Will 2014 Be a Holiday for Tax Cheats?

With the April 15 deadline for tax returns looming, the Washington Post reports that taxpayers are having great difficulty accessing the services of the Internal Revenue Services and many are unable to get the information they need to either file a return or claim refunds due them. The reason for these difficulties is quite straightforward. Since Republicans retook the House of Representatives in 2010, the IRS has been a prime target for the deep cuts the GOP has directed at the annual appropriation bills. According to the Post, the IRS annual budget has been slashed by $1.2 billion, or 17 percent after adjusting for inflation.

As Mother Jones subsequently pointed out, the cuts serve the party agenda in two respects. They not only reduce spending but contribute to the public anger that IRS opponents within the GOP wish to see directed against the agency. But the IRS cuts serve another purpose that may be even more important than the first two.

The Kiplinger Tax Letter recently reported:

Short on personnel and funding, the IRS audited only 0.86% of all individual tax returns in 2014. And the 2015 audit rate will definitely fall even lower as the agency's resources continue to shrink. For example, funding for enforcement in the IRS's current budget is 5% less than last year. So the odds are pretty low that your return will be picked for review.

IRS estimates that 248 million tax returns will be filed during the current fiscal year, nearly 18 million, or 8 percent, more than when the agency budget started being slashed four years ago by House Republicans. But the increased number of tax returns only partially measures the extent to which the IRS workload has grown. During that period, personal income grew by $1.5 trillion, or about 11 percent, and the best available data indicate that a highly disproportionate share of that growth was concentrated in the highest-income households, where taxpayers claim the largest number of deductions and file the most complex returns.

I would argue, however, that the complexity of the tax returns of high-income taxpayers is increasing far more rapidly than their income. Enforcement has in recent years become dramatically more difficult as the wealthiest Americans attempt to shield their rapidly swelling wealth from the tax collector.

Tax lawyers and accountants have discovered over the past decade or so that converting assets previously held by corporations into assets held by partnerships can significantly reduce tax burdens. The partnership structure often allows deductions to be directly passed to the individual investor rather than taxed before they can be passed on as dividends.

According to a report last fall from the Government Accountability Office, the number of partnerships, particularly partnerships with large assets, exploded during the 2002-2011 decade (the most recent period for which data was available). According to GAO, the number of "partnerships" with more than $1 billion in assets increased by more than 500 percent during that period, while the number partnerships with 10,000 or more direct or indirect partners grew by nearly 900 percent.

Many of these entities have grown to resemble large publicly traded corporations, some with hundreds of thousands of partners. Assets held by these partnerships totaled more than $22 trillion in 2012 -- up from less than $9 trillion 10 years earlier. To give you some perspective on exactly how much money $22 trillion is, the World Bank reports that for 2012, the market capitalization of all U.S. publicly traded corporations totaled less than $19 trillion.

The problem with partnerships is not simply that they can provide a framework for legal tax avoidance, but that they can create a level of complexity that make tax enforcement hellaciously difficult and thereby provide an opportunity for the taxpayers to take not only deductions that are permitted by law but also deductions that the IRS might challenge if they had the resources to unravel the intricate legal and accounting scheme built into this new generation of businesses.

GAO describes the movement of these mammoth partnerships toward greater and greater complexity as "tiering." An example might be Partnership A, which pays earnings directly to individuals from the proceeds of a number of businesses that it owns. These businesses may be organized under the Internal Revenue Code also as partnerships or Class C corporations or Class S corporations or trusts. Those businesses in turn own other businesses that in turn own still more businesses -- all organized under the revenue code as partnerships, trusts or corporations depending on the nature of the particular business they are engaged in and the revenue code's treatment of such businesses. This vast web of paper entities is created in large part to minimize the taxes paid by the investors in Partnership A.

Examining a sample of tax returns of partnerships with more than 100 partners and more than $100 million in assets, GAO found that more than two thirds had at least 100 or more "tiers" or pass-through entities, and 36 percent had at least 1,000 or more tiers or pass-through entities.

The level of complexity in developing an accurate statement of the income and loss produced by each of these entities, including the amount passed on to the next tier within the web, grows as the size of the web expands. The workload for the IRS in determining if these statements accurately and fairly reflect the income and expenses of these businesses increases proportionately.

But there is an additional consideration here. The businesses engaged in manufacturing these financial labyrinths are able to hire the best legal and accounting talent in the country to assist them. It is against this backdrop that the savaging of the IRS budget should be viewed. A government agency with a salary structure that makes it nearly impossible to compete against the best legal and accounting firms in the country in the best of times is being forced to fire staff, furlough its remaining employees and subject those who remain to ever-increasing workloads while at the same time the complexity of that workload is increasing exponentially.

GAO found IRS's performance in dealing with partnerships to be about what you might expect under the circumstances. The IRS has not only failed to rise to the challenge of determining whether partnerships are paying the taxes due under the law, but they have largely failed to take the field. In 2012, IRS closed 84 audits on partnerships that the GAO classified as large for an audit rate on large partnerships of less than 1 percent. By comparison, IRS has traditionally audited about 27 percent of the returns of Chapter C corporations.

When Republicans won the House in 2010, they promised tax cuts much deeper than those they have been able to deliver. Perhaps they have found other ways of reducing the tax burden of their supporters that don't require alterations in the revenue code?