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How the IRS Works: Functions and Audits

Even the most enlightened citizen curses taxes at least once a year—possibly while simultaneously acknowledging that they’re the price of a civilized, developed society. Even knowing the value of that bargain, loathing the taxman is as inevitable as taxation itself. In the U.S., at the federal level, that unenviable duty falls on the Internal Revenue Service (IRS).

As America’s tax collector—and as close to a four-letter word as any three-letter acronym could ever come—the IRS has a well-defined mission: “Provide America’s taxpayers top-quality service by helping them understand and meet their tax responsibilities and by applying the tax law with integrity and fairness to all.”

Key Takeaways

  • Founded in 1862, the Internal Revenue Service (IRS) is a U.S. federal agency responsible for the collection of federal taxes and enforcement of tax laws.
  • Most of the work of the IRS involves income taxes, both corporate and individual, processing nearly 253 million tax returns in 2020.
  • The IRS is responsible for conducting audits to ensure that taxpayers are claiming or paying what is owed and not cutting corners or hiding assets or income.
  • After peaking in 2010, the number of IRS audits have been on the decline each year.

First, a Little History

After winning independence from Great Britain, the framers of the Constitution gave Congress the power to levy and collect taxes and duties. Most of the country’s revenue came from tariffs on trade and excise taxes.

The onset of the Civil War changed everything—or more precisely, the need to pay for that conflict. Congress and President Lincoln enacted the nation’s first income tax with the Revenue Act of 1862, which created the office of the Commissioner of Internal Revenue. The law was temporary but gave the office the right to levy excise taxes on commonly consumed and traded goods, as well as the means to collect those taxes. It also marked the first progressive tax in U.S. history.

On incomes of between $600 and $10,000, a 3% tax was levied, while a 5% tax was levied on incomes of more than $10,000. The need to have an agency in place for enforcing and collecting these taxes gave birth to the Bureau of Internal Revenue, the predecessor to the IRS.

Following the Civil War, political opposition to the Revenue Act mounted while collections from the income tax fell. The act was allowed to expire in 1872. Thereafter, the government relied primarily on tariffs on imported goods. Between the Civil War and World War I, as much as 60% of federal receipts came from custom duties, which generated significant annual budget surpluses for the government.

However, a reduction in sugar tariffs under the McKinley Tariff Act of 1890 led to a decline in revenue. The Department of the Treasury forecast a budget deficit of $70 million for 1894, the first in 30 years. This led to renewed support for an income tax. The end result was the adoption of the Wilson-Gorman Tariff Act of 1894, which imposed an income tax on primarily the wealthy—estimates suggest 1-2% of the population were subject to the income tax.

The income tax was challenged on constitutional grounds. In March of 1895, the Supreme Court in Pollock v. The Farmers’ Loan and Trust Company ruled the income tax conflicted with Article I, Section 9, Clause 4 of the Constitution, which prohibits Congress from collecting income taxes without apportioning them among the states on the basis of population. In 1909, Congress adopted a resolution calling for a Constitutional amendment, which the states ratified in 1913.

In October of 1913, President Woodrow Wilson signed into law the Revenue Act of 1913, which imposed a 1% tax on incomes above an exemption of $3,000 for single taxpayers and $4,000 for married couples. An additional 1% was applied to income above $20,000 and 6% on incomes above $500,000. The first Form 1040 appeared in 1913. Less than 2% of households would have been required to fill one out.

Income tax rates rose sharply during World War I, peaking at 77% in 1918 for those making $1 million per year, when it was just 15% two years earlier. By 1925 the top rate had fallen to 25%, which applied to incomes of $100,000 or more. Then the Great Depression came and with it the return of high rates. In 1932, incomes greater than $1 million were taxed at 63%.

The “tax-collecting agency” was revamped in the 1950s first by President Truman as a part of his reorganization plans. The patronage system of the agency was replaced with a career civil service system. The move was endorsed by President Eisenhower, who in 1953 rechristened the Bureau of Internal Revenue the Internal Revenue Service.

One of the Largest Government Employers

The IRS, one of the world’s most effective tax administrators, is a bureau of the U.S. Department of the Treasury. It’s one of the largest organizations of the federal government with an employee base of around 73,500 people. The IRS Restructuring and Reform Act of 1998, commonly referred to as RRA 98, revamped the structure, governance, and powers of IRS to its present form. In effect, the IRS was reorganized on the lines of private sector models for greater efficiency and effectiveness.

The IRS is headed by a commissioner who has a five-year term of office and is appointed by the president with the advice and consent of the Senate. Charles Rettig is the current (49th) IRS commissioner. The other position appointed by the President is the chief counsel, who is the chief legal advisor to the IRS commissioner on matters relating to the interpretation, enforcement, and administration of the laws.

The organization is headquartered in Washington, D.C., with regional campuses located around the country in select cities. The IRS has four primary divisions: Wage and Investment, Large Business and International, Small Business/Self-Employed, and Tax-Exempt and Government Entities.

Who Audits the Auditors?

The IRS Oversight Board is a nine-member independent body which was created by the IRS Restructuring and Reform Act of 1998 tooversee the Internal Revenue Service in its administration, management, conduct, direction, and supervision of the execution and application of the internal revenue laws or related statutes and tax conventions to which the United States is a party.

The board does not have any enforcement authority and has no role in developing policy. One important responsibility entrusted to the IRS Oversight Board had been to review and approve the annual IRS budget request submitted to the Department of the Treasury. However, the board does not have enough members confirmed by the Senate and has suspended operations. Its last budget recommendation report, for fiscal year 2015, was issued in May 2014.

The Taxman Cometh

The IRS collected almost $3.5 trillion in gross revenue in 2019, the latest year for which figures are available. That revenue is used to fund government operations. The service processed more than 253 million taxpayer returns and issued $452 billion in refunds.

Source: IRS Data Book

The Dreaded Audit

An IRS audit is a scrutiny of an individual’s or organization’s tax records and financial information to make sure that the tax amount and information reported is accurate. The probability of getting audited by the IRS works as a good enough reason for people to stay honest and pay taxes on time.

However, timely and correct tax payments do not guarantee that you may not be audited, nor does it mean that a return that is selected for audit is sure to have an error. According to IRS, there are different methods used to select which returns will be audited. The common ways are:

  • The computer makes a randomized selection of people to be audited based on a statistical formula.
  • Mismatching documents and information. Say, the information reported in Form 1099 or W-2 doesn’t match.
  • The tax records may be audited since they show transactions with other’s whose name was selected for audit.

However, there are few triggers that are likely to land you on the list. If your return is selected for audit, you will receive a notification by mail. The audit can be conducted via mail or in-person review. The IRS audited 771,095 taxpayers in 2019, which was down from one million examinations it conducted the previous year. Both figures represent approximately 0.5% of all returns filed.

The Bottom Line

Though the IRS is one of the most efficient tax administrators in the world, its very nature attracts controversy. The complexity of the tax code and lack of understanding of tax laws by taxpayers also gives rise to confusion. And recent accusations of politically motivated audits mean that the IRS is low on the popularity list to more than a few taxpayers. To resolve such situations—and attempt to assuage taxpayers—there is the Office of Appeals, which helps to resolve disputes impartially and out of court.

In 2019, the Office of Appeals had received roughly 85,000 cases. In addition, the Taxpayer Advocate Service (TAS) provides free personalized help to taxpayers for IRS-related problems.

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