U.S. Markets close in 2 hrs 31 mins

Next Target of IRS Robo-Audits: Small Business

Richard Satran

The promise is huge, tax experts say, but so is the threat of failure and abusive practices as a multiyear, $3 billion high-tech upgrade of the U.S. tax system begins to take over more of the Internal Revenue Service's heavy lifting in collecting taxes and forcing compliance.

The IRS is taking in 80 percent of all tax returns electronically, and the agency is beginning to do real-time scoring that selects returns for auditing. So far, the computer-driven processing in so-called "robo-audits" have caught mostly low- to middle-income taxpayers whose returns were frozen, although many were later found to have filed legitimate returns. Meanwhile, the government has cut back drastically on the number of auditors handling compliance cases, forcing it to rely more on computers to ferret out tax evasion.

Small businesses are next up for robo-audits, which will be a complicated task that's already causing widespread concern and confusion among taxpayers and preparers. The IRS is now processing tax returns by checking them against data from third-party records of all credit-card and electronic-payment data providers. It is also using data from social media, email and other online activities. The IRS's own advisory boards have warned that the agency is not prepared for this step, and many problems will likely arise.

The IRS has consistently declined to comment on any of the technology now in use, and tax experts say such secrecy endangers the success of programs that require a high degree of cooperation from the public to succeed.

The agency has denied it will invade personal email without a warrant or that a Facebook post can "trigger" an audit. Once an audit is flagged by other screening methods, however, the use of such material is allowed, and IRS administrative approval is usually all that is needed. Among the things auditors can do: chart and analyze social media such as Facebook, use social media in verifying claims made on tax returns, sort personal data into 32,000 categories, program machines to analyze taxpayer behaviors, analyze relationships based on Social Security and other personal identifiers, track email patterns and Internet addresses, and match returns to credit card payments.

[Read: How the IRS Tracks Your Digital Fingerprints.]

The data fields the agency will track have been revealed in records in which officials disclosed the plans to trade groups or in limited statements to Congress. The plans provide an outline but little detail. Absorbed in its extended budget crisis, Congress has spent little time questioning IRS about how the technology will affect privacy or inconvenience taxpayers caught in the web.

The technology at the IRS's disposal is so comprehensive that it would only take a few steps for the IRS to handle the entire tax-filing process for most Americans electronically. Under proposals already made and tested successfully in trials, anyone filing a simple return with only standard deductions could choose to let the government do all of the work. The IRS would send a check if too much was withheld or a bill for taxes was owed.

Such a "simple return" would place the burden on the IRS to tell taxpayers what they owe. But objections from some members of Congress, some IRS officials and strong opposition from the tax-preparation industry have scuttled those proposals for now. The program offers convenience and savings, but it was stalled by lobbying and Congressional gridlock as more invasive plans to compile personal data for audits won approval when included with emergency-relief measures during the financial crisis.

The agency's expanded powers, including access to all credit-card payment data, came with little debate in the midst of the financial crisis as part of a provision inserted in the Housing Relief Act of 2009. The agency argued it needed the new tools to collect an estimated half-trillion dollars in U.S. taxes that people dodge each year. It has also advocated gaining more technology tools to stamp out the million-plus identity thefts that take place annually, even though it is the Social Security Administration's numbers that are the source of the thefts.

Following the trend of business. In making its case for more sophisticated technology, the agency said it is simply using many of the same tools private businesses already employ, such as browser "cookies" and data-mining tools used in marketing, hiring and other industries. The difference is that the IRS, as one of the most powerful government agencies, also has rights to use personal data, health information and private communications that go far beyond a corporate researcher's data set and sometimes surpass those of the Federal Bureau of Investigation or police.

"Tax returns have been guided by the legal concept of exceptionalism, outside the legal norms," says Paul Schwartz, University of California law professor and co-director of the Berkeley Center for Law & Technology. "The IRS is working under guidelines that go back to 1960 and the tax return is filed under legal compulsion. But there is so much information on everyone now it makes it harder for people to comply if the IRS uses data not in your return. It can get you into trouble." In other words, people might incriminate themselves with a careless online post, he says.

[Read: What Does the IRS Know About You?]

The agency has claimed steady success in tracking tax cheats. So far, however, its technological upgrade has shown incremental gains in tax collection. It has also created big snags in the system and a huge spike in complaints. Millions of tax returns have been frozen and delayed by the computer-generated processing, hitting mostly low- to middle-income taxpayers. The so-called "tax gap" of uncollected taxes is widening and the number of audits held in backlog has increased.

Meanwhile, there are growing concerns in Congress and oversight agencies about the unintended effects of the new data tools. IRS National Taxpayer Advocate Nina Olson has been a consistent critic about the lack of disclosure in what data is being used, and the burden robo-audits put on lower-income taxpayers. Last month, Sen. Charles Grassley, R-Iowa, called on the IRS to explain "abuse intrusions of privacy" in its data mining. The IRS has responded that it protects people's privacy and adheres to the law.

"Things that were not feasible in the past because there were financial barriers are possible now, and might be legal - but they are not necessarily what you want, and they should only be implemented with full transparency and awareness of people affected by the changes," says Harry Surden, a University of Colorado-Boulder School of Law associate professor and former fellow at Stanford's Center for Computers and the Law. "Technology has changed things very quickly and not just by degrees, so they become something entirely different."

Even some of the toughest critics of the IRS say the agency needs to rise to the challenge of a high-tech global economy by using more technology tools. Tax evaders use sophisticated tools to avoid detection.

"The bigger people will figure it out," says tax attorney and former IRS revenue officer Elizabeth Atkinson of LeClairRyan in Virginia Beach, Va. "For small business, I'm afraid it's going to be a disaster." Virtual currencies like bitcoins can make it easier for tax evaders to send cash to secret offshore accounts. "Zappers" are used by some retailers to blank out data on sales receipts. "Phantom-ware" is a kind of software used to conceal sales and other computer records from outside detection. With each technology innovation the IRS introduces, serious tax evaders come up with a way around it.

When the IRS does go after offshore tax dodges, the target is usually money laundering aimed at concealment, she says. Most of the offshore accounts held by wealthy Americans are legal, and the IRS does not see them as a significant source of new revenue. Nor do wage earners, whose income is reported on W2 forms, make up a large portion of the IRS's estimated tax gap. Corporations account for just 10 percent of tax dodges or underpayment, the IRS says.

The IRS says tax cheating is rampant among small businesses, however, which it claims make up 60 percent of uncollected taxes and will be the main target in the next phase of the high-tech program. Now that the agency has added credit-card data payments to its robo-audits, it will have a much clearer, more immediate view of small-business income from third-party sources.

But small business owners are largely unaware of the heightened scrutiny they face, says tax lawyer Atkinson. What's more, IRS agents are not prepared to assess the massive new amounts of data they will have at their disposal.

"Just looking at restaurants, the records they require for credit card transactions will include charge records that include tips," says Atkinson. "Those [tips] will have to be backed out. And small-business reporting requirements vary from state to state, and in different kinds of businesses, and that makes it even harder."

The IRS has been slammed by both the IRS National Taxpayer Advocate and the IRS Information Reporting Program Advisory Committee for failing to provide guidelines on how to report transactions for the new third-party information for small businesses.

The IRS should post guidelines not only in the interest of fairness but also as a deterrent to spur greater compliance, says Michael Knoll, co-director of the Center for Tax Law and Policy at the University of Pennsylvania Law School. "I would think they would want people to know, as a deterrent. I don't understand the secrecy." In its own mission statement, the IRS says its role is to provide taxpayers "top quality service by helping them understand and meet their tax responsibilities and enforce the law with integrity and fairness to all." And in its own studies, the agency says compliance is high among wage earners because they know their salary information will be cross-checked against W2 and 1099 forms.

[Read: IRS Data Web Snares Mostly Low- and Middle-Income Taxpayers.]

In the secretive rollout of new information reporting, the agency instead appears to be using a "gotcha" approach to catch people unaware, tax experts say. Some speculate this tactic will yield results that show more impact for critics in Washington who want to see increased revenue.

Ultimately, though, the effort could backfire in unpredictable ways. Cooperation of the public will be needed for the IRS to carry out its use of electronic filing, since it remains voluntary for individual filers. Given slack job growth in recent years, the tax system could be flooded with more self-employed people and contractors filing returns, not just the "unretired" who have lost jobs and take contract work. The IRS will be pressed to educate and inform this population as it fends for itself at tax time, Atkinson says.

"The IRS needs to give very clear guidance because they are part of the government and have as social contract they need to honor," says Atkinson. "If the taxpayer feels the system is fair, even if they think it is bad for them, they will comply begrudgingly. But when the perception is that they are the only ones doing so, people are more willing to go underground and hide what they make. And that will hurt everyone. "

More From US News & World Report