Surprise! IRS Enforcement Increases Tax Revenue

11/2/2012

Sometimes, we learn very surprising things about taxes and the IRS, like in last week’s TaxTrends post about the lack of firearms training in the Criminal Investigation Division. Other times, the tax news of the day isn’t all that surprising. In fact, in the case of an article published in the newest issue of Accounting Review, it’s making most people go, “Duh!”
 

Three professors analyzed data from 5,000 corporations over 17 years from 1992-2008 to answer an age-old question (which also, not coincidentally, is the title of their article): "Do IRS Audits Deter Corporate Tax Avoidance?" Their not at all surprising answer? Yes, they do! The authors explain, "Our evidence from large samples implies that U.S. public firms undertake less aggressive tax positions when tax enforcement is stricter. Reflecting its first-order economic impact on firms, our coefficient estimates imply that raising the probability of an IRS audit from 19 percent to 37 percent increases their cash effective tax rates, on average, by nearly 2 percentage points, which amounts to a 7 percent increase in cash effective tax rates."

Shocking, isn't it? The authors do acknowledge it's not really surprising that more audits equal more taxes, but also say it wasn’t exactly obvious before they started their study. What if they found that corporations were just so confident they could outmaneuver the IRS that audit rates didn't matter?
 

What is rather interesting is that the study also found that shareholders of a company actually benefit from IRS audits, especially if corporate governance is particularly weak. Co-author Jeffrey Hoopes of the University of Michigan reports that "strict tax enforcement promotes good financial reporting and tends to check managers' proclivities to divert corporate resources for their personal use under the guise of saving taxes.” The example they cite is Tyco, where top executives minimized taxes by relocating profits to low-tax foreign countries, then diverted millions of dollars for their own personal use (CEO Dennis Kozlowski is currently serving a prison sentence).
 

So what can we conclude? While IRS enforcement can be cumbersome and annoying, it does keep corporations in check. But the real question is, what does all this mean for you? In 2010, 15.7 million Americans were contacted by the IRS, and many of them were chosen through random selection, so there’s no foolproof way to prevent an audit. Before you file your tax return, make sure you have records and documentation to support every item, just in case they decide to contact you!