The IRS's AI Announcement Is Really About Taxpayer Intimidation

by Bruce Willey, Published by Real Clear Markets

The IRS commissioner announced last month that the agency will now deploy artificial intelligence in pursuit of “wealthy tax cheats” who are using partnership structures to pay “little to no tax.” But the announcement’s logic doesn’t pass the smell test -- the real intent seems to be to intimidate successful small businesspeople away from using legal tax minimization strategies. 

It matters because the messaging from the IRS appears, on minimal review, to be deceptive, which then raises the question of the agency’s motives. An informed conclusion is that the agency’s real targets – as with so many of the IRS’s recent actions and statements – are entrepreneurs and small business owners. 

The reason? They’re “just right” as targets: There are enough of them scattered throughout the country that their income as a group is significant. But at the same time, without “private jet wealth,” most individuals don’t have the depth of liquid resources to defend themselves in the face of a deep audit or a case that goes to tax court. 

Taxpayers that fall in those categories probably ought to batten down their hatches for what lies ahead. 

The commissioner touted the use of AI technology as a powerful revenue compliance tool, targeted at large hedge funds, real estate private equity partnerships and law firms. But the IRS press release that came out the same day was a buzzword salad of epic proportions: “With the help of AI, the selection of these (large partnership) returns is the result of groundbreaking collaboration among experts in data science and tax enforcement, who have been working side-by-side to apply cutting-edge machine learning technology to identify potential compliance risk in the areas of partnership tax, general income tax and accounting, and international tax in a taxpayer segment that historically has been subject to limited examination coverage.” 

What does that mean? I’m guessing that the agency has not suddenly become the ultimate authority on AI-enabled investigations, but if it strings enough buzzwords together, it will feel intimidating to taxpayers nonetheless. The suggestion that it’s going to train AI large language models to magically recognize patterns that the IRS itself can’t figure out isn’t credible. That’s not how AI works. 

Even less credibly, the IRS is suggesting that its AI tool will be capable of finding cheating on returns from some of the most sophisticated taxpaying entities on earth, all of whom are subject to regulatory and statutory restrictions that would likely put them out of business if they ever knowingly cheated on their taxes. And all of whom have bottomless resources to defend against any claim made against them by the IRS’s “groundbreaking” “cutting-edge” machine learning technology. 

Private equity funds have special carried interest rules that give them highly favorable tax treatment, and which have withstood wave after wave of congressional initiatives to kill them. Big law firms have big-time tax law practice groups and big assets to defend their methodologies. Hedge funds with their massive income streams are the guys paying the big law firm practice groups in the first place.

That’s not their target.

It's an IRS misdirection play, and the people the IRS is really after are those lower-end high earners. Not the wizards of Wall Street hedge funders, but more the millionaire next door-type dry cleaner, or the woman who founded the engineering firm, or the couple that’s assembled a handful of fast-food franchise outlets. 

Those are the people whose tax defense pockets are not unlimited. Not surprisingly, they’re also the same people who can effect dramatic tax savings with proper minimization strategies.

Unless, of course, they can be scared into submission. And that, I propose, is exactly what the IRS is trying to do with its “machine learning” mumbo jumbo press release. 

“Don’t even think about trying to minimize your tax obligations,” goes their narrative. “We’re a modern, technologically sophisticated agency, with scary AI monitoring technology that can spot any funny stuff you might try, and we’re coming after you the moment we detect anything suspicious.”

Said differently, the IRS message is: “Resistance is futile. Do not do anything we don’t like – even if it’s legal – because we have the resources and the motivation to make your life hard and expensive if you do.”

This action by the IRS isn’t a one-off; the agency is exhibiting a consistent pattern of behavior where it seeks to control the levers by which taxpayers can seek to minimize their full tax obligations. 

The implications of this are clear for the kinds of successful-but-not-deep-pocketed taxpayers described:

• You have a target on your back from the IRS and its 87,000 new agents.

• Document, document, document your business transactions and keep the records well past the suggested discard dates.

• Look more than ever to tax planning strategies; if you’re going to be audited for being successful and owning a business anyway -- and need to keep extensive records just in case -- you’ve done the lion’s share of the work and borne much of the expense that effective tax strategies would require. You might as well use the approaches to minimize your tax owed.

In the end, the IRS seems to be beefing up for a fight against every business owner in the country. This is one of those times to follow the adage “When someone shows you who they really are – believe them.” Put together a good advisory team before problems arise, and listen to the counsel they give you.

And finally – none of this kind of activity on the part of the IRS will change until taxpayers demand changes from their elected representatives. Read the IRS announcements and make your own judgments – and let your representatives in Washington know what you think about it.