The Internal Revenue Service will start examinations of several hundred high-net-worth (HNW) taxpayers beginning July 15. These audits follow the IRS’ concerted efforts to coordinate examination of HNW individuals’ tax returns. These examinations will address partnerships, private foundations (PFs), trusts and other matters for sophisticated individual taxpayers. With coordinated IRS campaign, HNW taxpayers can expect aggressive IRS audits. To respond effectively, taxpayers will need a coordinated strategy.
IRS Focus on HNW Individuals
On June 18, IRS Large Business and International (LB&I) Division Commissioner, Douglas O’Donnell, announced that the IRS will start examinations of several hundred HNW individuals beginning July 15. The key goal of the campaign is to work across IRS divisions to address sophisticated planning utilized by HNW individuals. The IRS hasn’t indicated what it considers “high net worth” for purposes of this campaign.
The IRS created the Global High Wealth Industry Group in 2009 (often referred to as the “Wealth Squad”) to strengthen its ability to audit and collect tax from HNW individuals, their related entities and non-U.S. assets.
The IRS has faced increasing scrutiny for failing to collect tax from HNW individuals. The Treasury Inspector General for Tax Administration’s (TIGTA) 2019 and 2020 Audit Plans both recommended that the IRS prioritize enforcement against high-income individuals who didn’t file tax returns.
TIGTA reported on May 29, 2020 that the IRS has failed to address high-income non- filers. TIGTA estimated 34% of high-income non-filers owed an estimated $45.7 billion in taxes for the 2014 through 2016 tax years.
Wealth Squad Targets
IRS HNW individual audits may address several areas utilized by HNW individuals. These issues are likely to include partnerships and other passthroughs, PFs and international matters.
1. Partnerships and Other Passthroughs. The campaign will likely target HNW taxpayers with partnerships and other pass-through entities. O’Donnell indicated in his remarks that exam activity will address taxpayers with pass-through structures, such as partnerships, S corporations and disregarded entities. The Bipartisan Budget Act of 2015 overhauled the partnership audit rules to make it easier for the IRS to audit partnerships and collect tax from those audits. Increased focus on HNW audits brings the partnership audit changes back into focus. Partners and partnerships should review their structures and partnership agreements in light of the partnership audit changes before an exam begins.
- PFs in Focus. IRS examinations are expected to include individuals with PFs. On June 18, Tamera Ripperda, IRS Tax-Exempt and Government Entities Division Commissioner, stated that she expected examinations of PFs to increase, linking individual compliance to private PFs. HNW individuals and families utilize PFs to facilitate charitable giving and charitable activities. PFs can help build a family’s charitable legacy and help younger family members gain experience managing wealth and serving communities. The tax rules governing PFs are complex. PFs are subject to several excise taxes and compliance requirements to ensure that PF assets are devoted to charitable purposes and to ensure that disqualified individuals don’t obtain certain prohibited personal benefits.
- Traps for Multi-jurisdictional Families. Individuals with non-U.S. assets and income are subject to special tax and reporting requirements for offshore accounts and assets. The IRS has focused enforcement efforts on taxpayers with offshore bank accounts, assets and structures for several years. Reporting and compliance for these assets can be a trap for the unwary, especially for taxpayers living outside the United States, globally mobile individuals and multi-jurisdictional families. The IRS maintains a voluntary disclosure practice for individuals to regularize non-compliance with US international tax and reporting obligations.
- TCJA Examinations for Individuals. The 2017 Tax Cuts and Jobs Act (TCJA) made major changes to the taxation of HNW individuals with international assets and activities. Many of the changes had a disproportionate impact on HNW individuals, including the rate structure of the Internal Revenue Code Section 965 transition tax, global intangible low taxed income and limits on available deductions. In May, the IRS announced a TCJA campaign and stated that “[t]he goal of this campaign is to identify transactions, restructuring and technical issues and better understand taxpayer behavior under the new law.” HNW individuals should be prepared to address TCJA tax issues and related planning during the coming cycle of examinations.
Managing a Wealth Squad Audit
IRS compliance campaigns focus IRS resources on issues that the IRS believes are common to many taxpayers. The response to a Wealth Squad audit should account for the nature of IRS campaigns and developments in global transparency.
- IRS Campaigns. In 2016, LB&I announced that it was shifting its audit strategy and implementing “campaigns” intended to identify the most serious tax compliance risks, improve return selection, create specific plans to move taxpayers towards compliance and then deploy its limited resources efficiently. LB&I has announced 65 campaigns since January 2017, and 54 campaigns are currently active. So-called “treatment streams” for individual campaigns vary, but they include issue-based examinations, soft letters and the publication of international practice units. Taxpayers under audit should determine which active LB&I campaigns directly affect both their individual tax returns and any related entities and be prepared to explain if their position diverges from the campaign approach as outlined in any practice units.
- Information Document Requests. HNW individuals selected for examination can expect the IRS to issue one or more Information Document Requests (IDR) during the course of the audit. The IRS can request any existing records, information or data that may be relevant to determining an individual’s tax liability. HNW taxpayers should prepare to communicate with their examination team about the availability of any requested information and the expected deadline for responding to any IDRs before the IRS issues a final IDR. If a taxpayer fails to respond to an IDR by the deadline, the IRS examiner follows a 3-step mandatory IDR enforcement process.
The IRS examiner will issue a delinquency notice to the taxpayer within 10 business days of the IDR response date. If a taxpayer fails to meet the deadline in the delinquency notice, the examiner issues a pre- summons letter. If a taxpayer fails to respond to the pre-summons letter, or if the IRS believes the taxpayer’s response is incomplete, the examiner will coordinate with IRS counsel to issue a summons. If a taxpayer doesn’t comply with the summons, the Department of Justice can file a petition in a U.S. district court to enforce the summons.
- Information Exchange Revolution Underlies International Enforcement. The COVID economic downturn and revenue shortfalls come at a time when the IRS has increased access to taxpayer information. The global wealth management industry’s age of transparency has provided the IRS with unprecedented amounts of non-U.S. financial account information from foreign governments and financial institutions.
Multi-jurisdictional families face added pressure in U.S. audits because the U.S. audit can have trail on effects, such as triggering enforcement actions by authorities outside the United States. Taxpayers undergoing audits should understand the scope of information reporting obligations and how governments cooperate to enhance enforcement on cross- border issues.
How Can Taxpayers Prepare?
HNW individuals should be prepared to address issues relating to their sources of income, estate planning, foreign financial accounts, gifts to family members, assets transferred to PFs or charitable organizations and to identify assets they own both within and outside the United States. Increased scrutiny of IRS audits of HNW individuals make it extremely likely that the IRS will consider increasing enforcement measures.
HNW taxpayers should ensure they understand how the IRS’ audit campaign could affect them and which issues, or positions, they should be prepared to defend if they are selected for examination.
Erin Gladney and Paul DePasquale are partners in the New York office of Baker McKenzie.