Over the past several decades, correspondence examinations have become the IRS’s primary method for auditing individual taxpayers. The Transactional Records Access Clearinghouse (TRAC) at Syracuse University just reported that of the 659,003 individual audits conducted by the IRS in Fiscal Year (FY) 2021, all but 100,000 were conducted by correspondence. TRAC reports that correspondence exams now account for 85% of all audits, up from about 80% in the previous two years.
Originally designed for “less complex” matters, correspondence exams are now used for complex factual issues including the child tax credit, earned income tax credit, self-employment income (gross receipts and expenditures), and charitable deductions. Correspondence is also the only method applied in “unreal” audits – examinations that the IRS doesn’t count as “audits” under IRC § 7602 because it says they don’t arise to an examination of the taxpayer’s books and records. Through the Automated Correspondence Examination (ACE) system, unless the taxpayer responds in writing, a correspondence exam automatically moves from one stage to the next, up to the issuance of a Notice of Deficiency, without any human intervention.
IRS maintains that correspondence exams are an efficient and cost-effective method of conducting audits. For example, in a summer 2021 release, the IRS justifies the low cost of these audits ($150 for the IRS!) by highlighting the minimal burden on taxpayers. This blog will show just how wrong the IRS is about the burdens correspondence audits impose on taxpayers and their consequences.
Over the decades, advocates for taxpayers, myself included, have consistently criticized this method and maintained it does not adequately protect taxpayer rights, including the right to be informed, to pay no more than the correct amount of tax, to challenge the IRS and be heard, and to a fair and just tax system. Recently, The Tax Law Center at New York University and the Center for Taxpayer Rights published a paper about this topic, Exclusionary Effects of the IRS Correspondence Audit Process Warrant Further Study, in which we question the effectiveness of correspondence exams and propose additional research and pilots.
To get a sense of the disproportionate impact the IRS overall audit strategy has on Earned Income Tax Credit taxpayers, and why it is so important not only to revise that strategy but also to reform the audit process, please take a look at some rather stunning statistics from the IRS Statistics of Income compliance webpage. Table 17 sets forth Exam Coverage and Recommended Additional Tax After Exam, by Type and Size of Return, for Tax Years 2010-2018. (I am using Tax Year (TY) 2018 because it best aligns with the NTA Annual Report numbers, which use Fiscal Year (FY) 2019, discussed later in this post).
Total TY 2018 individual tax returns filed: 153,927,628
Total TY 2018 individual tax returns with EITC: 26,492,486
EITC returns are 17.2% of all TY 2018 individual returns.
Total audit closures of TY 2018 individual tax returns: 234,543
Total TY 2018 individual tax return audit closures selected for EITC: 165,611
EITC returns are 70.6% of all TY 2018 individual audit closures.
Total TY 2018 individual audit closures with no change: 41,276
Total TY 2018 individual audit closures, selected for EITC,with no change: 28,277
EITC returns are 68.5% of all TY 2018 individual no-change audits.
What this data tell us is that over 70% of all IRS individual audit closures for TY 2018 returns involved EITC despite the fact that only 17.2% of individual income tax returns claim the EITC. This is up from what I reported in the 2005 Annual Report to Congress, when 48% of IRS individual examinations involved the EITC despite only 17% of individual income tax returns claim the EITC. And remember – these “audit” numbers don’t include “unreal audits” involving EITC, such as math errors under IRC § 6213. Further, EITC audits constitute more than 2/3 of the no-change individual audit closures. Now, this figure does not take into account downstream adjustments to proposed assessments in appeals or Tax Court, or abatements in audit reconsiderations. Given the low response rate for correspondence exams, that there are any no-change audits is stunning to me. At any rate, the IRS spent resources forcing 28,000 people – 12% of all TY 2018 EITC audit closures! — to produce documentation of eligibility, when they were eligible all along.
These numbers are all the more outrageous when you consider the fact that the dollar amount of EITC improper payments are only $16 billion or 3.6% of the IRS’s current $441 billion gross tax gap estimate. (It is only 1.6 % if you buy the Commissioner’s $1 trillion tax gap estimate, which I don’t). Why would the IRS focus so much on low income taxpayers? Certainly, the fact that EITC is subject to improper payment reporting requires the IRS to audit some EITC returns. But the requirement to audit some returns is not a justification for adopting an assembly-line approach to the most low-income taxpayers. Could it possibly be the IRS uses that approach because it beefs up the overall audit coverage rate and the number of audits, at really low cost?
Now comes the National Taxpayer Advocate’s 2021 Annual Report to Congress, with its 9th Most Serious Problem focusing on Correspondence Exams. Let’s take a look at some of the data (relating to FY 2019) presented in the report:
- 53% of individual (IMF) audits were on taxpayers with Total Positive Income (TPI) under $50,000. Of this 53%, 82% of the taxpayers claimed refundable credits including the EITC. (TPI includes “only total positive income values from wages, interest, dividends, other income, distributions, Schedule C net profits, and Schedule F net profits. Losses are treated as zero.” MSP #9, endnote 7.)
- 92% of IMF audits on taxpayers with TPI under $50,000 were conducted by correspondence exam.
- The average direct time spent by an IRS auditor on a correspondence exam for taxpayers with TPI under $50k was 2 hours, compared to 11 hours for office exam and 41 hours for field exam.
- 4% of Wage & Investment Division correspondence exam resources was spent answering phone calls; 96% was spent on handling correspondence. The Level of Service on the correspondence exam line was 40.7% (Note that this is for 2019, so it is pre-pandemic ….)
- 35% of 361,000 IMF audits closed in FY 19 for taxpayers with TPI under $50,000 were the result of no taxpayer participation, of which 14% involved undeliverable mail.
- Unlike field auditors, who can use both internal and external sources, including USPS trace, to locate better addresses, correspondence examiners can only use internal sources.
- Only 3% of taxpayers with TPI under $50,000 were represented in correspondence audits.
- Of the 24,700 petitions to Tax Court in FY 19, 17,700 originated in correspondence exam.
- 94% of audit reconsiderations originated in correspondence exam; 44% of these original audits closed because there was either no record of a taxpayer response or IRS correspondence was undeliverable.
- 88,000 of taxpayers audited in FY 19 with TPI under $50,000 were placed in collection; 45% of these were in Currently Not Collectible-Hardship status as of 10/28/21.
So. The primary method of auditing low income individual taxpayers is by correspondence. If you are more affluent, you are more likely to have a single auditor assigned to your case in office or field exam, but not if you are low income – i.e., in correspondence exam, no one employee is assigned to your case. If you are more affluent, the IRS is more likely to spend more time looking at your documentation, and communicating with you. Not so if you are low income. If you are more affluent, the IRS makes more of an effort to actually locate a more current address if mail is returned undeliverable. Not so if you are low income.
It’s not just that mail is undeliverable. IRS audit notices are incomprehensible to taxpayers. In 2007, the Taxpayer Advocate Service did a survey of a representative sample of taxpayers who had been audited about their EITC claims. More than 25 % of those taxpayers said they did not understand from the initial letter that they were under audit. More than 70% said the audit letter was difficult to understand, including they did not understand what documentation the IRS wanted them to provide. If you don’t understand you are under audit, that will affect your response. And if you don’t understand what you should send in to prove your eligibility, that will affect your audit outcome.
And in fact, we see this in the no-response and agreed rates of audits of low income taxpayers versus more affluent ones, who are more likely to have a single auditor assigned to the case. Here’s a chart from the 2021 Annual Report to Congress:
To make matters worse, past TAS studies have compellingly shown that correspondence exam procedures actively harm taxpayers. In 2012 TAS reviewed a representative sample of taxpayers whose EITC claims were disallowed in correspondence exam and later conceded in full by Chief Counsel when the taxpayer filed a United States Tax Court petition. In that study we found that these taxpayers, on average, contacted the IRS five times during the audit (one taxpayer contacted the IRS 21 times!). 78 % were ultimately able to submit documentation that was accepted by IRS appeals officers or counsel attorneys after the Tax Court petition was filed. In 20% of those cases, appeals/counsel accepted documented that IRS auditors had rejected.
Correspondence exams have been a recurring topic in the Annual Reports to Congress when I was the National Taxpayer Advocate. At a quick glance, I found Most Serious Problems on various aspects of correspondence exam in Annual Reports from 2001 (my first), 2002, 2003, 2005, 2006, 2007, 2008, 2009, 2011, 2013, 2014, 2015, 2016, 2018, 2019, and 2020. (My recollection is, in the years we didn’t write about some aspect of correspondence exam, we were just tired of it and decided to give it a rest for one year.) TAS has conducted numerous research studies on the topic. And yet the IRS response has been unchanged over the years.
Why does the IRS persist in believing correspondence exam is an efficient, cost-effective method of auditing? First of all, because it defines efficiency and cost-effectiveness from the IRS perspective – that is, correspondence exam works for the IRS. It doesn’t have to dedicate (human) resources to the task; it can churn out a lot of audits and get a lot of assessments, all of which feed into its reports of audit coverage and enforcement results.
In fact, correspondence exams are a classic example of IRS assessing efficiency from a superficial cost-benefit analysis, disregarding the administrative burden these exams impose on taxpayers, especially low income taxpayers. As Les, Keith and I discuss in an upcoming article, the learning, compliance, and psychological burdens of an administrative process can significantly undermine the policy goals of a program, and can even be used to deliberately deter eligible taxpayers from benefitting from a program.
In this blog post, we’ve seen that IRS intransigence over years regarding the correspondence exam process has created a procedural justice nightmare for taxpayers, especially low income ones, as well as generating lots of unnecessary and expensive downstream work for itself. In part 2 of this “How Did We Get Here?,” I’ll discuss some recommendations for fixing this mess.