AI Tax Audit: Protecting Your Privacy from the IRS

The IRS’s Digital Transformation

Earlier in 2022, I received an invitation to attend a lecture with the mind-numbing title, “The Transformation of Tax & Customs Law into the Digital World of Processes, Automation and Predictions.” I wasn’t able to attend, but it reminded me that like the android hosts in Westworld, the IRS was developing an artificial consciousness.

Or, as two lawyers writing about the increasing use of artificial intelligence and big data in tax enforcement and compliance asked, “Do IRS computers dream about tax cheats?”

We don’t believe that the IRS is suddenly becoming sentient, but for more than a decade, the agency has been using data and analytics to parse tax return data to uncover taxpayer errors and, occasionally, tax fraud. For instance, in the decade from 2007-2017, the volume of data analyzed by the agency grew by a factor of 100.

How AI and Big Data Are Changing Tax Audits

The technology infrastructure necessary to analyze this data has evolved as well, making initiatives such as Operation Hidden Treasure possible. In an effort to root out tax evasion involving cryptocurrency investments, the IRS is working with blockchain analytics firms to develop “signatures” or potential indicators of tax fraud by “analyzing blockchain and de-anonymizing [crypto] transactions.” The goal is to “track, find, and work to seize crypto in both civil and criminal settings.”

But that’s really just the tip of the iceberg. If you’ve experienced an IRS audit lately, you might have noticed that the agency is demanding a lot more information than it once did. For example, one firm that represents taxpayers in cryptocurrency audits publishes a list of information the IRS always requests in such audits. It’s far too detailed to publish here, but suffice it to say that the IRS demands records for every cryptocurrency transaction, including emails, text messages, and more. All this data is analyzed by the agency’s increasingly sophisticated AI tax audits tools.

IRS Campaigns: Big Data in Action

Keep in mind, Operation Hidden Treasure isn’t the IRS’s only campaign using big data and AI to uncover tax evasion and fraud. The agency employs similar tools to identify taxpayer noncompliance in dozens of areas. Beyond cryptocurrencies, the foreign activities of taxpayers are a major focus. The IRS is now targeting techniques like the foreign earned income exclusion and expatriation. These methods, once recommended for legitimate tax reduction, are under scrutiny.

Among the most significant investments the IRS has made in this area is an artificial intelligence tool called Lead and Case Analytics (LCA), developed in conjunction with Palantir Technologies, a company specializing in data analytics. The IRS justifies the approximate $100 million cost to develop LCA by stating,

“Today’s sophisticated financial schemes to defraud the government demand the technology to compile disparate case data and the analytical tools to wade through complex financial records to identify fraudulent activity.”

Thus, even though the official IRS audit rate has fallen sharply in recent years, every tax return is now subjected to computer scoring and compared to returns from people with similar income and occupations. This means the effective audit rate is 100%.

The Tax Gap: Myth or Reality?

The goal, as always, is to reduce the “tax gap,” which IRS Commissioner Charles Rettig told Congress last year could be as large as $1 trillion per year. This is the difference between what the IRS thinks taxpayers should be paying and what it collects.

Frankly, we find this enormous number preposterous. To the extent that the tax gap exists at all, it’s mainly because of the mind-boggling complexity of the Tax Code. Nina Olson, the IRS’s former taxpayer advocate, told Congress in 2006 that in 94% of audits, IRS examiners found no willful tax evasion—only inadvertent errors by taxpayers and their advisers who simply don’t understand the monstrously complex rules.

Instead of worrying about a tax gap that is largely the result of a Tax Code no one understands, why not simplify the rules?

Unfortunately, both parties’ politicians want to shape the Tax Code to benefit their constituencies. They are not interested in simplifying it. So, the complexity will likely persist.

This complexity also raises ethical concerns. Is it fair to expect taxpayers to navigate a system so convoluted that even experts struggle to understand it? And as the IRS becomes more reliant on AI and big data, the risk of misinterpretation increases, potentially leading to wrongful audits or penalties.

Using AI to Defend Against AI Tax Audits

Which leads us to ponder: Can individuals and small businesses use tax compliance technology to fend off the IRS?

The answer, perhaps surprisingly, is “yes.” While AI tax audits tools are mainly used by tax administrators and Fortune 500 companies, they’re becoming more accessible for everyday users, with no coding experience required. The goal is to encourage a settlement with minimal or no additional tax being due.

AI analysis is inherently probabilistic—when you run an AI simulation, the outcome is expressed as a probability based on the data loaded into the system. As these tools become more widely available, if you or your business is audited by the IRS, and there is a disagreement on your tax returns, you and your advisors can tell the agency:

“Don’t take our word for it. Using the same data you have, we analyzed it independently. Our AI program tells us that we have a 95% probability of winning this case. Are you still sure you don’t want to settle?”

Understanding these tools and how to use them could be crucial for protecting your financial interests. For example, maintaining organized and detailed records of all transactions, especially those involving cryptocurrencies or foreign assets, can help you defend against an IRS audit.

The bottom line is that despite the IRS hype about the tax gap and its use of AI tax audits, there’s nothing stopping the rest of us from using the same tools as they become available.

Protecting Your Privacy from IRS Scrutiny

In this new era of tax compliance technology and AI-driven enforcement, protecting privacy from IRS scrutiny becomes increasingly important. As the IRS continues to expand its digital reach, individuals should take proactive steps to safeguard their financial privacy.

Strategies like using encrypted communication and diversifying offshore assets can help. So can being cautious with your digital footprint. They can make it harder for the IRS to profile your financial activities.

The IRS’s use of AI tax audits is a powerful tool, but it doesn’t have to be a one-sided advantage. By understanding the technology and employing your own defensive strategies, you can level the playing field and protect your financial interests.

Need Help?

Since 1984, we’ve helped more than 15,000 customers and clients protect their wealth using proven, low-risk domestic and offshore planning. To see if our planning is right for you, please book in a free no-obligation call with one of our Associates. You can do that here.