Quick Study: To Close The ‘Tax Gap’, Take A Look At Partnerships

Key Concepts:

• Tax gap: The difference between taxes owed and taxes collected.
• Partnerships: A type of business structure, often complex, with multiple tiers of ownership.
• C corporations (C corps): Large, public corporations.
• S corporations (S corps): A type of business structure that passes income, losses, deductions, and credits through to their shareholders.
• Sole proprietorship: The simplest business structure, owned and run by one person.
• IRS Audits: Examinations of tax returns to ensure compliance.
• Tax avoidance: Legal strategies to minimize tax liability.
• Tax evasion: Illegal strategies to avoid paying taxes.
• Strategic Operating Plan: The IRS's plan to improve tax collection.

1. The Tax Gap and the IRS's Challenge

• The US tax system faces a significant tax gap, estimated at over half a trillion dollars annually.
• This gap represents the difference between taxes owed and taxes actually collected by the government.
• The IRS struggles to address this gap due to limited staff and resources.
• Less than 0.5% of the 250 million+ tax returns filed annually are audited.

2. Stanford Research on Partnerships

• The IRS collaborated with the Stanford Graduate School of Business and the Stanford RegLab to analyze 12 million tax returns, focusing on partnerships.
• Partnerships are a major contributor to the tax gap.
• Partnerships have increased significantly since the 1980s due to tax law changes intended to benefit small business owners.
• There are now more than twice as many partnerships as C corporations.

3. Partnership Structures and Complexity

• Partnerships can range from simple structures with a few partners to highly complex, multi-tiered organizations.
• Complex partnerships can have multiple layers of ownership, where a partnership owns another partnership, and so on.
• These structures can resemble "spider webs" with interconnected partners and owners.
• There is no legal limit to the number of owners a partnership can have.

4. Audit Outcomes and Return on Investment

• Auditors are often wary of complex partnerships due to the time-consuming nature of untangling their structures.
• Complex partnerships selected for audit are less likely to be asked to pay additional taxes, as auditors may back off after a quick look.
• However, when the IRS thoroughly investigates these complex audits, it often finds substantial amounts of underpaid taxes.
• The return on investment for auditing complex partnerships is high: for every dollar spent, the IRS recovers $20 in revenue.

5. IRS Strategic Operating Plan and Audit Efficiency

• The IRS's 2023 Strategic Operating Plan includes a focus on large C corporations and complex partnerships.
• Auditing complex partnerships yields eight times the return compared to auditing large C corporations.
• The research suggests that focusing on complex partnerships is a more efficient use of IRS resources.

6. Using Data and AI to Identify Complex Partnerships

• The IRS could use data and AI to visually map complex partnerships and identify potential areas of tax avoidance or evasion.
• Key data points include the number of owners, partners, and tiers of ownership.
• This data can serve as clues to identify tax filings that may be underreporting income.

7. Notable Quotes

• "The estimated annual tax gap between what's owed to the government and what it actually receives, is more than half a trillion dollars." - Becky Lester
• "For every dollar it costs the IRS to audit complex partnerships, it gets back 20 in revenue." - Becky Lester

8. Conclusion

• The research indicates that increasing resources for tax collectors, particularly for auditing complex partnerships, would significantly increase revenue for the country.
• Focusing on complex partnerships is a more efficient strategy than auditing large C corporations.
• Using data and AI to identify and analyze complex partnership structures can improve audit efficiency and reduce the tax gap.