The IRS is supposed to focus on audits of corporations and high-income and wealthy taxpayers. But who’s really under the agency’s microscope?
Some answers can be found in a new report shedding light on the IRS’ struggle to implement a key directive: not increasing audit rates for taxpayers earning less than $400,000 a year.
This challenge stems from President Biden’s promise not to raise taxes on those with lower and middle incomes. (Democratic presidential nominee Vice President Kamala Harris who has proposed several new tax credits, has also embraced that promise.) Notably, the pledge, which sounds simple and appears to be rooted in tax fairness, is wreaking a bit of havoc at the IRS.
The Treasury Inspector General for Tax Administration (TIGTA) says the IRS must address several complex issues to comply with the $400,000 directive, as it applies to taxpayers selected for audit.
Meanwhile, data show that the IRS has audited nearly half a million taxpayers making less than $200,000 a year as recently as six years ago.
So, on one hand, there are political promises, and on the other, there’s the reality of who actually faces high IRS audit rates.
Here’s more of what you need to know.
$400,000 tax pledge and IRS audit surge?
The $400,000 income tax threshold came about during President Biden’s presidential campaign four years ago. Biden promised that people and households making less than that amount per year wouldn’t see tax increases.
Two years later, the Biden administration enacted the Inflation Reduction Act (IRA). That massive law, chock full of tax credits (like the EV tax credit) and other clean energy incentives, allocated $80 billion in funding to the IRS.
- Those funds were supposed to enhance processes, technology, staffing, and compliance.
- Congress has since clawed back some of the funding, but about $24 billion is earmarked for IRS enforcement.
Still, the IRA triggered Treasury Secretary Janet Yellen to go all-in on the $400K threshold. Yellen directed the tax agency to ensure new funds wouldn’t be used to increase historic audit rates for small businesses and households making less than $400,000 a year. Instead, the agency would focus on high-income noncompliance.
Note: The tax audit directive is supposed to address concerns that the new IRS funding would increase scrutiny of middle-class taxpayers. As Kiplinger reported, that idea spurred fear and worry on social media when some lawmakers alleged that 87,000 new IRS agents were essentially coming for the tax dollars of middle-income earners.
Related: Are 87,000 IRS Agents Coming for Your Tax Dollars?
Despite the Treasury directive, the TIGTA report reveals that turning a political promise into effective policy and changing the IRS audit landscape will be challenging.
How will those challenges impact taxpayers?
IRS problems
According to the TIGTA, the IRS has only made "limited progress" in figuring out how to comply with the $400,000 tax audit directive. Here are some of the issues.
- Defining “income.” The IRS is reportedly trying to determine how to calculate the $400,000 threshold. The tax agency currently focuses on "total positive income," which is the total of all positive income sources (e.g., wages, salaries, investment income, Social Security Benefits, rental income, etc.) before deductions and losses.
- Establishing a historical baseline. To effectively measure future compliance, the tax agency needs to determine "historical" audit rates. The IRS will likely use the 2018 tax year as the base year, but the TIGTA report says the calculation method hadn’t been selected.
- Defining "small business." The Treasury and IRS haven’t agreed on what constitutes a small business for the $400,000 threshold purposes. (Note: The U.S. tax code doesn’t define “small business.”)
- Potential marriage penalty. The IRS’ current approach doesn't distinguish between individual and joint filers. So, the $400K limit applies to single filers, while married couples essentially share the threshold. The TIGTA report indicates this could put married couples at a higher audit risk.
Making $400K a year
There’s another concern with the $400,000 threshold: Earning $400,000 a year for some doesn’t mean having $400,000 a year in income. So, it begs questions about whether the income threshold is somewhat arbitrary or unfair.
Senate Finance Committee ranking member Mike Crapo (R-Idaho) wrote in a column about the tax audit directive that to most Americans, what they “make” means what they take home after paying expenses and incurring losses. Crapo added that using total positive income for the audit threshold could “catch many unsuspecting taxpayers in the IRS audit dragnet.”
Crapo has also expressed concern that the IRS may be auditing too many people who make less than $200,000 — far less annual income than the Treasury directive dictates.
For instance, six years ago (the 2018 base tax year the IRS uses), nearly half a million federal returns with less than $200K in income were reportedly audited.
Who gets audited most by the IRS?
Despite the $400,000 threshold and the IRS's intention to concentrate tax compliance efforts on high-income earners and large corporations, recent data paint a different picture.
EITC recipients: In recent years, taxpayers claiming the Earned Income Tax Credit (EITC), a tax break designed primarily for low to moderate-income workers, were audited at about a 1.27% rate. That is more than five times the overall average audit rate (in 2021) of 0.25%.
Taxpayers with low incomes: Data from the Transactional Records Clearing House at Syracuse University show that two years ago, taxpayers earning less than $25,000 had an audit rate of about 1.27%. That’s higher than any other income group that year except those earning over $1 million.
Middle and upper-middle-income earners: In 2022, taxpayers with yearly incomes between $200,000 and $1 million had an audit rate of only 0.6%.
Despite intentions to focus on high-income taxpayers, the audit rate for millionaires has dropped. In 2022, only about 1.1% of millionaire tax returns were audited, down from 8.4% fourteen years ago.
Data also show the IRS audited taxpayers with lower incomes at higher rates than many middle and upper-middle-income taxpayers.
In response, some will point out that Secretary Yellen said audit rates were not increasing from historical levels and that overall audit rates for all tax returns have declined over recent years.
However, others believe that as a practical matter and with tax fairness in mind, taxpayers with lower incomes are audited more than they probably should be based on earnings level.
Higher IRS audit rates
Why would people with lower incomes be subject to potentially higher audit rates? Various agencies, including the Government Accountability Office (GAO), have cited several factors. Here are a few.
Automation: Many audits of lower-income taxpayers are automated, making them easier and less costly for the IRS.
Resources: Before the IRA, limited IRS resources led the agency to focus on simpler audits that could be conducted quickly, often affecting lower-income taxpayers. (The argument is that wealthier taxpayers and large corporations tend to have more complex returns that require more time and highly skilled agents.)
Data: The IRS can match reported income with third-party information returns for wage earners, making it easier to spot discrepancies.
Correspondence: The IRS has increasingly relied on correspondence audits (conducted entirely by mail), which are less resource-intensive and often target lower-income taxpayers. According to the Congressional Research Service (CRS), these audits have made up about 85% of all individual audits in recent years.
On the flip side, some reasons for low audit rates of higher-income earners include (but aren’t limited to) reduced IRS staffing and the complexity of higher-income audits, which require more staff time and expertise.
Hence why, the agency has said it will use some of its IRA funding to hire and train experienced agents and auditors, among other staff.
IRS audit triggers: What you can do
Many eyes will remain on the IRS as the agency tries to nail down its audit, compliance, and enforcement approach in line with the $400,000 directive.
Recent numbers show some progress. For example, the tax agency has acknowledged that effectively targeting high-income tax evasion with a focus on wealthy individuals and large corporations is crucial for revenue collection. (As Kiplinger reported, the IRS recently collected $1.3 billion in back taxes from wealthy non-filers.)
But, the disparity in audit rates remains a concern. That is particularly problematic since, not long ago, a study based on U.S. Treasury data found that the IRS audited Black taxpayers at much higher rates.
Related: Does the IRS Audit Some Taxpayers More Than Others?
- While we wait to see how the IRS approaches audit rates, stay tuned to aspects of your tax return that can be considered IRS audit red flags.
- Work with a qualified and trusted tax preparer if you’re concerned about making a mistake on your return.
And remember, it's your right to properly claim tax deductions and credits you’re entitled to, so keep good tax records and documentation to support your claimed tax breaks. Proper documentation can go a long way if the IRS takes a second look.
