Businesses take aggressive tax positions when IRS budget declines

Companies take IRS budgets into consideration when developing their year-to-year tax strategies and take more aggressive tax positions when IRS budgets are smaller, and retreat to less risky tax positions when IRS budgets are higher, according to a new study.

The study, which appears in the American Accounting Association’s Journal of Forensic Accounting Research, examined the relationship between IRS resources, tax aggression and the likelihood of tax fraud. The results suggest firms increase their tax risk profile and show signs of more tax aggression and higher likelihood of tax fraud when they believe the chances of extra scrutiny from the IRS will be lower.

“We wanted to explore what external factors affect a company’s decisions regarding tax avoidance,” said Danielle Stanley, an assistant professor of accounting at Coastal Carolina University who coauthored the study, in a statement. “Specifically, we wanted to see if companies were more comfortable with aggressive tax strategies when they think the IRS has fewer resources to engage in audits.” 

The paper takes a different tack from earlier research. “Previous work looked at corporate tax decisions in light of historical audit rates, asking whether recent audit rates influenced tax strategy,” said Hannah Smith Antinozzi, an assistant professor of accountancy at the University of Memphis who coauthored the study, in a statement. “We took a different approach and looked at corporate decisions in the context of publicly-available data on the IRS’s forecast budget.” 

The IRS recently announced plans to ramp up its audits of large corporations and partnerships as well as wealthy individuals, using funding from the Inflation Reduction Act, as part of its updated strategic operating plan.

“Their objective is to nearly triple the audit rate on large corporations with assets over $250 million, increase the rate by tenfold on large, complex partnerships with over $10 million and increase the audit rate by more than 50% on wealthy individual taxpayers with total positive income over $10 million,” said Eric Hylton, a former commissioner of the IRS’s Small Business/Self-Employed division and deputy chief of the IRS’s Criminal Investigation division who is now national director of compliance at the tax consulting firm Alliantgroup, in a recent interview with Accounting Today. “When you take all those things in perspective, you see that the IRS is shifting some of their resources toward the high-income net worth individuals. Now, the challenge obviously is making sure you have the personnel to be able to address any of these issues. And I think they’re going to be going through extensive training. This is really part of the fallout from the lack of funding that the Service has received, probably a 30% reduction over the last 10 or 15 years, and in enforcement personnel. That expertise has been lost, so it’s going to take some time for the Service to be able to work on any of these issues, but they’re pursuing it pretty heavily.”

“They’re going to be hiring a lot of new personnel, and they’re getting very creative in who they’re going to hire,” said Mark Baran, a managing director at Top 25 firm CBIZ MHM’s National Tax Office. “These experts are going to be looking at and requesting a lot of information, so that information should be organized and ready to go, just in case companies or wealthy individuals are selected for audit.”

For the study, the researchers examined data from 10,992 companies between 2011 and 2021. To assess changes in how aggressive each company was in its tax positions, they looked at changes in each company’s effective tax rates and uncertain tax benefits. The researchers collected data on IRS budgets from the Treasury Department, and the team then used statistical tools to account for variables, enabling them to better identify any correlation between corporate tax positions and the projected IRS budget for the following year. 

“We looked at IRS budget projections for the next year, because that is when the IRS could begin conducting audits on this year’s tax filings,” Stanley stated. “Our biggest finding was that companies appear to take IRS budgets into consideration and take more aggressive tax positions when budgets go down. That’s over and above any correlation to historical audit data.” 

They found that concurrent IRS resources provide better evidence than past audit rates to measure the likelihood of tax fraud or aggressive tax decisions. Companies increase their tax aggressiveness and the likelihood of committing tax fraud as IRS resources decline, suggesting that businesses account for IRS resources when making their tax decisions. The results held true even after controlling for the most recent year’s historical audit rate. That suggests proposed IRS budgets — which are typically the most up-to-date information available regarding the IRS’s resources to audit in the future — do influence companywide decisions to aggressively pursue tax positions and potentially commit tax fraud. 

“In other words, our findings suggest companies pay more attention to the IRS’s projected budget than they do to recent audit rates when making decisions about how aggressive to be with their tax strategy,” Antinozzi studied. “One takeaway message here is that cuts to IRS budgets seem to have the unintended consequence of encouraging aggressive tax behavior.” “And from a practical standpoint, our study suggests auditors should be aware that firms are more likely to make dicey tax decisions when IRS budgets are down,” Stanley stated. “That makes it particularly important for auditors to allocate their available resources in ways that will identify tax fraud.”