IRS narrows scope of many corporate tax audits

By Albert B. Crenshaw
Washington Post

WASHINGTON — When it comes to tracking down corporate tax cheats, the Internal Revenue Service is betting that less is more.

Under a new program designed to allow its auditors to cut to the chase, the increasingly cash-strapped agency is authorizing them in many cases to drop some traditional components of business audits and focus instead on big-ticket items such as tax shelters.

The new LIFE — for limited issue-focused examinations — program, which went into operation late last year, will allow the tax collectors to reach a pre-audit agreement with a business, promising to examine only the items that they have agreed to place on the table, bypassing such time-consuming checks as looking at the cost of goods sold and whether employment taxes were paid correctly.

"Just like the private sector, we in government have limited resources, and increasingly we need to spend our time on what is material, what is important," said Larry Langdon, a former Hewlett-Packard Co. tax executive who has headed the IRS' Large and Mid-Size Business Division since 1999.

The process also will benefit corporate taxpayers by making it easier for them to know in advance what issues will be dealt with and what records they will have to produce, Langdon said.

Langdon's division covers businesses with assets of more than $10 million. There are about 150,000 of those, and about 1,700 are large enough to be subjected to regular audits. "What we would really like to do," he said, "is get better (audit) coverage in the middle-market taxpayers." If the agency becomes more efficient on large cases, he said, it will have more resources available for that effort.

"We are not comfortable that we have gotten the additional audit coverage we need into that group," Langdon said.

Such programs, IRS officials said, are the only way the agency can hope to keep up as companies become increasingly sophisticated in avoiding their obligations.

Corporate income tax payments rose in the late 1990s, but far less sharply than the profits companies reported to their shareholders. That triggered a controversy over whether businesses were escaping their fair share of taxes through such devices as shelters.

Though rising steadily in absolute terms through the 1990s, corporate taxes remained relatively constant at about 11 percent of total collections — before dropping both absolutely and proportionately in 2001. Corporate collections declined to $186.7 billion, or 8.8 percent of total revenue, from $235.7 billion, or 11.2 percent, the year before. Individual income taxes accounted for 55 percent of federal tax revenue in 2001 and employment taxes an additional 35 percent. Business's share of tax payments has been declining for years — it was more than 30 percent in the 1950s — much of which is the result of shifts in the economy. Some tax experts contend the decline wouldn't be as great if IRS enforcement efforts were more thorough.

Most of the corporate tax collections are paid voluntarily. Audits and other enforcement actions in 2001 resulted in recommendations that the agency seek an additional $14 billion from corporations.

At the same time, audit rates for businesses — and individuals — have been declining markedly in recent years. Only about a third of very large businesses are audited every year, down from more than half as recently as 1995. Audit rates for businesses with assets of between $10 million and $250 million — the ones Langdon is concerned about — have plunged from 20 percent to 30 percent in the early 1990s to 10 percent to 15 percent in 2001.

In the past, IRS auditors prioritized issues with a company and then went as far down the list as the agency's money and personnel permitted. "In a LIFE examination, the issues, not resources, will be the driving force in setting the scope of an examination," according to a training document sent to auditors in October.

Under the program, teams of IRS auditors will review a business's return and "select items for examination based on ... risk-analysis techniques" and "materiality" — whether an item is big enough to be worth pursuing, according to a memo from Langdon that accompanied the training materials.

"The LIFE process provides team managers with the authority to waive specific mandatory compliance items," the memo said.

IRS officials said they believe their analytical techniques, along with their knowledge of the company's history, will prevent taxpayers from using the LIFE process to divert attention from scams and abuses. For example, LIFE will not be used when "a taxpayer has a history of substantial noncompliance," according to the training materials.

But some agents in the field have expressed concern about the restrictions the process will put on them. Training has emphasized prevention of audit "scope creep," one said, worrying that the system "will curtail the ability of the agents to expand the audit into new issues."

"What is an audit, if not pursuing leads that one finds when one is in the books and records of a company, in the course of an examination?" the agent said.

Kristin Moore, an IRS team manager from Portland, Ore., said: "We are not (saying) we necessarily know all the issues going into the audit. In addition, within the LIFE process, we are still going to be doing some preliminary work," such as examining records and interviewing company officials. That work, augmented by technical experts and experience, then leads to the risk analysis and finally to the materiality question.

"We have a very disciplined regime with regard to selecting returns for audit," including the audit history of the company and the profile of the industry it is in, Langdon said. "We have good research. We are picking up even in the middle market the returns that have the largest" potential for unpaid tax.

IRS Commissioner Charles Rossotti voiced alarm, as he left his post this fall, about the agency's ability to enforce the tax laws with a shrinking budget. During his five-year term, Rossotti often touted improved organization and technology as crucial to IRS success in trying to keep up with individual and corporate taxpayers that are wealthier and tougher to check on.

"The majority of tax revenues now come from sources that are more subject to manipulation by those who wish to pay less than the law requires and (that are) much more difficult and time-consuming for our agents to uncover," he said.

Business groups including the U.S. Chamber of Commerce and the National Federation of Independent Business say they are aware of the new corporate audit program but have taken no position on it.

But John Satagaj, president of the Small Business Legislative Council, said, "If there's something that gets the clutter out of audits, I'm in favor of it."