This article was initially published by Tax Notes Federal on March 1, 2021
Data, developments, and the tax gap
Global mobility has become a fixture in the 21st century. Recent data shows continuing increases in the number of high-net-worth individuals taking steps to relocate to new countries. This trend has resulted in a realignment of privately held assets and investment strategies as holders of private capital seek to diversify their holdings and look for conservative and stable investment options outside the United States.
Conversely, some high-net-worth individuals living outside the country are considering moving to the United States to optimize their wealth planning strategies and take advantage of a more stable political and economic climate.
The IRS recognizes that these notable shifts are occurring in conjunction with a greater concentration of wealth in fewer individuals and families, particularly those who are both globally mobile and savvy cross-border investors. In response to these shifts, on July 15, 2020, the IRS Large Business and International Division launched a campaign to audit high-net-worth individuals. Data from the IRS’s 2019 Data Book1 Table 17A illustrates a three-part division in taxpayer type: those with less than $100,000 in positive income, those with $100,000-$1 million in positive income, and those with more than $1 million in positive income. The third category represents the group of U.S. taxpayers with the highest positive income and is further broken down in $5 million increments. Taxpayer audits are selected based on data analytics within the IRS. LB&I Compliance Planning and Analytics provides LB&I Global High Wealth (GHW) a list of the high-net-wealth tax population to identify businesses and financial enterprises controlled by individuals with assets and earnings in the tens of millions of dollars.2 The Compliance Planning and Analytics division uses available “compliance data warehouse data” to assess the compliance risk of filed or unfiled returns.3 Then the workload services group (WLS) analyzes these returns and flags those with the highest risk indicators for GHW examination.4
The IRS estimates that the average annual gross tax gap, the estimated difference between the amount of tax that taxpayers should pay and the amount actually paid voluntarily and on time, to be $441 billion for tax years 2011 through 2013. The IRS further estimates that approximately $39 billion (9 percent) of this is caused by nonfilers. According to the IRS, high-income nonfilers contribute the majority of the nonfiler tax gap, despite their small number.5 As a result, the IRS has announced a series of new campaigns to identify and expand reviews and in so doing is targeting the high-net-wealth and international taxpayer population in an attempt to close this portion of the tax gap.
These efforts are consistent with, but separate from, new compliance developments, such as the Corporate Transparency Act. This law was included in the National Defense Authorization Act (H.R. 6395) and enacted in January 2021 because Congress believed that, among other things, the United States needs to join international compliance standards for its anti- money-laundering regime and help counter the financing of terrorism. The Corporate Transparency Act therefore directs the Treasury secretary to maintain the “beneficial ownership” information of corporations and limited liability companies in a secure, nonpublic database. This is an additional informational return filing requirement and affects (1) equity owners who directly or indirectly own at least 25 percent of the ownership interests in a private company, or (2) those who control a private company.
LB&I and the ‘Wealth Squad’
LB&I serves subchapter C corporations, subchapter S corporations, and partnerships with assets greater than $10 million. These businesses typically employ large numbers of employees, conduct business in an expanding global environment, and deal with complicated issues involving tax law and accounting principles. In 2009 the IRS created the GHW program, commonly referred to as the IRS “Wealth Squad.” GHW was formed to take a holistic approach in auditing and collecting tax from high-net-worth taxpayers and related entities. GHW audits are generally broad and comprehensive, focus on the taxpayer’s entire economic picture, and assess tax compliance across all income sources and investments. The Wealth Squad auditors are trained to examine the individual’s income tax return and the related income tax returns of any entity in which the individual has a controlling interest, such as a C corporation, S corporation, partnership, private foundation, or trust. The first wave of new IRS audits by the GHW is just starting, and the IRS is also using information that it first collected 10 years ago when the GHW program began. Further, the IRS is reportedly retraining some agents to allow them to better understand specified complex areas of the tax law.
The Wealth Squad work sources
- In general, LB&I’s Compliance Planning and Analytics has the primary responsibility to prepare a list of the high- wealth taxpayer population and conduct a risk assessment analysis to identify returns with high-risk indicators for noncompliance. The returns with the highest risk indicators are referred to WLS for a further assessment, potentially resulting in the enterprise being selected for Wealth Squad examination.
- WLS also accepts referral forms submitted by other IRS departments. Once it is determined that a referral may be appropriate for GHW, the enterprise is subjected to the risk assessment process. Referrals that are not accepted by WLS are forwarded to the appropriate planning and special programs office or sent back to
- WLS receives whistleblower claims from the Whistleblower Office.
- WLS may also identify a significant issue related to high-net-worth individuals and perform further analysis to determine whether a campaign should be launched.
As the IRS steps up enforcement and makes a concerted effort to target high-net-worth individuals, the best way to prepare is to be aware of the filing and reporting obligations in Section II of this article. It is well recognized that a transaction is not complete for tax purposes until the filings are done. As a result, any activity or transaction should be undertaken with attention to the tax and compliance filings that will be required. The starting point of any tax audit will be the tax return filings, and when filings are missing, the IRS will prepare those forms with the information it has, which is generally not in the taxpayers’ best interests. Therefore, it is highly recommended that taxpayers are proactive in being tax compliant and timely reporting all required information to avoid potential penalties or increased chances for an audit.
Further, taxpayers and their legal advisers and accountants can take steps to be well prepared for a GHW audit. The following preparatory steps should be considered by all high-net-worth individuals and their advisers:
- create a full, high-level overview of the taxpayer’s assets, income, and activities to develop a holistic picture (that is, individual income and assets, business entities and related assets and income, charitable organizations and activities, organizational charts, and the like);
- produce a detailed overview of the taxpayer’s individual assets and income (U.S. versus non-U.S., and related U.S. and non-U.S. reporting requirements);
- develop a detailed overview of the taxpayer’s business interests and related income and activities (U.S. versus non-U.S., and related U.S. and non-U.S. reporting requirements);
- review gifts, trusts, and charitable activities;
- run a mock audit review (prepare and pull files as if an audit had been initiated to identify any areas of concern); and
- work with one’s CPA and attorneys on an audit plan.
Common forms used by global taxpayers
The TCJA, which became law on December 22, 2017, overhauled major provisions of U.S. tax law. It reduced the top individual income tax rate to 37 percent and doubled the standard deduction and child tax credit, but it also eliminated most of the deductions for state and local taxes, hurting those living in states with high state and local income taxes. Similarly, while the TCJA permanently reduced the corporate income tax rate from a top marginal 35 percent to a flat 21 percent and allows companies to efficiently repatriate their foreign cash and cash equivalents with just a one-time 15.5 percent tax and the remaining earnings with an 8 percent tax, it also introduced complex rules that move toward a territorial system of taxing foreign subsidiary profits. Overall, the changes will benefit many, but they may also result in new and potentially complex filing requirements, which taxpayers are advised to stay on top of, especially in light of the six compliance campaigns announced by LB&I on May 21, 2018. The campaigns include Form 3520, “Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts’” and Form 3520-A, “Annual Information Return of Foreign Trust With a U.S. Owner”; noncompliance, nonresident alien (NRA) tax treaty exemptions; and Form 1040-NR, “U.S. Nonresident Alien Income Tax Return” Schedule A deductions, as well as NRA tax credits.
Following is a summary of some of the key federal tax compliance requirements and related
forms, including forms that are expected to be addressed by the IRS’s new campaign. To learn more about who must file a form, what information it requires, and when the form is due, use the tables to navigate to the appropriate form.