Outlook: Issuers face tax enforcement challenges in new year

The final size of the Internal Revenue Service's $80 billion budget boost remains in question but as the agency backfills missing personnel, issuers can expect the coming year to include a heavy dose of IRS audit activity.

"My understanding is that there are a lot of agents in training," said Rich Moore, a tax partner at Orrick, Herrington & Sutcliffe. "While volume has picked up from the pace over the past half-decade or so, it feels more like a return to normal audit levels than a big step-up. A big step-up may be coming soon." 

Putting more teeth into the enforcement side is dependent on the disputed budget increase funded by the Inflation Reduction Act. The extra money became a political football during the debt ceiling negotiations between the White House and Congress.

Orrick, Herrington & Sutcliffe

One side of the argument believes that beefed-up enforcement will lower the national debt by bringing in more tax revenue. A Republican-backed bill in the House proposes rolling back the extra funds, but its future remains cloudy. 

"This appears to be dead on arrival in the Senate," said Marc Joffe, state and federalism policy analyst at the Cato Institute, a libertarian think tank. "If it could not be successfully coupled with Israel aid, which was popular at the time, it is hard to see how it could ever pass." 

Joffe also points to numbers from the Congressional Budget Office that estimate a $14.3 billion cut in IRS funding would result in a $26.8 billion reduction in tax revenues over ten years resulting in a net increase in the deficit of $12.5 billion. 

In August IRS Commissioner Danny Werfel made his case for keeping the funding intact during a Tax Forum event. "The bottom line is an IRS after the Inflation Reduction Act is a very different IRS than before," he said.

"We have a unique opportunity, a once in a generation chance to envision and realize the future of tax administration. For these improvements to continue and accelerate, a consistent, reliable funding stream remains critical for the agency both in our annual appropriations process and in maintaining Inflation Reduction Act funding." 

Continued high interest rates are keeping arbitrage back in play and piquing interest from the IRS as many issuers are getting a refresher course in the complex rules that govern what issuers can do with market-based earnings. 

Arbitrage is defined as the difference between the rates of the issuance of bonds at a lower tax-exempt rate and investment of the proceeds in obligations paying higher taxable rates.

As a rule, the Treasury Department discourages against tax-exempt arbitrage bonds. Congress has passed laws governing what can be done with arbitrage proceeds, with the IRS in charge of enforcement. Industry experts are predicting no change in how the rules work, now that it's back in fashion.   

"Congress's perspective is, we've got a scheme in place that works well, that prevents arbitrage, and that issuers generally can comply with," said Michael Decker, senior vice president for research and public policy at Bond Dealers of America. "There doesn't seem to be a lot of movement behind changes to the arbitration rules. There might be some effort around technical corrections, but I don't think there are going to be substantial changes." 

While interest rates were low, arbitrage didn't really present a problem. But funds sitting in 90-day escrow accounts can now generate enough revenue to draw scrutiny from regulators.

"We are already seeing it," said Moore. "For deals with proceeds that will be invested, this is now a standard discussion early on in the deal process." 

If money is made on the bonds through arbitrage, the IRS expects for it to be paid in the form of a "rebate," but there are exceptions. If the proceeds are used to bolster reserve funds or if they are used on special projects with a firm completion date to spend the money, the issuer may be able to keep the money without penalty. If that doesn't happen, trouble ensues, usually in the form of an audit.   

"We are already seeing issuers who are having to make rebate or yield reduction payments as a result of the higher interest rates and many more that are starting to accrue liabilities that will need to be paid later down the road," said Brian Helming, head of arbitrage rebate at Hilltop Securities. "The key is being aware of the potential liability and being prepared to make the arbitrage rebate or yield reduction payment when they are due." 

The appearance of manipulating debt to take advantage of interest rates continues to be an area of interest to the IRS and a troubling issue for tax attorneys. 

In October the IRS hinted about adjustments to the often confusing Rule 149 which governs the expectations of legally spending tax exempt bond proceeds used to fund special projects.  

During a panel discussion at the Government Finance Officers Association Mini Muni conference, Jian Grant, an attorney with the U.S. Department of the Treasury revealed that clarifications on 149 are under review, "I'm not going to talk about the specifics of these because some of them are in the works," she said. "This is a new guidance resulting from the various comments we received over the years both internally and externally." 

In September the IRS announced an AI-enabled and IRA-funded crackdown "on wealthy, partnerships and other high earners that have seen sharp drops in audit rates for these taxpayer segments during the past decade." 

"The years of underfunding that predated the Inflation Reduction Act led to the lowest audit rate of wealthy filers in our history," Werfel said in a statement. "I am committed to reversing this trend, making sure that new funding will mean more effective compliance efforts on the wealthy, while middle- and low-income filers will continue to see no change in historically low pre-IRA audit rates for years to come."