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Mapping the maze where the IRS could find billions in unpaid taxes

SIEPR senior fellows Rebecca Lester and Daniel Ho are untangling the incredibly complex corporate structures some taxpayers use to reduce their tax bills.
Partnerships are estimated to be responsible for three times as much tax non-compliance as corporations. | Image: iStock/Amax Photo

In 2021, the difference between what U.S. taxpayers owed the federal government and what they paid hit nearly $700 billion. This 鈥渢ax gap鈥 has been growing for years while the Internal Revenue Service鈥檚 budget has shrunk, declining by 18 percent between 2010 and 2021. The audit rate for millionaires fell by more than 70 percent in roughly that same period.

To reverse these trends, the Biden administration鈥檚 Inflation Reduction Act allocated $80 billion in additional funding to the IRS over the next decade. If it鈥檚 used wisely, that money could help the agency track down some of those missing billions, says Rebecca Lester, an associate professor of accounting at 成人大片 Graduate School of Business, a senior fellow at the 成人大片 Institute for Economic Policy Research(SIEPR), and an expert on taxation. 鈥淧rior research shows high returns to IRS business enforcement: If you allocate money to the IRS for enforcement, then for every dollar you put in, you get more than a dollar back,鈥 she says.

In collaboration with Daniel Ho of 成人大片 Law School 鈥 who is also a SIEPR senior fellow 鈥攁nd colleagues from the , Lester has posted a new paper that, for the first time, maps out the complex 鈥渟piderweb鈥 of partnership structures some taxpayers set up to reduce their tax bills. The research also examines what tools the IRS could use to most efficiently track and evaluate these tax-planning schemes.

Lester notes that this paper marks the start of a longer-term project and builds on prior work by Ho and of the University of Chicago. Their coauthors include of New York University, of 成人大片, of the University of Georgia, of 成人大片, and Annette Portz from the IRS. 

Hidden figures

There are three fundamental business types in the U.S., Lester explains. At one end of the spectrum are sole proprietorships 鈥 individuals who run small businesses. On the other end are large publicly traded companies. In the middle are millions of pass-through (or flow-through) businesses, like limited liability corporations, whose income is generally not subject to taxation at the business level but passes directly to the owners and is taxed as personal income.

Partnerships are one type of pass-through business; they vastly outnumber public firms and control more than $30 trillion in assets. They are increasingly common, growing from 29 percent of U.S. business entities in 2003 to 40 percent in 2020. They are estimated to be responsible for three times as much U.S. tax non-compliance as corporations.

They are also very poorly understood. 鈥淢ost academic research focuses on public companies for the simple reason of data availability,鈥 Lester says. 鈥淏ut we think these flow-through businesses are where a very large portion of tax planning happens and that they contribute disproportionately to the tax gap.鈥

Lester and her coauthors shed new light on these partnerships by gathering their tax forms and linking them to their owners in the tax data. Through this process, they created one of the first comprehensive maps of partnership-related businesses in the United States.

Most immediately, they found that roughly 80 percent of the nearly 7 million partnerships they examined are directly owned by individual taxpayers. These 鈥渟imple鈥 partnerships appear to largely be used for business operating and investing purposes.

The other 20 percent constitute what the researchers call 鈥渃omplex鈥 partnerships, intricate networks of relationships between individuals and business entities whose ownership may not be readily apparent. They may have multiple layers of ownership involving clusters of overlapping partnerships. Their income increases with complexity: Their operational income was almost twice that of simple partnerships, and their investment income was seven times that of simple partnerships.

These more byzantine structures, Lester suggests, could be used by some taxpayers for tax planning. 鈥淲hen you look at these spiderwebs of relationships, it鈥檚 very hard to imagine reasons that they would exist for purely legal ends,鈥 she says.

Follow the money

Lester and her colleagues studied the relationship between a partnership鈥檚 complexity and whether the IRS will uncover unpaid taxes. In short, the more complex an organization is, the less likely the agency is to identify additional amounts due when it conducts an audit. One possible explanation is that complex cases are simply more difficult to review. The researchers find that complex audits are more likely to be closed quickly with no tax assessed, possibly because a speedy 鈥渘o change鈥 decision allows examiners to focus on other cases where assessments are more likely.

The researchers also found that when IRS examiners do find and assess additional tax to a complex organization, the amount assessed is much larger than in other partnership audits. 鈥淭his is consistent with the idea that complexity is somehow indicative of the total amount of potential tax avoidance,鈥 Lester says. 鈥淭here is something about these partnerships that is not simply for the legal protection of a business.鈥

These large assessments contribute to an overall high audit return on investment, the amount the IRS recovers from a taxpayer as compared to the cost of the audit. The researchers found that the ROI of complex audits is very high 鈥 20 times the audit cost. This rate is twice that of simple audits and eight times that previously found for corporate audits.

The infusion of funding from the Inflation Reduction Act could help the IRS bring more of these complex partnerships into compliance, though Lester emphasizes that the agency must be judicious in how it spends its resources. 鈥淚f the government wants to more effectively enforce the tax system, it will be challenging for the IRS to hire enough partnership auditors, as many with the expertise work for big accounting or law firms,鈥 she says. 鈥淲e need to think of other strategies the IRS might deploy as they approach the problem.鈥

This research into pass-throughs could be a start. 鈥淏uilding from this paper, we hope to shed new light on the structures taxpayers use and bring new data tools about these partnerships to help the IRS to even more efficiently enforce the tax code,鈥 Lester says.

This story was October 30, 2024 by 成人大片 Graduate School of Business Insights.

 

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