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The IRS is increasing its enforcement activities focused on high-wealth individuals. The agency announced in June 2020 that it would initiate several hundred exams of high-income taxpayers after the expiration of its People First Initiative, which temporarily had postponed compliance actions and suspended key compliance programs in response to the COVID-19 pandemic. In October 2020, the IRS said that it had resumed its enforcement activities and initiated audits of high-wealth taxpayers and related entities (e.g., partnerships, S corporations).
Action item: IRS enforcement priorities and strategic goals signify that increased scrutiny of high-wealth taxpayers and related entities will continue and can be expected to intensify. High-wealth individuals who may become subjects of IRS examinations should be prepared to address expanded inquiries into related entities, as many of the structures on which the IRS intends to focus for its increased enforcement efforts have complex ownership interests in a variety of flow-through entities.
The Large Business & International (LB&I) Division in 2009 created the Global High Wealth Industry Group in light of concerns that some wealthy individuals were not complying with their tax obligations. The group was tasked with looking beyond reviewing individual tax returns to analyzing the taxpayer’s complete financial picture, including all controlled and related entities. In July 2019, the group announced a compliance campaign targeting high-income non-filers, many of whom receive Form 1065, U.S. Return of Partnership Income, Schedule K-1, Partner's Share of Income, Deductions, Credits, etc., and other information returns. In June 2020, LB&I announced that it planned to begin examining hundreds of high-income individuals and related entities.
LB&I in October 2020 released Publication 5319, FY2021 LB&I Focus Guide, outlining its FY2021 strategic goals to strengthen compliance activities, including expanding coverage of passthrough entities, high-wealth taxpayers, and high-income individuals. In addition, the IRS Tax-Exempt and Government Entities (TE/GE) Division announced in June 2020 that it expected to see increased audits of private foundations with linkages to structures controlled by high-wealth individuals. This initiative includes using data analytics and risk assessments to study the role private foundations that are interwoven into high-wealth enterprises play in tax planning for high-income individuals.
The IRS is employing its enhanced data analytics capabilities to identify ‘high-risk’ taxpayers and prioritize its efforts around high-wealth taxpayers and passthrough entities. The agency pools and leverages data from different sources, including publicly available information, information received from other US government agencies, and other countries. In addition, the IRS employs artificial intelligence, machine learning, and other newly developed digital tools to identify interrelationships among taxpayers, third parties, and assets to identify and audit high-income individuals.
Losses from taxpayer activities (e.g., ownership of horse farms, private airplanes, or private yachts) reported on Form 1040, U.S. Individual Income Tax Return, Schedule C, Profit or Loss from Business (Sole Proprietorship), or conducted through passthrough entities that the IRS determines should be treated as ‘hobbies’ may not be used to offset income from other sources. Audits of high-wealth individuals may scrutinize deductions for operating expenses, depreciation, and net operating losses from activities that the IRS, after considering all the facts and circumstances, views as not undertaken with a realistic objective of making a profit.
In these situations, the IRS may conclude that the activity was not conducted in a businesslike manner and that the taxpayer failed to maintain complete and accurate books and records. Also, the IRS will take into account whether the taxpayer relies on income from the activity for his or her livelihood, or instead has personal motives in carrying on the activity.
Observation: High-wealth individuals who carry on activities as successful businesses properly may deduct ordinary and necessary expenses paid or incurred in carrying on the trade or business, including expenses for the production or collection of income and the management, conservation, or maintenance of property held for the production of income. However, during audits of these activities, the IRS may look for potentially questionable deductions, including for personal living expenses paid on behalf of the taxpayer and salaries and consulting fees paid to family members and other related parties.
If a taxpayer does not materially participate in an activity, losses generated from that activity are considered passive, meaning that they are not deductible in the absence of passive income. During audits of high-wealth individuals claiming losses, the IRS generally scrutinizes whether the taxpayer works on a regular, continuous, and substantial basis in operations sufficient to constitute material participation in the activity.
When analyzing whether a taxpayer materially participates in an activity, the IRS may review related Form W-2, Wage and Tax Statement, and other non-passive activities to assess whether, in light of the taxpayer’s other employment obligations, it appears likely that the taxpayer works at least 100 hours in the activity, no one else works more hours than the taxpayer in the activity, and no one else receives compensation for managing the activity. The IRS also may request calendars and other documentation to support material participation.
Observation: The IRS may find that the taxpayer does not materially participate in the activity if (for example) the taxpayer (1) is not compensated for services; (2) lives far from the activity; (3) has a Form W-2 wage job requiring 40 or more hours a week for which he or she receives significant compensation; and (4) has other investments, rentals, business activities, or hobbies that absorb significant amounts of time.
High-wealth individuals frequently fund private foundations to promote their charitable interests. During an audit of a high-income individual, the IRS may review interactions between the taxpayer and the private foundation to analyze whether (1) there has been any ‘self-dealing’ between the private foundation and its substantial contributors, (2) the foundation annually distributes income as required for charitable purposes, (3) there are limits on the private foundation holding interests in private businesses, (4) there are provisions that investments must not jeopardize the carrying out of exempt purposes, and (5) there are provisions in place to assure that expenditures further exempt purposes.
High-wealth individuals selected for audit under one of these initiatives likely will be presented with a Form 4564, Information Document Request, commonly referred to as an IDR. In addition to requesting copies of the taxpayer’s Form 1040 and related workpapers and reconciliation schedules, letters and notices from the IRS, and audit reports issued by federal and state agencies, the IDR also likely will request:
IRS enforcement priorities and strategic goals indicate that increased scrutiny of high-income taxpayers and related entities will continue and is expected to intensify. High-wealth individuals who may become subjects of IRS examinations should be prepared to address expanded inquiries into related entities, as many of the structures on which the IRS intends to focus for its increased enforcement efforts have complex ownership interests in a variety of flow-through entities.