting proposal was never a part of the House's Build Back Better legislation, so it certainly wasn't in the version that passed [the House].”
“Most people think of an audit as hearing from the IRS, maybe getting a letter saying they owe money, or being told to come in for a meeting,” Casey Schwab, professor of accounting at the University of North Texas, told PolitiFact. “Information being reported to the IRS doesn't imply that you will be audited.”
Schwab confirmed that audits are labor- and time-intensive, so the IRS needs to be selective about who they audit.
What the Build Back Better Act Means for Taxpayers
Although the legislation won't have a far-reaching impact on the audits of the vast majority of Americans, as argued by Rep. McCarthy, there will likely be a higher audit rate of high-income taxpayers and corporations.
In a July 2020 report, the Congressional Budget Office estimated that a $40 billion increase in tax enforcement funding would result in recovered funds of $103 billion, for a net effect of $63 billion. The U.S. Department of Treasury's Office of Tax Analysis puts this net effect even higher at $400 billion in new revenue after accounting for the additional enforcement expenses.
Most recently, the Congressional Budget Office estimated that the increased funding for additional IRS staff would likely put tax audit rates at the levels they were at ten years ago.
In the past ten years, tax audit rates have plunged. The overall audit rate for the tax year 2019 was 0.4%, compared to 1.1% in 2010, according to a January 2021 report from the Congressional Research Service. Accordingly, if the CBO's estimate is correct, taxpayers can expect the overall audit rate to approach 1.0%.
However, the likelihood of being audited is greater for high-income taxpayers than low- and middle-income taxpayers. For instance, in 2018, the audit rate was 0.54% for individuals earning between $50,000 and $75,000; conversely, the audit rate was 6.66% for taxpayers reporting income over $10 million.
Looking back at the 10-years-ago figures, the audit rate for 2011 tax returns was 0.64% for individuals earning between $50,000 and $75,000; for taxpayers earning over $10 million, the audit rate was 27.37%.
CBS News reports that audit rates for high-income taxpayers decreased significantly over the past decade. For taxpayers earning over $1 million a year, the audit rate fell by half between 2010-2018, according to a Syracuse University analysis. Conversely, audit rates for taxpayers earning between $50,000 and $75,000 decreased by 31% during that same period.
Will the Senate pass the Build Back Better Act? And if so, when?
According to MarketWatch, analysts on both sides of the political aisle expect the legislation to pass the Senate. In fact, despite recent statements made by Sen. Joe Manchin (D-W.Va.) that the legislation is unlikely to pass the Senate before the end of the year, both analysts MarketWatch spoke to believe it would pass the Senate and be signed by President Biden before Christmas.
“I think the chances are very, very good that this bill will pass, and I wouldn't bet the mortgage on it, but I would predict that it's going to happen by this month,” Seth Hanlon, a senior fellow at the liberal Center for American Progress, told MarketWatch.
Kyle Pomerleau, a senior fellow at the conservative American Enterprise Institute, agreed with this assessment.
“I think that the Build Back Better Act ultimately passes. I think before Christmas seems like a reasonable timeline,” Pomerleau told MarketWatch. “There are other political challenges involved if this bleeds over into next year, and I think that the Democrats want to avoid that.”
How Can High-Income and High-Net-Worth Taxpayers Prepare for the Build Back Better Act?
Experts suggest that the risk of a tax audit will lead to increased compliance. “My view is the preponderance of the evidence suggests the deterrence effect of enforcement on evasion is clear and, in many cases, substantial,” Joel Slemrod, an economist teaching at the University of Michigan Ross School of Business, told MarketWatch. “Surprisingly, just getting a letter from a tax agency improves compliance. That's what I call the ‘you're-on-our-radar' effect.”
There are ways that high-income and high-net-worth taxpayers can ensure compliance and prepare for the increased likelihood of a tax audit if the Build Back Better Act is enacted as currently drafted. The IRS says that most audits for high-income taxpayers involve three different tax years, often include related entities, and frequently take years to resolve.
Tax audits are often initiated for the following issues:
- Unreported Income. Tax documents, including W-2s and 1099s, are all reported to the IRS by the payor. If there are any discrepancies between these tax documents and what you record on your tax return, it will trigger an audit. Even if you don't get tax documents regarding income, you need to report the income you earn.
- Making gross errors on tax returns. Major discrepancies can not only trigger an audit, they can also lead to penalties or even criminal charges.
- Self-employment expenses. Taxpayers often overestimate their self-employment expenses or include deductions that aren't permissible.
- Rental losses. Rental losses can only be active losses if the taxpayer is actually a real estate professional, as defined by the IRS.
- Overseas Accounts. In the past several years, the IRS has increased scrutiny of overseas accounts, according to CBNC. This could increase further after the enactment of the Build Back Better Act. Moreover, the Director of Collection Policy for the IRS released a memorandum to staff in August 2021 instructing them to conduct research to identify potential sources of tax collection, including foreign financial assets subject to reporting requirements under the Foreign Account Tax Compliance Act.
- Being a high-income earner. Statistically, audit rates increase dramatically as income increases. In 2015, the last year for which we have complete audit information, those earning more than $10 million faced a 12.06% chance of being audited.
To minimize the risk of an audit and to ensure a swift and favorable resolution if you are audited, taxpayers should:
- Make sure to file all required tax returns timely
- Save all documentation regarding the income, expenses, gains, and losses you are reporting in your tax return.
- Make sure to report funds held in overseas accounts accurately.
- Consult with an experienced tax professional. With the right preparation, you can put your mind at ease regarding any potential tax audit. A wealth management attorney and tax attorney can guide you through your options.
- Meticulously track all cryptocurrency transactions. The Build Back Better Act will require digital currency brokers to file yearly reports, starting in January 2023. While much is still unclear regarding the tax ramifications of cryptocurrency investments, taxpayers should keep detailed records of all cryptocurrency transactions to minimize audit risks and avoid overpayment of taxes.
The wealth management attorneys at GLFPE can help you understand the potential implications of the Build Back Better Act so that you can ensure compliance, make any necessary changes to your estate plan, and reduce the risk of a tax audit.