Compliance

The IRS’s PR Gamble on AI and Partnership Audits

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On September 8, 2023, the IRS announced that it is leveraging artificial intelligence (AI) to target large partnerships. https://www.irs.gov/newsroom/irs-announces-sweeping-effort-to-restore-fairness-to-tax-system-with-inflation-reduction-act-funding-new-compliance-efforts. Large partnerships (those with more than $100 million in assets and 100 or more partners) have been an enforcement black hole for the IRS. On average, more than 80% of large partnership audits have resulted in “no change”-– meaning that the audit resulted in no tax adjustment. This is more than double the no-change rate of large C corporation audits. While these no-change rates are disappointing from the perspective of IRS enforcement, the audits that resulted in changes fared even worse. When field audits of large partnerships resulted in changes to the return, from tax year 2010 to 2018, the average audit income adjustment was negative $264,000.

And not only has the IRS been unsuccessful in generating revenue from these audits, but large partnership audits are time consuming. IRS revenue agents spend on average 345 hours on each large partnership audit, and the audits last on average 1.7 years. The average audit closed 2.99 years after the original return was filed. This was just inside of the three-year statute of limitations on assessment. And less than one percent of these audits had a statute extension signed – surely due to the seasoned practitioners representing the taxpayers in these audits. This indicates that many of these audits may be closed because the IRS revenue agents assigned were unable to identify issues within the three-year statute of limitations, and the taxpayers wisely decided not to provide the agents with additional time.

Because of its poor selection of large partnership returns for audit, and the lack of revenue generated by such audits, by 2019 the IRS had largely abandoned large partnership audits. The IRS audited 54 large partnerships out of more than 20,000 that filed tax returns in 2019 (an audit rate of 0.3 percent). But despite these difficulties, the Government was unwilling to give up on enforcement of large partnerships. Congress granted the IRS more expansive powers when auditing large partnerships and the IRS reworked its audit selection tools.

With the enactment of the Bipartisan Budget Act, Congress centralized the partnership audit regime, effective beginning in the 2018 tax year. That regime made it easier for the IRS to audit large partnerships by (1) allowing tax adjustments and assessments to be made at the partnership level and (2) establishing a partnership representative with sole authority to act for the partnership in the audit. These changes to the previous (TEFRA) partnership audit regime made it easier for the IRS to resolve audits, assess adjustments, and collect the tax due.

Even with this increased statutory authority, the IRS still needed to figure out how to better select large partnerships for audit. The IRS has various methods for selecting returns for audit. But the most prevalent is statistical modelling. Generally, the IRS will run filed returns through its statistical models to identify returns that have a higher risk of noncompliance. Partnership returns will be run through these models twice a year. And additional runs are made whenever the IRS needs to increase its audit inventory. Classifiers then manually review returns identified as higher risk. Those classifiers will identify specific issues to audit on a return and then forward the case to an audit manager to assign to a revenue agent.

The IRS uses two statistical models to review partnership returns – the Partnership Model and the Large Partnership Compliance Model (LPCM). The Partnership Model has been used since 2018. It reviews all partnership returns for which the IRS’s Large Business & International (LB&I) Division is responsible (those being all partnership returns filed showing $10 million or more of assets). For the 2020 tax year, the Partnership Model reviewed 249,464 partnership returns with $10 million or more in assets. As of April 2023, 400 of those returns had been selected for audit.

The LPCM is the IRS’s newest statistical model aimed at partnerships, and is currently, as its name implies, being used exclusively to identify audit potential for large, complex partnerships. The new model uses multiple indicators of risk for noncompliance that are based on accounting rules, tax law, and a machine learning algorithm. IRS subject matter experts assign importance to different metrics, which the LPCM then uses to classify the risk of noncompliance for each return as very low, low, medium, high, or very high. The IRS is quite impressed by this statistical model, and has classified it as an AI system. Federal agencies are required to publish lists of AI use cases, see Executive Order 13960, Promoting the Use of Trustworthy Artificial Intelligence in the Federal Government, and the IRS includes the LPCM on its list. (Interestingly, the Treasury Department has included a redesign of the National Research Program on its latest list of AI use cases.)

But putting a name to something does not make it so. The Government Accountability Office (GAO) found deficiencies in the development and testing of the LPCM. See GAO-23-106020, IRS Audit Processes Can Be Strengthened to Address a Growing Number of Large, Complex Partnerships.

First, IRS subject matter experts tested returns that the LPCM flagged as high risk to determine whether it was correctly identifying issues with audit potential. But checks were not done of returns identified as lower risk to determine if the LPCM was failing to identify issues with audit potential. Therefore, the LPCM was developed with the use of unrepresentative data. The IRS conceded that this was due to budget and time constraints. Second, the GAO also found that the LPCM used untested assumptions to select assign audit risk to returns. As one example, assumptions used to develop the business risk indicators on partnership returns and the weighting factors used to develop aggregate risk scores were drawn from interviews with IRS subject matter experts. These individuals’ views were not tested against outcomes from audited returns or validated research. The GAO notes that these shortcomings violate best practices of statistical modeling and AI development.

Ultimately, the issues identified by the GAO can be fixed. And the GAO provides guidance to the IRS on the steps that it can take to improve the LPCM. But the IRS used the LPCM in April 2023 to identify 150 large, complex partnership returns from the 2021 tax year as having high audit potential. The IRS has assigned 75 of those returns for audit. The September 8, 2023 public announcement of those audits touts the LPCM, and specifically ties its development and deployment to the Inflation Reduction Act funding.

Based on the GAO’s findings, the IRS’s public relations efforts seem like a gamble. There may be deficiencies in the LPCM that tarnish its audit selection. And the realities of these large partnership audits, including the relative resource and information disparities between these wealthy partnerships and IRS field agents, make it difficult for the IRS to sustain successful audit adjustments. If the IRS’s large partnership enforcement shortcomings continue with these 75 large partnership audits, it may diminish support the IRS’s needed technological development and additional funding. But the IRS has apparently taken a calculated gamble that either (1) its efforts will be successful or (2) the announcement will garner positive press, and the potential negative results of these audits will not garner any press.

Some Recipients of PPP Loan Forgiveness Face Tax Jeopardy

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In this article, Anthony Kim explores the implications for taxpayers who had their Paycheck Protection Program loans forgiven, including potential legal jeopardy stemming from improperly issued loans and forgiveness.

The COVID-19 pandemic presented unprecedented challenges for Americans from all walks of life. Not surprisingly, the federal government reacted to this crisis by offering substantial financial aid to businesses and consumers. As part of the Coronavirus Aid, Relief, and Economic Security Act, the government made hundreds of billions of dollars in forgivable loans available to American businesses through the Paycheck Protection Program. These loans were offered to businesses so they would have funds available to keep paying their workers and thus avoid catastrophic job losses during a time of national emergency. The PPP was intended to provide a much-needed lifeline to American businesses and workers who were suffering during the national emergency. Better still, once the PPP loans were properly forgiven (see below), the loan amounts aren’t treated as taxable income.

By the time the program ended on May 31, 2021, more than 11 million PPP loans had been extended, with a total value of about $786 billion.[1] Borrowers under the program could qualify for loan forgiveness by submitting Small Business Administration Form 3508S, “PPP Loan Forgiveness Application,” a one-page form seeking basic information and, most importantly, written confirmation that the borrower complied with all PPP forgiveness requirements — for example, rules regarding eligible uses of loan proceeds and a declaration that the proceeds had been used for eligible payroll and non-payroll costs.[2]

Notably, the PPP loan forgiveness process listed documents that each borrower “must maintain but is not required to submit.” With a basic one-page form and no supporting documentation to submit, how many applicants received PPP loan forgiveness? Ninety-two percent of loan recipients sought forgiveness of loans totaling about $753 billion,[3] and almost everyone that requested PPP loan forgiveness received it: 10,482,553 PPP loan forgiveness applications were received, with 10,436,367 fully or partially forgiven, for a total of $742,833,627,955.[4] Of the applicants that submitted Form 3508S, 99.6 percent received PPP loan forgiveness.[5] While under normal circumstances a forgiven loan means the amount becomes taxable income, PPP loan recipients escaped this liability as long as they qualified under the PPP criteria for loan forgiveness.[6]

With the disbursement of so much easy money, criminal opportunists naturally were drawn to the program. Enforcement statistics released by the Department of Justice taken against various bad actors that tried to exploit the PPP are alarming. In 2020 the Justice Department announced that it had charged 57 defendants with PPP-related fraud for their attempts to steal over $175 million from the program.[7] Just two years later, the Justice Department announced that it had seized more than $1.2 billion in fraudulently obtained COVID-19 relief funds and had charged more than 1,500 defendants with crimes in federal districts across the country.[8] And the Justice Department continues to ramp up its focus on PPP-related fraud. In September the department announced the establishment of three strike force teams to further enhance efforts to combat and prevent COVID-19-related fraud.[9]

Along with the Justice Department’s criminal enforcement measures, what can we expect from the IRS regarding the PPP? First, anyone that obtained a PPP loan through an illegal scheme or by other fraudulent means must include income derived from those illegal or criminal activities in the same manner as income from other sources.[10] A loan doesn’t constitute income to the borrower because of the corresponding obligation to repay the sum borrowed.[11] However, if the facts establish that the recipient recognizes no obligation to repay the loan, the transaction can become a wrongful appropriation and fall within the broad definition of gross income.[12] Thus, taxpayers caught in the wide net of the Justice Department’s PPP-related criminal fraud investigations will be determined to have illegal gross income.

Second, even if a recipient of a fraudulent PPP loan managed to avoid the Justice Department’s criminal sweep, the next potential snare is whether the loan was properly forgiven. A seemingly anodyne IRS chief counsel advice released September 16 (ILM 202237010) concluded that if a taxpayer fails to satisfy the conditions for PPP loan forgiveness, they have reportable gross income equal to the amount of the loan.[13]

The amount of a PPP loan that is properly forgiven as provided under the PPP isn’t included as gross income for federal income tax purposes.[14] Qualifying forgiveness occurs if the PPP loan recipient satisfies the forgiveness criteria set forth in 15 U.S.C. sections 636m and 636(a)(37)(J), the participating lender forgives the loan in whole or in part, and the forgiven amount doesn’t exceed the full principal amount of the loan. To request forgiveness of a PPP loan, the loan recipient (or an authorized representative) must attest to eligibility for forgiveness, including verifying that the loan proceeds were properly used for eligible expenses, that the amount applied for forgiveness satisfies all the limitations relating to specified costs, and that other legal requirements were met. To receive qualifying forgiveness on a PPP loan, at least 60 percent of the loan amount must be used for payroll costs, and up to 40 percent of the loan amount may be used for other specified costs.

What does the PPP loan forgiveness process mean for federal tax purposes? Taxpayers that had their PPP loans forgiven but rushed through the process and maintained poor supporting documents have reason to worry. Discovering whether a PPP loan recipient failed to report gross income for the loan amount that didn’t (or can’t) qualify for loan forgiveness is low-hanging fruit for a revenue agent conducting an audit. The name of every recipient of a PPP loan is publicly available; a revenue agent can easily search publicly available sources to find the name of any given recipient.[15]

During an audit, the revenue agent could ask the taxpayer for basic information to determine if the taxpayer failed to report the forgiven amount of their PPP loan on their federal income tax return. In an information document request, the IRS could simply ask a taxpayer for information that Form 3508S required applicants to maintain to qualify for loan forgiveness. As a former IRS attorney who advised revenue agents conducting audits, I would recommend that the government seek basic information on the PPP loan forgiveness issue as follows:

  • You, Mr. John Doe, received a PPP loan in the amount of $XXX,XXX in tax year 202X. If this is incorrect, please explain.
  • To request forgiveness of a PPP loan, the loan recipient must attest to eligibility for forgiveness, including by verifying that the loan proceeds were properly expended on eligible expenses and that the amount applied for forgiveness satisfies all the limitations relating to specified costs, and meet other legal requirements. Did you file (by paper or electronically) Form 3508S to request forgiveness of your PPP loan received in tax year 202X?
    1. If yes, provide the following:
      1. a copy of your filed application (Form 3508S), including the signed attestation requesting forgiveness of your PPP loan;
      2. contact information, title, and authority of the individual who signed the attestation requesting forgiveness of your PPP loan;
  • name(s) and contact information of any third party that assisted you with the PPP loan forgiveness application;
  1. name(s) and contact information of any person(s) or entity(ies) that possess, or could possess, documents supporting your application for PPP loan forgiveness (the specific list of required supporting documents for PPP loan forgiveness is set out on pages 4 and 5 of Form 3508S);
  2. any and all documents and representations required by 15 U.S.C. section 636m(e) and by the SBA that support your application for PPP loan forgiveness (the specific list of required supporting documents for PPP loan forgiveness is set out on pages 4 and 5 of Form 3508S); and
  3. any and all documents, including correspondence with third parties and authorized representative(s), related to your application requesting forgiveness of your PPP loan.
  1. If you assert that any of the requested information in request 2.a.i through 2.a.v above is subject to either attorney-client privilege, federal tax practitioner privilege under 26 U.S.C. 7525, or work-product privilege prepared in anticipation of litigation, provide a log specifically asserting each applicable privilege along with: (1) the name(s) of the author(s), recipient(s), and individual(s) copied on the communication; (2) the subject matter of the communication/document; and (3) the date of the document/correspondence.

The taxpayer’s responses to those questions will help determine whether the PPP loan recipient properly qualified for loan forgiveness. As concluded in ILM 202237010, if a taxpayer does not factually satisfy the conditions for PPP loan forgiveness because they inaccurately represented that they satisfied them, the taxpayer has reportable gross income.[16] And if a taxpayer’s responses to IRS questions during a civil tax audit present evidence of deception, the situation becomes far more complicated.

Who is likely to be selected for audit and receive these IRS information document requests? The potential population to be audited is large: More than 10 million applicants received full or partial loan forgiveness of PPP loans.[17] It will be interesting to see how the IRS decides to pursue this PPP loan forgiveness issue. It may begin by sending out to the entire population of forgiven loan recipients a soft letter noting a potential noncompliance issue and requesting a response from the taxpayer.

What is an IRS “soft letter?” As part of its compliance campaign program, and sometimes before an examination has begun, the IRS may send a taxpayer a letter inquiring about a tax position the taxpayer has taken or asking the taxpayer to take some action, such as providing specific information. For example, the IRS issued a soft letter to some taxpayers addressing virtual currency transactions.[18] In this letter, the IRS instructed that the taxpayers take specific actions by a fixed date. Taxpayers aren’t required to respond to a soft letter, but disregarding the IRS’s friendly tap on the shoulder for information could trigger an audit.[19]

Beyond the scary possibility of being selected for an audit or receiving a soft letter regarding PPP loan forgiveness, there are other issues for forgiven PPP loan recipients to worry about:

  • Potential application of the civil fraud penalty under section 6663, a 75 percent addition to any tax due.
  • Possible referral for criminal investigation. Internal Revenue Manual section 25.1.3.1.1(1) instructs IRS agents to refer a taxpayer for criminal investigation when affirmative acts of fraud are found. If an agent discovers that a taxpayer inaccurately represented that they satisfied loan forgiveness conditions in attested documents and determines the presence of affirmative acts of fraud/deception, the revenue agent must suspend the civil examination and refer the matter for criminal investigation. IRM section 25.1.3.3(3).

If the points discussed above cause a PPP loan recipient whose loan was forgiven some anxiety, he may think that filing an amended return reporting gross income of the amount of improperly forgiven PPP loan will correct the problem and at least start the statute of limitations period. Not so. In Badaracco,[20] the U.S. Supreme Court held that “a taxpayer who submits a fraudulent return does not purge the fraud by subsequent voluntary disclosure; the fraud was committed, the offense completed, when the original return was prepared and filed.” So filing an amended return won’t provide relief from a civil fraud penalty or start the statute of limitations for assessment. If the IRS determines that a taxpayer committed fraud by requesting and receiving PPP loan forgiveness, it has no time limit to contact the taxpayer about their failure to report forgiveness of PPP loan income. The issue could hang over the taxpayer forever.[21] That’s a significant COVID-19 hangover.

If a taxpayer knows that they didn’t factually satisfy the conditions for PPP loan forgiveness and inaccurately represented that they satisfied them, can they mitigate criminal liability somehow? Would the filing of an amended tax return help avert a criminal prosecution?

Don Davidson was an assistant U.S. attorney with the Justice Department, a deputy general counsel, a senior vice president at UBS Financial Services, and a partner with a trio of multinational law firms in New York and San Francisco. Given his experience with criminal matters in both the public and private sectors, I asked Don for his views on a basic fact pattern regarding this PPP loan forgiveness issue: A taxpayer received a PPP loan, received forgiveness of the loan, and knows that he didn’t meet the criteria for loan forgiveness even though he attested to meeting requirements when he filed Form 3508S with the SBA. The taxpayer is concerned about possible criminal liability from this situation. Does the taxpayer have any potential criminal exposure? And if so, is there anything the taxpayer can do now to reduce his potential criminal exposure?

Davidson confirmed that under the facts presented the taxpayer is subject to potential prosecution for both the underlying fraud against the PPP and the false return, with a tax evasion offense arising from their failure to properly report the income associated with the improperly forgiven PPP loan. Also, he noted that filing an amended return, or “self-reporting” after the crime is complete, isn’t a Get Out of Jail Free card, though it may help to reduce the potential punishment. Legally, the fraud crime is complete when the false attestation has been submitted, and the tax crime is complete when the false return has been filed.

As a former federal prosecutor, Davidson offered this view for those who may be concerned about criminal liability from PPP-related offenses:

There are pros and cons to tacking a criminal tax charge on to a case involving some illicit monetary gain (e.g., fraud, bribery, extortion, money laundering, etc.). On the plus side, a tax charge provides both additional plea-bargaining leverage and significant investigative resources from the IRS’s Criminal Investigation division (“CID”). CID agents are often invaluable in white-collar cases because they bring demonstrated skill and expertise in following complicated monetary transactions and deciphering mounds of financial documents, account statements, and the like. The downside of bringing the IRS into a criminal case is that the agency is going to rightfully expect that a “tax count” (i.e., some violation of Title 26 of the United States Code) will be included in the charges that eventually will be brought. Charging a tax offense, in turn, requires the United States Attorney’s Office to consult and receive written approval from their counterparts at “Tax Justice,” the tax crime subject matter experts at Justice Department headquarters in Washington, D.C. Since the 94 U.S. Attorneys Offices largely work independently and normally do not need sign off from “Main Justice” to prosecute most cases, the requirement to consult and seek approval from the tax specialists in Washington, D.C., is generally something they would prefer to avoid if possible. Nevertheless, despite the extra administrative and logistical burden of prosecuting a criminal tax charge, I usually found it a worthwhile trade-off in order to get the benefit of the CID investigators. Adding a CID agent or two to an investigative team is a true “force multiplier” for federal prosecutors, and the unhappy target who finds himself or herself on the business end of such an investigation is in a very precarious position.[22]

In sum, if you submitted Form 3508S, received PPP loan forgiveness, and maintained the proper paperwork required to qualify for loan forgiveness under the program, there is little to worry about. You may need to respond to an IRS soft letter, but I suspect that of the more than 10 million applicants who received full or partial forgiveness of PPP loans totaling more than $742 billion, there are many who will be dealing with far more than a soft letter.

[1]Small Business Administration, “Forgiveness Platform Lender Submission Metrics” (Sept. 11, 2022).

[2]SBA, Form 3508S, “PPP Loan Forgiveness Application” (revised July 30, 2021).

[3]SBA, supra note 1.

[4]Id.

[5]Id.

[6]IRC section 61(a)(11); section 1106(i) of the CARES Act.

[7]Justice Department, “Acting Assistant Attorney General Brian Rabbitt Delivers Remarks at the PPP Criminal Fraud Enforcement Action Press Conference” (Sept. 10, 2020).

[8]Justice Department, “Justice Department Announces COVID-19 Fraud Strike Force Teams” (Sept. 14, 2022).

[9]Id.

[10]Reg. section 1.61-14.

[11]James v. United States, 366 U.S. 213, 219 (1961).

[12]United States v. Rochelle, 384 F.2d 748, 751 (5th Cir. 1967) (holding that fraudulently obtained funds were taxable to the recipient, even though he had received them in the form of loans, since he had no intention of fulfilling his representation or repaying the moneys he received).

[13]Chief counsel advice is a term used to describe a subset of legal advice that is required to be released to the public under section 6110. Not all legal advice is subject to this public disclosure requirement. Chief Counsel Directives Manual section 33.1.2.2.3.2(4).

[14]Section 1106(i) of the CARES Act provides that for purposes of the code, any amount that would be includible in gross income of the recipient by reason of forgiveness described in section 1106(b) “shall be excluded from gross income.” Thus, section 1106(i) operates to exclude from the gross income of a recipient any category of income that may arise from covered loan forgiveness, regardless of whether that income would be (1) properly characterized as income from the discharge of indebtedness under IRC section 61(a)(11), or (2) otherwise includible in gross income under IRC section 61. However, it’s important to note that many states may address forgiven PPP loans by either treating forgiven loans as taxable income, denying the deduction for expenses paid for using forgiven loans, or both. For a summary of how various states are addressing the forgiven PPP loans, see Katherine Loughead, “Which States Are Taxing Forgiven PPP Loans?” Tax Foundation (last updated Aug. 23, 2021).

[15]Moiz Syed and Derek Willis, “Tracking PPP,” ProPublica, July 7, 2022.

[16]Section 61(a) generally provides that “gross income means all income from whatever source derived.” That applies to all payments that are “undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion.” Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 431 (1955). Even if the SBA can pursue repayment in the case of the misuse of PPP funds, a recipient that retained the PPP loan proceeds under a claim of right has gross income under section 61(a).

[17]Id.

[18]IRS, “Reporting Virtual Currency Transactions.”

[19]There have been grumblings about the use of soft letters by the IRS. National Taxpayer Advocate, “Objectives Report to Congress: Fiscal Year 2021,” at 79 (June 29, 2020).

[20]Badaracco v. Commissioner, 464 U.S. 386 (1984).

[21]If a taxpayer received PPP loan forgiveness, knew the application was false, and bragged to others about this deception, the taxpayer is at risk that the information will make its way to the IRS through a whistleblower submission. The tax code provides a financial award for whistleblowers who provide information to the IRS that assists in the detection of underpayments of tax. Section 7623.

[22]Email to author from Donald S. Davidson.