In 2021, the difference between what U.S. taxpayers owed the federal government and what they paid hit nearly $700 billion. This “tax gap” has been growing for years while the Internal Revenue Service’s budget has shrunk, declining by 18% between 2010 and 2021. The audit rate for millionaires fell by more than 70% in roughly that same period.
To reverse these trends, the Biden administration’s Inflation Reduction Act allocated $80 billion in additional funding to the IRS over the next decade. If it’s used wisely, that money could help the agency track down some of those missing billions, says Rebecca Lester, an associate professor of accounting at Stanford Graduate School of Business and an expert on taxation. “Prior research shows high returns to IRS business enforcement: If you allocate money to the IRS for enforcement, then for every dollar you put in, you get more than a dollar back,” she says.
Hidden Figures
There are three fundamental business types in the U.S., Lester explains. At one end of the spectrum are sole proprietorships — individuals who run small businesses. On the other end are large publicly traded companies. In the middle are millions of pass-through (or flow-through) businesses, like limited liability corporations, whose income is generally not subject to taxation at the business level but passes directly to the owners and is taxed as personal income.
Partnerships are one type of pass-through business; they vastly outnumber public firms and control more than $30 trillion in assets. They are increasingly common, growing from 29% of U.S. business entities in 2003 to 40% in 2020. They are estimated to be responsible for three times as much U.S. tax non-compliance as corporations.
They are also very poorly understood. “Most academic research focuses on public companies for the simple reason of data availability,” Lester says. “But we think these flow-through businesses are where a very large portion of tax planning happens and that they contribute disproportionately to the tax gap.”
The researchers also found that when IRS examiners do find and assess additional tax to a complex organization, the amount assessed is much larger than in other partnership audits. “This is consistent with the idea that complexity is somehow indicative of the total amount of potential tax avoidance,” Lester says. “There is something about these partnerships that is not simply for the legal protection of a business.”
By Dylan Walsh / Stanford Business Insights
