Don’t Bet on IRS Budget Cuts Lowering Small Business Audit Rates

Scott Shane

Thursday, March 20th, 2014

After several years of increases, the Internal Revenue Service (IRS) small businesses audit rate declined in 2013, data released recently by the tax authority reveal.

The audit rate for business tax returns – a category which includes small and large corporations, as well as partnership and Subchapter S returns – fell from 0.71 percent in 2012 to 0.61 percent in 2013. The drop brings the overall business audit rate back in line with its 2005-to-2011 average of 0.61 percent.

Before you get too excited about this drop, however, take a look at the rate in historical context. The current business audit rate of 0.61 percent is considerably higher than the 0.36 percent rate that prevailed in 2004.

Audit rates are much higher for small corporations than for businesses organized as partnerships and S-corps. As the audit rates by year for different types of small businesses (the image above) shows, audit rates for small corporations have been consistently higher than those for partnerships and S-corps since the mid-2000s.

Audit rates for all three categories of small businesses declined in 2013, but remained higher than they were in 2004. For S-corps, the fraction of businesses audited declined from 0.48 percent in 2012 to 0.42 percent in 2013, slightly higher than the average from 2005 to 2011, but double the 0.19 percent rate in 2004.

For partnerships, the audit rate fell from 0.47 percent in 2012 to 0.42 percent in 2013. That’s slightly higher than the 0.38 percent rate from 2005 to 2011, but up considerably from the 0.26 percent rate in 2004.

For small corporations (those with assets of less than $10 million) audit rates dropped from 1.12 percent in 2012 to 0.95 percent in 2013. That’s close to the 0.90 percent average rate that prevailed between 2005 and 2011, but is much higher than the 0.32 percent present in 2004.

Some have argued that belt tightening at the IRS is behind the reduction in audit rates. Since 2010, the tax authority’s budget has been steadily reduced, as Congress has sought to get the federal deficit under control. In response to declining resources, the agency has reduced its enforcement workforce from 22,710 employees in 2010 to 19,531 in 2013.

These observers are betting that the fraction of small businesses audited will continue to decline this year because Congress lowered the IRS’s funding by 5 percent as part of its 2014 budget deal.

However, I’m not so sure that budget cuts are behind the recent decline in small business audit rates. Between 2010 and 2012, the IRS cut its tax enforcement workforce by 8.9 percent, but the audit rate on small corporations, S-corps and partnerships all increased, with the overall business audit rate rising from 0.58 to 0.71 percent.

Budget cuts don’t require the agency to lay off employees involved in enforcement. The tax authority could maintain the size of its tax enforcement workforce and cut its budget elsewhere. Or the IRS could reduce individual or big business audit rates to maintain the level at which it examines small businesses.

Given the tax agency’s belief that small business owners are responsible for a sizeable portion of the tax gap
 – the difference between taxes owed and taxes paid – the IRS seems unlikely to cut the small business audit rate considerably this year. Reducing the number of small business examinations would likely lower tax collections more than would a corresponding reduction in the number of individual audits.

About Scott Shane

Scott Shane is A. Malachi Mixon III, Professor of Entrepreneurial Studies at Case Western Reserve University.