IRS Audit

When the IRS asks, “What’s the Password?”

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We have all heard warnings ad nauseum about not sharing passwords. See e.g., Iliya Garakh, The 5 Risks of Sharing your Password, Techopedia (July 5, 2023). (And who can forget that classic Seinfeld episode The Secret Code, aired November 9, 1995.) Well, now, someone else may be seeking to overcome your natural reservations and obtain your password, and they aren’t scammers either. Nowadays, snugly cloaked in authority, the IRS in examining businesses may be asking for the usernames and passwords to accounting software programs, such as QuickBooks, Sage Accounting, Zoho Books, and others on the market. See United States v. Rouse, 2011 U.S. Dist. LEXIS 77025, *4-6 (holding tersely an IRS summons for QuickBooks records enforceable under I.R.C. § 7602).

As explained in the FAQs on the subject, https://www.irs.gov/businesses/small-businesses-self-employed/use-of-electronic-accounting-software-records-frequently-asked-questions-and-answers, the IRS finds that as electronic information management has become the standard in the private sector, the taxing agency’s ready and full access to such systems will reduce compliance burden and boost the efficiency of any examination. Win-win, right? And this forward-looking approach was, in fact, the result of requests from the tax practitioner community itself. Jim Buttonow, IRS audits of small business software files, Journal of Accountancy (December 31, 2011). Thousands of revenue agents have subsequently been trained in using QuickBooks under licenses from Intuit.

At the same time, concerns continue to be raised over the routine insistence on businesses surrendering their usernames and passwords to examining revenue agents. The IRS has sought to assuage these concerns with FAQ 3 of the above-cited FAQs to the effect that taxpayers can solve the problem by simply creating a temporary password with administrator access for any submitted backup file. In this way, the IRS happily explains, the taxpayer will be able to “preserve any favorite password,” as if ensuring that a cherished prom song remained the key to their business records was ever anyone’s genuine concern.

For many practitioners, the genuine concern is that once the programs are accessed, how far afield may the examiner decide to go? Their fears may be summed up by the apocryphal Arab proverb “Beware of the camel’s nose.” (And for parents, also relevant would be the title of the popular children’s book, If You Give a Mouse a Cookie.)

Apparently, the IRS expects that practitioners may rightly feel the hazard in providing such sensitive client information and resist the government’s request. And, in FAQ 9, the IRS hints that a practitioner’s failure to provide this sensitive information would violate the governing rules of practice under Circular 230 and subject the practitioner to discipline.

The IRS has occasionally warned agents to exercise “professional judgment” in requesting records. One executive document explains, “it may not be necessary to request the backup file in a limited scope audit of one expense item on the tax return.” Memorandum for Examination Area Directors, September 1, 2011, SBSE 04-0911-08. Such pronouncements on administrative self-control are laudable but also not self-executing. Practitioners must remain vigilant about audit-scope creep and be prepared to request a meeting with the examiner’s manager should the camel’s nose—or head—appear.

For example, FAQ 2 also indicates that requests for accounting software backup files will be made “early in the examination.” Yet, backup files have been requested in the later stages of an audit and even after substantial records have been provided. The FAQs may be of most value to the examiners.

As a preventive matter, taxpayers should become thoroughly familiar with the features of their particular accounting software program, so that tax years can be kept in separate batches. And, if confronted with an IRS request for accounting software password and username information, how can practitioners respond? First, ensure that you have provided the IRS responsive hard copy documents. Second, in your correspondence with the IRS consider reviewing and citing to cases where courts have declined to require production of log-in and password information as method of fact gathering where responsive information has already been shared. Farley v. Callais & Sons LLC, 2015 U.S. Dist. LEXIS 104533 (E.D. LA 2015); In re Milo’s Kitchen Do Treats Consol. Cases, 2015 U.S. Dist. LEXIS 48808 (WD PA 2015).

Practice Pointer: Should Your Client Sign an IRS Statute Extension?

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Most taxpayers, and representatives for taxpayers, who are involved in an IRS audit genuinely want to cooperate with the assigned revenue agent conducting the civil tax investigation. But how should you approach the situation if the IRS asks the taxpayer to extend the normal assessment period by signing an agreement (Form 872)? Let’s start with an overview:

What is the statute of limitations on tax assessment?

Section 6501(a) of Title 26 establishes a generally applicable statute of limitations providing that the IRS may assess tax deficiencies within a 3-year period from the date a tax return is filed. In other words, the law grants the IRS a limited window of time to investigate and assess additional tax beyond the amount reported by a taxpayer on his/her own tax return. The statute of limitations “is intended to run against those who are neglectful of their rights, and who fail to use reasonable and proper diligence in the enforcement thereof . . . .”  Pashley v. Pacific Elec. Co., 153 P.2d 325, 326 (1944) (internal citation omitted).

Why is the IRS asking the taxpayer for a statute extension?

On the one hand, the IRS may have encountered a particularly complex issues that requires more time to adequately understand the proper tax result. On the other, the IRS may not have been entirely diligent in properly and timely developing the audit. In either case, the IRS has determined it needs additional time to conduct the audit.

What administrative rules/policies apply to the IRS when it seeks a statute extension in a case?

The Internal Revenue Manual provides that it is the policy of the IRS to secure consents to extend the period to assess only in cases involving “unusual circumstances.” IRM 25.6.22.2.1(1). Two reasons most often cited by IRS agents to explain the need for a statute extension are: (1) the limitation period for a taxable year under exam will expire within 180 days and there is insufficient time to complete the examination and the administrative processing of the case; or (2) the assessment period must be extended so that the case can go to Appeals–there must be at least 395 days remaining on the assessment statute of limitations when the case is receive by Technical Services and at least 365 days remaining on the statute of limitations when the case is received by Appeals. IRM 25.6.22.2.1(3)a, b.

What should the taxpayer (and taxpayer’s representative) consider in deciding whether to agree to sign a statute extension?

First, the most pressing concern for a taxpayer when considering whether to sign a statute extension is likely this – will rejecting an IRS request to sign a statute extension create a greater problem for me? The calculation for a taxpayer is to determine which choice presents the worst case scenario: (1) signing a statute extension prolongs the audit and associated time/expense/stress; or (2) rejecting the IRS’s request presents the risk that the IRS will summarily determine tax adjustments for the tax year under audit or perhaps lead to other unknown problems from an irked revenue agent.  Second, does rejecting the IRS’s request to sign a statute extension mean that the taxpayer is not cooperating in audit?  Why does a taxpayer’s cooperation in an audit matter? Well, Congress offered a carrot for taxpayers to work cooperatively with the IRS in an audit.  Under section 7491(a)(2)(B), if a taxpayer cooperates with the IRS during an audit, then the normal burden of proof flips from the taxpayer to the government. This is a meaningful procedural advantage for a taxpayer that should be considered in a taxpayer’s decision-making process. The bottom-line is that a taxpayer who refuses to sign a statute extension request is not considered to have failed to cooperate for purposes of section 7491(a)(2)(B). On this issue, tax representatives must consider whether advising their client not to sign a statute extension runs afoul of Circular 230. Generally, section 10.23 of Circular 230 provides that a practitioner “may not unreasonably delay the prompt disposition of any matter before the Internal Revenue Service.” Advising a client not to sign a statute extension requested by the IRS does not violate Circular 230.

How should the taxpayer (and taxpayer’s representative) respond to the IRS’s request for a statute extension?

Consider two suggestions: first, ask the IRS revenue agent to explain why additional time is needed in the audit. The IRS Internal Revenue Manual provides that if a taxpayer and/or authorized representative responds to a request to extend the assessment statute with questions or other concerns, “examiners will discuss the taxpayer’s rights . . . the reason for the request, and any other pertinent information, such as how the proposed extension date was determined and the fact the statute can, if necessary . . . to help the taxpayer make an informed decision.” IRM 25.6.22.3(7).  Second, consult a tax attorney to consider the strategic benefits and hazards from rejecting the IRS’s request for the taxpayer to sign a statute extension request. In our view, there must be an exceptional circumstance for a taxpayer to sign a statute extension; otherwise, if the IRS failed to use reasonable and proper diligence in the enforcement of the assessment period, then that is not a problem that the taxpayer should have to address.

Cracking Down on Foreign Bank Secrecy While Becoming a Tax Haven: The Irony of U.S. Tax Policy

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Overview

The Foreign Account Tax Compliance Act (FATCA) has been a cornerstone of the U.S. government’s efforts to combat tax evasion involving foreign financial accounts. By imposing obligations on Foreign Financial Institutions (FFIs) to report information about financial accounts held by U.S. taxpayers, FATCA has largely eliminated overseas tax havens.

However, the reciprocal exchange of information is not as robust in the opposite direction. While the U.S. has entered into a number of Intergovernmental Agreements with other jurisdictions to facilitate the exchange of information under FATCA, the level of information the U.S. provides to other countries about their citizens’ financial accounts in the U.S. is not always equivalent. The U.S. has not committed to adopting the Common Reporting Standard, which is the global standard for the automatic exchange of financial account information, developed by the Organization for Economic Cooperation and Development.

This asymmetry in information exchange has raised concerns that the U.S. could be seen as a tax haven for non-U.S. persons. For instance, certain trusts, limited liability companies, and other investment vehicles in the U.S. can offer non-U.S. persons a degree of confidentiality about their ownership interests and assets. This is particularly true in states with favorable trust and corporate laws that do not require the disclosure of beneficial ownership information.

It is important to note that the U.S. has taken steps to address some of these concerns. The Corporate Transparency Act requires U.S. and foreign persons to report their beneficial ownership information of certain U.S. entities to the Financial Crimes Enforcement Network. This legislation is aimed at preventing and combating the misuse of legal entities for purposes of money laundering, tax evasion, and other illicit activities.

But the Corporate Transparency Act has significant limitations. It only applies to entities that are formed or registered by the filing of a document with a secretary of state or similar office. This means that certain entities, such as trusts that are not registered with a secretary of state or similar office, are still not required to disclose beneficial ownership information. This continuing lack of transparency, combined with the potentially favorable tax treatment of foreign persons, means that the U.S. has emerged as a major international tax haven.

FATCA: Legislation Passed by the U.S. in 2010 to Combat Offshore Tax Evasion by U.S. Taxpayers

  • Requires foreign financial institutions (FFIs) like banks and investment companies to report information about financial accounts held by U.S. taxpayers to the IRS.
  • Includes requirements for US taxpayers to report foreign assets and offshore accounts.
  • Imposes a 30% withholding tax on certain payments from U.S. sources made to FFIs that do not comply with FATCA reporting requirements.

U.S. Implementation of FATCA

  • The U.S. has signed intergovernmental agreements (IGAs) with many countries to facilitate implementation of FATCA and information sharing.
  • Partner countries entering into IGAs agree to share that information with the IRS.
  • These IGAs require the partner countries to share information with the IRS, but help to protect the financial institutions of partner countries from FATCA penalties.
  • More than 100 countries have entered into IGAs with the U.S., requiring FATCA compliance.
  • This effectively breaks secrecy laws in tax havens and forces disclosure of information about accounts held by US taxpayers
  • FATCA has resulted in the disclosure of billions in previously unreported offshore assets and income, helping the IRS crack down on offshore tax evasion

The U.S. Also Used Its Criminal Laws to Target Institutions in Foreign Tax Havens

The enforcement of FATCA went hand-in-hand with the U.S. government’s broader efforts to pursue tax compliance and combat offshore tax evasion. The aggressive enforcement actions that began around 2009, prior to FATCA’s enactment, were a clear signal of the government’s intent to crack down on noncompliance with tax obligations related to foreign accounts.

The Department of Justice, in collaboration with the IRS, targeted FFIs that they believed were complicit in helping U.S. taxpayers hide assets and income offshore. High-profile cases against Swiss banks, in particular, led to numerous deferred prosecution agreements and non-prosecution agreements. Under these agreements, FFIs were required to admit to wrongdoing, pay fines, and provide detailed information about U.S. customers who had held undisclosed accounts. These enforcement actions resulted in billions of dollars in fines and the disclosure of thousands of account holders to the IRS.

Following these disclosures, the IRS pursued U.S. taxpayers who had not reported their foreign accounts and income. The IRS offered several Offshore Voluntary Disclosure Programs and the Streamlined Filing Compliance Procedures as a way for U.S. taxpayers to come into compliance voluntarily. Taxpayers who did not take advantage of these programs and were subsequently identified faced significant penalties and potential criminal prosecution.

The International Community Seeks to Implement Financial Account Information Sharing

The larger international community has sought to implement FATCA’s information-sharing provisions on a broader scale. The Common Reporting Standard (CRS) is a global standard for the automatic exchange of financial account information between tax authorities. It was developed by the Organization for Economic Cooperation and Development (OECD) in 2014 and has been adopted by over 100 countries and jurisdictions.

  • CRS requires financial institutions like banks, brokers, and funds in participating countries to identify foreign account holders and report information on their accounts to their domestic tax authority. This includes account balances, interest/dividend payments, sale proceeds from financial assets, and other income.
  • The domestic tax authority then automatically exchanges that information with the tax authorities in the account holder’s country of tax residence. This enables tax authorities to verify if their tax residents have properly reported their offshore financial accounts and income.
  • Reciprocal exchange is a key component of CRS. If country A exchanges information about country B’s tax residents, then country B will also provide the same information about country A’s tax residents.
  • Over 100 countries and jurisdictions participate in CRS information exchange, including major economies like the UK, Germany, France, China, India, and Japan.
  • The U.S. does not participate in CRS.

The U.S. Has Not Joined CRS Due to Opposition from Congress and the Financial Industry:

  • The U.S. already unilaterally receives financial account information from other countries through FATCA. CRS is therefore seen as providing little benefit for the U.S.
  • There are concerns about the costs to U.S. financial institutions of implementing CRS due diligence and reporting systems.
  • Powerful voices in Congress oppose adopting legislation that facilitates information sharing with foreign governments to assist their tax enforcement.
  • In summary, CRS is a widely adopted global standard for reciprocal exchange of financial account information between tax authorities, but the U.S. is a notable non-participant due to political and industry opposition.

The U.S.’s Emergence as a Tax Haven

The OECD defines a tax haven as a jurisdiction that (1) has no obligation to exchange information, (2) lacks transparency, (3) does not require a local presence, and (4) has zero or nominal tax rates. For non-U.S. persons, the U.S. meets these four requirements.

  • The U.S. does not provide meaningful reciprocal reporting of financial accounts to other countries.
    • The U.S. has not adopted CRS or implement fully reciprocal information exchange under FATCA.
  • S. entities still can lack transparency.
    • The U.S. has taken significant steps to increase transparency of entity ownership. Prior to this year, there was no U.S. requirement to identify the beneficial owners of U.S. entities. But the Corporate Transparency Act (CTA), effective in 2024, now requires the disclosure of the beneficial owners of certain U.S. entities.
    • But the CTA only applies to entities that are formed or registered through a filing with a secretary of state or similar office. This means that certain types of legal entities, including many trusts, are not subject to the beneficial ownership reporting requirements of the CTA. The U.S. Treasury Department has been tasked with developing regulations to implement the CTA, which may in the future seek to expand its application to trusts and other entities. It is also possible that future legislation or regulatory action could expand the reporting requirements to include additional types of legal arrangements, including trusts.
    • But, at this time, there is still the potential for foreigners to shield their ownership of entities and assets in the U.S.
  • Foreigners do not need a U.S. presence to hold U.S. financial assets, entities, or trusts.
  • Foreigners can generally pay little or no U.S. tax when they invest in U.S. assets.
    • Generally, foreign taxpayers are subject to U.S. tax on (1) fixed, determinable, annual or period (known as FDAP) income and (2) income from a U.S. trade or business.
    • Foreign taxpayers generally pay no tax when selling U.S. assets other than real estate.

The Sunset of International Tax Havens

The enactment of the CTA signals a commitment by the U.S. to enhance financial transparency and combat the misuse of entities for illicit purposes, including tax evasion. The CTA, along with the aggressive enforcement of its tax laws as seen in the past decade, suggests that the U.S. is taking steps to shed any perception of being a tax haven.

As the U.S. aligns with global trends towards financial transparency, it is possible that the characteristics which have made the U.S. attractive for foreign persons seeking confidentiality may change. The playbook used by the U.S. to dismantle secrecy in offshore jurisdictions—compelling information sharing and enforcing domestic laws—could be adopted by other nations looking to protect their tax bases. This international effort is further supported by initiatives like the OECD’s CRS and the automatic exchange of information agreements.

For advisors and financial institutions in the U.S. that assist foreign persons, it is crucial to operate within the bounds of both U.S. law and international legal frameworks. The Department of Justice has the authority to prosecute U.S. persons for crimes such as aiding and abetting tax evasion, even if the tax evasion occurs under another nation’s laws. Additionally, engaging in activities that facilitate the evasion of another country’s taxes can expose U.S. persons to legal action by that foreign jurisdiction. As the Department of Justice pursued the Swiss, foreign nations can pursue U.S. institutions and persons.

Conclusion

At Kim & Rosado, our partners’ background as tax attorneys with the Department of Treasury provides us with unique insights into the government’s enforcement strategies. We understand the serious nature of these matters and the importance of proactive compliance. We offer our clients expert guidance on navigating the complex web of U.S. tax laws, including the intricacies of reporting foreign financial assets and income. Our goal is to ensure that our clients are not only compliant but also protected from the severe consequences that can arise from noncompliance.

For individuals and institutions that may already be facing scrutiny or enforcement actions, we leverage our extensive experience to advocate on their behalf, seeking resolutions that minimize exposure and penalties. Our direct partner involvement means that clients benefit from the highest level of expertise and representation in these serious and high-stakes matters.

By the Numbers: The Corporate Transparency Act and the Probable Impact to IRS Global High Wealth Taxpayer Audits Beginning in 2024

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Back in 2009, the IRS formed the Global High Wealth (GHW) unit focusing on taxpayers who had elevated income and a complexity in their financials that warranted a “holistic approach.” From 2009 through 2022, our seasoned partner Tony Kim served as one of five IRS attorneys working to support this new unit. He found that understanding how a web of partnerships, domestic and foreign trusts, offshore accounts and corporations linked to reveal a GHW taxpayer’s true taxable income was no easy task. But, the IRS first had to find these dots to connect them.

The IRS’s Data Book shows that the agency struggled with GHW audits. IRS Data Book Table 17. As of fiscal year 2010, 13,322 tax returns were filed by taxpayers who had total positive income of $10,000,000 or more – that’s the range to fall within this GHW population. IRM 4.52.1.2. From that number, 21.5% of the returns were audited with an average recommended adjustment of $610,397. Fast forward to fiscal year 2019, where the number of GHW tax returns filed grew to 24,457, resulting in just 10.2% audit coverage with an average recommended adjustment of $49,805. If the GHW division was a stock, we’d probably sell and take a loss. Before we do, let’s look under the hood for a moment.

In building a GHW case, the IRS prepares a review a “yK-1 analysis” for each taxpayer to gain an overview of the taxpayer enterprise that includes the taxpayer’s Form 1040 and all related entities. From this interactive link analysis of the GHW taxpayer and all of their web of entities, the IRS could then review the entire enterprise and consider how to build the case. IRM 4.52.1.1.5(1); IRM 4.52.1.3. The trouble with building this yK-1 analysis is that the IRS needs information on a GHW taxpayer’s web of entities. And, a GHW taxpayer’s ownership information in various entities is elusive.

The GHW unit’s audit results may increase dramatically in the coming years due to the recently enacted Corporate Transparency Act (CTA). Congress added the CTA section, 31 U.S.C. § 5336, to the Bank Secrecy Act to address the broader objectives of beneficial ownership transparency. The CTA requires certain types of domestic and foreign entities, called “reporting companies,” to submit specified beneficial ownership information (BOI) reports to the Financial Crimes Enforcement Network (FinCEN), a bureau of the U.S. Treasury, that is charged with safeguarding the U.S. financial system from money laundering and promote national security through the collection, analysis, and dissemination of financial intelligence. All of the information that connects GHW taxpayers to their holdings so critical to a yK-1 analysis will soon become available to the IRS beginning in 2024 when taxpayers are required to file BOI reports with FinCEN. The CTA provides, “[b]eneficial ownership information shall be accessible for inspection or disclosure to officers and employees of the Department of the Treasury . . . .” Couple the CTA with the additional funding provided by Congress in the Inflation Reduction Act that will lead to the hiring of more revenue agents and you have the stage set for quite a dramatic change to the landscape of GHW taxpayer audits beginning in 2024.

Conclusion

The IRS is becoming a data-centric organization. By mining ever greater sources of data, the IRS can more effectively select taxpayers for audit. And the adjustments resulting from those audits will be larger. The new beneficial ownership information reports are a source of valuable information for the IRS. The IRS is likely to use information gleaned from beneficial ownership information reports to select and prosecute audits. Experienced counsel can help you navigate both IRS audits and the new beneficial ownership information reporting requirements.

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.