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Bring Back the Tax Ferrets

Dec. 9, 2021, 9:45 AM

The IRS is overmatched. The agency is up against taxpayers willing to pay armies of experts top dollar to devise intricate, and legally problematic, tax avoidance schemes. Increasing IRS funding is one way to combat this juggernaut, but we should do something else: Bring back a 19th-century tax enforcement mainstay—the “tax ferret.”

Wealthy taxpayers face millions or even billions in tax liabilities. But they spend some of this money on experts who mine the tax code for strategies that reduce their tax liabilities. By shifting income to low-tax jurisdictions or creating tax shelters, the experts often save the taxpayer much more than the—very high—fees they charge.

Most of the strategies devised by the tax experts are complicated. But some strategies devised by tax avoidance experts are not legal. Taxpayers still pursue them because the IRS is unlikely to spot the illegal scheme and even if it is identified, the IRS has to prove that the proposed scheme is illegal. Much of the $1 trillion annual “tax gap”—the difference between what is paid in taxes and what is legally owed in taxes—falls into these categories.

Enter the tax ferrets. These individuals or organizations would be government contractors with the right to audit the tax returns of taxpayers with incomes over $1 million and large corporations and get a cut, say 20%, of the additional revenue they collect, giving the ferrets the resources and incentives to uncover problematic tax schemes that may be uncollectible for IRS agents receiving government salaries.

In the past, state and local governments levying property taxes contracted with tax ferrets to identify untaxed or undervalued properties or stocks. The ferrets, who were authorized to operate in over 20 states, received a percentage of any additional property tax they secured for the government. Modern tax ferrets would do something similar for the federal government, reducing the tax gap in exchange for a cut of the extra revenue.

Modern-day tax ferrets could be licensed by the IRS to have access to restricted tax data, with IRS standards requiring expertise in tax law and data confidentiality, as well as scrupulous ethics. Indeed, experience with the IRS might be a requirement for a license, helping to facilitate cooperation between tax ferrets and the IRS and also providing an incentive for tax professionals to begin their careers with the IRS.

The tax return auditing process would begin with the IRS choosing returns to audit. This would prevent tax ferrets from earning fees on taxes the IRS can collect via its own investigative mechanisms. After the IRS has completed its review, tax ferrets would be entitled to audit additional returns of the wealthy or large corporations, or to take over any cases that the IRS has chosen to discontinue. To commence an audit, tax ferrets should pay an auditing fee of 1% of the taxpayer’s reported income to any taxpayer they choose to audit. This fee would compensate innocent taxpayers who are inconvenienced by the tax ferrets and would prevent tax ferrets from choosing too many returns to audit. Claims for additional tax payments brought by tax ferrets should be adjudicated by independent tax courts.

Tax ferrets would be entitled to a percentage of any additional tax revenues that resulted from their audits under these conditions. With the prospect of collecting millions or even billions of dollars in contingency fees, tax ferrets would have an incentive to uncover, comprehend, and oppose intricate tax schemes that are beyond the IRS’s capacity to pursue.

By adopting an old idea for modern times, present-day tax ferrets would level the playing field of tax enforcement. With massive payoffs available to tax enforcers as well as tax avoiders, the U.S. could make a significant dent in the $1 trillion tax gap—without requiring additional outlays by the IRS.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Yair Listokin is the Shibley Family Fund Professor of Law at Yale Law School. His scholarship studies tax law, corporate law, bankruptcy law, contract law, and the law of central banking.

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To contact the reporter on this story: Kelly Phillips Erb in Washington at kerb@bloombergindustry.com