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Will tax audits, enforcement increase to make up for pandemic shortfalls?

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Googling “pandemic affects tax revenues” turns up a trend in headlines, with phrases like “slashes,” “slice out of” and “falls sharply” appearing frequently. COVID-19 and the subsequent shutdowns sent tax revenues, often propelled by sales tax losses, straight down.

Though scattered locales now report surprisingly good revenues for the third quarter, the fear persists that sometime, some way, state and local jurisdictions are going to try to make up the losses.

“Many clients expect that states and municipalities may have no other choice but to raise income tax rates, expand their tax base and increase enforcement activities to address budget pressures resulting from all of the unanticipated costs to handle the COVID-19 emergency,” said James McGrory, a CPA and shareholder at Drucker & Scaccetti in Philadelphia, in a state where most tax revenues have recently beat estimates.

“Audits are increasing, albeit by bots, algorithms and big data,” said Daniel Morris, a CPA and senior partner at Morris and D’Angelo CPAs in San Jose, California — another state that’s reported better-than-expected revenues so far.

Armies from where?

The surprising rebounds followed the second quarter, when state and local tax receipts fell almost 4 percent compared with the year-earlier period, according to The Tax Foundation.

Income and sales taxes fell “considerably” while property and excise tax collections remained stable. State and local spending came in 0.7 percent lower in the second quarter of 2020 than it did in the same period a year earlier. “States are using federal aid, and the expectation of recapturing delayed collections, to keep spending more stable than tax revenues,” the Foundation added.

The questions now: Is the recent rebound real or will it turn out to be an anomaly between the initial pandemic-ignited downturn and an even darker economy as federal stimulus dries up? And how will “the expectation of recapturing delayed collections” play out on the local level?

“Clients are always worried about audits and enforcements. I do believe there will be a significant increase in automated collections but think there will be a bigger delay on the audit side,” said Chris Hardy, an Enrolled Agent and managing director at Georgia-based Paramount Tax and Accounting. “Both states and feds are significantly behind in processing correspondence, which will delay their ability to ramp up any significant audit efforts.”

When exactly will jurisdictions have the resources to unleash armies of auditors? “It takes money to hire people or technology to do those increased audits and enforcement … an investment for them. If it’s not in the budget now, it won’t be in a lesser budget due to the pandemic,” said CPA Daniel Henn in Rockledge, Florida. “States, unlike the federal government, don’t have a blank check to hire a bunch of people or buy new technology.”

Squeeze plays

Future enforcement could take many forms, preparers said, involving various techniques — and various taxpayer targets. Drucker & Scaccetti’s McGrory, for example, noted that New Jersey is revisiting a “millionaire’s tax,” a higher tax rate bracket for those with significant earnings, similar to what California has. “Other states, equally impacted, may look for similar ways to tax those individuals making the most in order to not increase the burden on all taxpayers,” he said.

Timothy Speiss, a CPA and co-partner in charge of the personal wealth advisors practice at Top 100 Firm EisnerAmper in New York, said there’s no general worry about ramped-up audits but noted, “State tax residency and related sourcing of state income tax (by taxpayers) could be a state and local tax audit area, considering taxpayers relocating to other jurisdictions.” This could be particularly lucrative for jurisdictions as the pandemic forced widespread working from home.

Ultra-wealthy clients “are under an intensifying microscope under recent Treasury special projects and associated agent realignments. Auditing the W-2 middle class does not drive more revenue,” Morris said. “To shrink the tax-collection gap, the IRS and states must audit the wealthy because they’re the ones that have the ability and capacity to leverage the rules and regulations (for the extremely most party legally) in their favor.”

In fact, at a recent event, IRS representatives said that the service is planning to focus on high-net-worth taxpayers soon. (See story.)

Increased examinations of losses, deferrals (especially 1031 transactions), and cash and/or digital enterprises are continuing. “Nothing really new here,” Morris said, “except that as states seek increasing revenues, they must always return to the people and enterprises that earn them to squeeze more.”

The biggest initiatives may come from state capitals. “Given the magnitude of projected state budget shortfalls, the expectation is that states will have to legislate tax increases and make budget cuts rather than rely on increased audits and enforcement to cover such shortfalls in any meaningful way,” said David Shuster, a principal and international tax/director of tax controversy services in the New York offices of Top 100 Firm Friedman. “That could be state legislation, or it could be states piggybacking on federal legislation to which they conform, or some combination.”

That’s not to say that audits and enforcement will decrease. “On the contrary,” Shuster said, “they seem likely to end up continuing at least as much as before inasmuch as the return on such activity has historically justified the expense, and also because less enforcement typically leads to less voluntary compliance and, thus, greater shortfalls.”

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