The Internal Revenue Service is spending more time auditing smaller businesses instead of larger ones, according to a new report out today by the Transactional Records Access Clearinghouse (TRAC). Since 2005, the IRS has cut the time it spends auditing firms with assets of $250 million or more by 33%. Meanwhile, the IRS has increased the hours it spends on businesses with assets of $5 million or less by 34%. Yet the report also shows that auditing big firms is much more lucrative than examining the tax returns of smaller ones. Why is the IRS moving in this direction?

Bigger Firm Audits More Profitable

This chart shows how much more money the IRS makes spending its time looking at larger firms:

TRAC_IRS Revenue.PNG

As the dollars-per-hour figure clearly shows, audits of the larger companies are far more profitable: the IRS earns a whopping $8,329 more per hour auditing firms with assets of $250 million or more than those smaller. This data makes it seem strange that the IRS would make such a shift. Its boss, the U.S. Treasury, collects far more money per hour from the bigger firms.

The Bigger They Are, The Harder the Audit

The report explains that this is due how much longer it takes auditors to examine the bigger firms than smaller ones. Since IRS employees are under pressure to meet quotas, they are steered away from spending more time on the bigger firms -- even if that time pays off better. That can be seen pretty clearly by the following two charts. This one shows that the number of firms audited in various size categories isn't that vastly different across most of the spectrum:

TRAC_IRS Number.PNG

But the hours spent vary greatly:

TRAC_IRS Hours.PNG

The IRS Mission?

This raises the question: should the IRS be trying to spread out its effort over roughly the same number of firms of various sizes, or focus on those where it can make the most money? According to its mission:

The IRS role is to help the large majority of compliant taxpayers with the tax law, while ensuring that the minority who are unwilling to comply pay their fair share.

That's not really a mandate to act like a profit-seeking entity: it's to catch the firms who aren't paying what they should be. That could be interpreted to make sure you catch the largest number of firms instead of collecting the most in unpaid taxes. Perhaps the IRS should altar its mission to specifically seek profit, but such an assertion could be controversial.

Auditor's Instinct?

What this report fails to explain is the judgment factor on the part of IRS agents. It's plausible that its auditors targets firms where they suspect incorrect taxes to have been paid. Since big firms have very sophisticated tax experts working for them, they should make fewer mistakes. If the IRS is focusing on those they strong suspect of not paying their taxes properly, then that could explain why it has had such dramatic success in its hourly earnings for big firms. After all, large companies have more revenue, so their mistakes would cost them more. But if those big firms are paying their taxes properly, then very time consuming audits could prove a huge waste of time.

More Evidence Reform Is Needed

One clear lesson from this report should be that the tax code needs simplification. If the IRS could spend less time on all audits, it could cover a larger number of firms. A less complex tax code would produce that end. Instead, the IRS feels pressure to spread its scarce resources over smaller businesses so that it can cover more ground. With tax code reform, the IRS could review more companies in less time, which would better ensure that more firms are paying what they owe.

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