The IRS's new emphasis - tax enforcement.

Over the last two years, there has been broad agreement that "enforcement" is an appropriate function of the IRS. This represents a real change from the feeding frenzy of IlLS bashing that took place just a few years ago, during Congressional hearings. The working equation now is "service plus enforcement equals compliance" The agency has improved service from the 1990s. Its telephone service (i.e., answering taxpayer questions) is much improved. Use of its website (www.irs.gov) is up dramatically. Electronic filing has grown. In 2004, 62 million taxpayers filed electronically; in 2005, more than half of all individual taxpayers are expected to e-file.

The IRS now sees that enforcement is crucial. Each year, too many taxpayers fail to pay their tax liabilities. The annual "tax gap" is in the many billions of dollars--money obviously needed in a period of large deficits. But the implications of an effective tax administration system go beyond deficits. When people fail to pay their taxes, it undermines public confidence in the tax system.

Why is enforcement necessary? As President Kennedy wrote to Congress in 1961:

To the extent that some people are dishonest or careless in their dealings with the government, the majority is forced to carry a heavier tax burden. For voluntary self-assessment to be both meaningful and productive of revenues, the citizens must not only have confidence in the fairness of the tax laws, but also in their uniform and vigorous enforcement ... If non-compliance by the few continues unchecked, the confidence of the many in our self-assessment system will be shaken and one of the corner-stones of our government weakened.

Results

The Service now understands this dynamic and it is ramping up enforcement activities:

1. After years of decline, enforcement revenues are increasing. Last year--fiscal 2004--the IRS brought in a record $43.1 billion in enforcement revenue, from audits, document matching and collection activity. This was up 15% from the year before, and from a low of $32.9 billion in 1999.

2. Audits of high-income taxpayers were up 40% from the year before. The Service engaged in almost 200,000 high-income audits last year, double the number from three years ago.

3. Total audits of individual taxpayers were up 19%, to just over one million, the highest since 1999.

4. Audits of the largest businesses--those with assets of $10 million or more--climbed over 30%, after years of decline.

5. The number of levies on taxpayer assets rose 21%.

6. The IRS referred more than 3,000 criminal prosecutions to the Department of Justice (DOJ), a nearly 20% increase.

Abusive Tax Shelters

The Service believes the public is being too creative in some areas--particularly, abusive tax shelters used by corporations and high-income taxpayers. Five factors contributed to their proliferation:

1. The tremendous complexity of the Code. Those who construct or participate in abusive tax shelters take advantage of the Code's complexity to obtain benefits that Congress never intended. Complexity has become shelter promoters' camouflage. They scour the nooks and crannies of the Code and regulations for tiny gaps, vague words, obscure loopholes and other weak spots. Promoters hope that both the taxpayer and the IlLS will be confused by a shelter's complexity, or that complexity will enable the shelter to escape the Service's detection.

2. The cozy relationship among sophisticated promoters. There have been reinforcing networks of commercial interests that design, develop and market these sophisticated products. These networks include investment bankers, accounting firms and law firms and brokerage houses; the promoters are increasingly international, stateless organizations. In the past, they were largely content to take advantage of gaps and tear lines in the income tax structure. Now, more and more, they seek to exploit those between tax laws and government administrators of different nations. 3. The erosion of professional ethics. Attorneys and accountants should be the pillars of our systems of taxation, not the architects of its circumvention.

4. An ineffectual regulatory scheme. Small penalties for failing to comply with IRS regulations undermined the regulation of abusive transactions. In some instances, blue-chip professionals actually weighed potential fees for promoting shelters and violating the law against the risk of IRS detection and penalty size. In an environment of deteriorated professional ethics, clearly the penalties were too low; they were no more than a speed bump on a single-minded road to professional riches.

5. The Service's withdrawal from the enforcement battlefield. From 1997-2001, the number of revenue agents, revenue officers and criminal investigators each decreased by more than 25%, with predictable results: audits conducted, monies collected and criminal prosecutions all declined.

The response to the spread of abusive tax shelters has been effective. 1. More transparency of abusive tax transactions. Over the last several years,Treasury and the Service have significantly increased and accelerated the issuance of published guidance on potentially abusive transactions. The need to list an abusive transaction has a deterrent effect on investors and is a clear signal that the IRS will challenge these tax positions.

2. Schedule M-3, Net Income (Loss) Reconciliation for Corporations With Total Assets of $10 Million or More. The IRS issued Schedule M-3, which requires corporations to provide more detail as to differences between income reported for financial accounting and for tax purposes. (1)

3. Economic-substance doctrine. One aspect of how the IRS deals with abusive tax shelters is its approach to the "economic substance" doctrine. When promoters have resisted the Service's information requirements, the IRS and the DOJ have vigorously pursued compliance with promoter registration, disclosure and list-maintenance requirements.

4. IRS victories. The IRS has won a number of key court opinions on privilege. (2) In defending the marketing and developing of generic products as traditionally privileged, the legal profession overreached, damaging a fundamental element of our legal system--privilege.

5. Promoter investigations. The IRS is going after promoters, both criminally and civilly. It is investigating more than 165 of them. A number of these investigations include criminal components, a departure from the past. Previously during a criminal investigation, all civil activity came to a halt. But the IRS is now moving forward, parallel with the DOJ. The enforcement model is changing.

Professional Ethics

To combat the erosion in professional ethics, the IRS doubled the size of its Office of Professional Responsibility and hired Cono Namorato to direct it. Years ago, Cono was a prosecutor for the DOJ. He began his career as an IRS criminal investigator.

To help maintain public confidence in tax professionals, the IRS has strengthened Circular 230. (3) The new standards send a strong message to tax professionals who might consider selling a questionable product to clients.

The American Jobs Creation Act (AJCA) was enacted in October 2004. It cracks down on abusive shelters and those who encourage and promote them. Sen. Charles Grassley (R-IA), Chairman of Senate Finance Committee, said of the AJCA:

   This is the strongest anti-tax shelter measure
   since 1986 ... it closes a lot of the
   loopholes that allow companies to escape
   their fair share of U.S. taxes. The message
   is, if you play by the rules, you'll get a tax
   break. If you don't play by the rules,
   you'll be caught and pay a heavy price.

The IRS now has authority to impose a monetary penalty on an individual who violates Circular 230. An additional monetary penalty may be imposed on the employer, firm or other entity if it knew or should have known of the misconduct.

The AJCA created an accuracy-related penalty for listed transactions and other reportable transactions having a significant tax avoidance purpose. It also created a penalty for failing to disclose reportable transactions. It increased penalties on promoters for failing to register a tax shelter with the IRS. It increased promoter penalties for failure to maintain investor lists and increased the promoter penalties for false statements. (4)

The Service is also targeting other areas in its enforcement build-up. It is paying particular attention to abuses among tax-exempt and governmental entities (e.g., credit-counseling and other charitable organizations). The IRS has under examination 50% of the credit-counseling industry and believes that, overall, charitable institutions are at risk.

Increased Enforcement

There is a real revival of enforcement at the Service, in many areas. The playing field is no longer as lop-sided as it once was. Taxpayers and promoters can no longer afford to take a carefree approach to questionable tax shelters, nor assume that the only risk is the possible payment of the fill1 tax with no penalty.

Now, they might have to pay the entire tax, plus a stiff penalty. A tax-payer might have to wrestle with questions like, "How much am I going to have to pay the lawyers and expert witnesses to litigate this thing? .... Should I fight the IRS in court?" Or, "Am I better off paying my attorneys for a lawsuit against the promoters who got me in this mess?"

Going to court is a public matter; thus, the IRS hopes that potential damage to reputation will be a factor. Many wealthy individuals otherwise seen as community leaders may not want to be identified as paying less than their fair share.

Conclusion

While the IRS cannot yet declare victory in its war against tax law abuse, it has made demonstrable progress, but there is much more to do. Americans need to be confident that when they pay their taxes honestly and accurately, their neighbors and business competitors are doing the same.

(1) For a discussion of Schedule M-3, see McGowan and Killion,"Schedule M-3: Closing the Corporate Book-Tax Gap," 36 The Tax Adviser 408 (July 2005).

(2) See, e.g., Jade Trading, LLC, Fed. Cl., 4/22/05.

(3) Treasury Circular 230, Regulations Governing the Practice of Attorneys, Certified Public Accountants, Enrolled Agents and Appraisers Before the Internal Revenue Service.

(4) For a discussion, see Chassman and Brennan, Tax Practice & Procedures, "AJCA Penalties for Noncompliance with Reportable Transaction Regs." 36 The Tax Adviser 232 (April 2005).

DAVID B. PORTER, J.D., ATTORNEY, ROBERT W. WOOD, P.C., SAN FRANCISCO, CA, AND CHAIR, TAX PROCEDURE AND LITIGATION COMMITTEE OF THE STATE BAR OF CALIFORNIA'S TAX SECTION