IRS Hybrid Audit Approach Best Bet to Scrutinize Rich Taxpayers

The IRS must reassess and refine its audit strategies to optimize resources, maximize compliance, and achieve its stated goal to increase scrutiny of high-income individuals. A hybrid audit strategy that ensures 100% of the top 1% of income earners are audited, with progressively lower rates for lower brackets, would be most effective.

IRS policies have shifted focus from a targeted income audit mandate to a broader sweep of all high-income taxpayers. This shift, highlighted in a Treasury Inspector General for Tax Administration report late last month, aims to ensure high-net-worth individuals are being audited more frequently. But it lacks metrics and could undermine efforts to ensure improvements in tax compliance among the wealthiest taxpayers.

The shift specifically involved abandonment of a previous Treasury directive that required auditing a minimum of 8% of returns for individuals with incomes over $10 million. The new policy aims for compliance across a wider spectrum, but it lacks specific methods to measure effectiveness—which raises concerns about its impact on audit rates.

Hybrid Approach

The earlier Treasury directive was a focused and measurable effort toward auditing the highest-earning taxpayers—who typically are the most complex, have the highest potential taxes owed, and the most opportunity for avoidance.

The reformed approach may fail to capture significant non-compliance among the wealthiest taxpayers. It would be difficult to quantify success or failure when the project involves increasing scrutiny on an ill-defined subset of returns.

When attempting to overhaul a culture that overlooks non-compliance by corporations and high-income taxpayers, broad mandates are a problem. The status quo is likelier to continue, as there is no metric to measure the degree the agency has fallen short.

A hybrid approach would combine the previous directive’s precision with a progressive audit threshold system. Such a system should ensure near complete audit coverage for the highest-income taxpayers, with progressively lower audit rates for lower high-income brackets.

A targeted and measured strategy also would enhance compliance among individuals with the greatest incentive and means to evade taxes—aligning with the IRS’s strategic operating plan.

As an example threshold, the top 1% of returns in terms of income could be made to face audit rates close to 100%. This would be an audit of more than 25% of the total income earned across the board.

Given its limited and shrinking resources, the IRS may need to roll out audit thresholds gradually. Achieving 100% audit coverage for the top 1% would entail auditing more than 1.5 million returns. In 2023, the IRS closed 582,944 audits in total—resulting in $31.9 billion in adjustments, for an average of a bit more than $54,000 per audit.

By comparison, for tax years 2016 through 2021, audits of individual taxpayers with $10 million in income or more averaged $124,389 per return. Broadly targeting the top 1% would require a substantial increase in labor, but the data we have suggests it would be worth the investment.

Those in the top 5% in terms of income could face a 50% audit rate, with a declining percentage as income brackets are descended. This approach would ensure the IRS’s limited resources are concentrated where each audit dollar invested has the highest potential return—both in terms of revenue through reassessment and future compliance through deterrence.

Benefits and Evidence

Focusing audit efforts on those with the highest potential for avoidance will help the IRS better deter tax evasion among those who could gain the most from it. It ensures taxpayers with the most complex financial situations and greatest resources to implement avoidance strategies are held to the highest standards.

The TIGTA report provides compelling evidence that auditing high-income individuals is more productive than doing so for their lower-income counterparts both in pure dollar value and dollar per hour of effort. From tax years 2016 through 2021, the Small Business/Self Employed Division’s audits of taxpayers with incomes of $10 million or more yielded four times more dollars assessed per return when compared with returns between $400,000 and $10 million.

The report highlights that the IRS achieved compliance with the 8% audit rate for three consecutive tax years, and abandonment of the directive has brought less effective audits—that is, an increase in the percentage of audits that result in no change in tax owed by the filer.

Through an escalating audit coverage approach, the IRS can combine the strengths of the former directive with a broader system, optimizing use of IRS resources where they will be most effective. That revenue increase can help expand compliance audits down the income brackets.

Defining what constitutes success or failure is a significant first step in undertaking such an economic project. Specific audit coverage thresholds for the highest income brackets do so—broad mandates don’t.

Andrew Leahey is a tax and technology attorney, principal at Hunter Creek Consulting, and adjunct professor at Drexel Kline School of Law. Follow him on Mastodon at @andrew@esq.social

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