Closing the “Tax Gap” & Introducing New Cryptocurrency Reporting Rules with Advanced Analytics

The world’s largest tax collection agency — the U.S. Internal Revenue Service — is proposing an ambitious upgrading plan to improve its performance, including major investments in data analytics and technology.  The plan, which was announced by President Biden in May, would help the agency reduce the estimated $600 billion “tax gap” between taxes collected and taxes due. 

Many economists and tax experts welcomed the IRS reform proposal, which they said would help reverse years of declining enforcement actions against companies and high-income individuals’ taxpayers at the agency.   

IRS Proposes a Major Investment in Advanced Analytic Tools 

A major focus of the proposed IRS reform plan would be increasing the applications of data analytics tools and machine learning, and collecting more third-party data to improve visibility into taxpayers’ income and tax liability.  To support the effort, the IRS would hire and train more specialized auditors to conduct examinations of high income and high net worth individuals, and complex structures like partnerships, multi-tier pass-through entities and multi-national corporations.   

By collecting more data from banks and other financial institutions and comparing it to the tax returns filed by taxpayers, the IRS could have more complete information.   

“As a result, voluntary compliance will rise through deterrence as would be tax evaders realize that the IRS has an additional lens into previously unreported income streams,” the proposed plan predicts. 

The Global Impact of Upgraded Analytic Capabilities  

It is encouraging to see this recognition of the value – and critical importance – of analytics technology by the IRS. Other tax agencies around the world, including the European Union, have also been upgrading their analytic capabilities and realizing significant improvements. For example, the Belgian Tax Authority has been able to reduce tax losses from VAT carousel fraud by an estimated 98% through the use of Contextual Decision Intelligence technology.  In this type of tax fraud, fraudsters rely on creating a network of shell companies and executing rapid financial transactions that result in their collecting VAT tax credits or refunds that were never actually paid.  By applying Entity Resolution and Network Generation, tax investigators have been able to quickly identify links and early warning signals to dramatically improve enforcement and block the fraudsters. 

For its core processing of tax returns, the IRS currently relies on a 1960s-vintage IT system called the Individual Master File (IMF), which is one of the oldest IT systems in the federal government. The agency proposes to dramatically upgrade its IT systems, including adopting what it calls “21st-century data analytic tools,” which will enable it to “develop innovative machine learning that can be deployed to better identify suspect tax filings […] such as comparing returns to similar tax filings and historical filings.” Currently, this cannot be done. 

One of the areas that would be targeted would be partnership income, which has risen dramatically over the last 30 years, from 5% of total reported income in 1990 to more than 35% in 2019.  More than four million partnership returns were filed in 2018, but only 140 of those were audited.   

The IRS estimates that its proposed increases in enforcement spending would generate a 4 to 1 return on investment – resulting in $320 billion in increased tax revenue for an $80 billion investment over 10 years.  Additional benefits would be generated by higher staff efficiency and higher taxpayer compliance that would come from “the widespread use of machine learning technologies,” the plan says. 

New Cryptocurrency Reporting Rules  

Another element of the proposal is to recognize and plan for the growing use of cryptocurrencies, and as a significant first step, the IRS will begin requiring companies to start reporting all transactions of $10,000 or more that involve cryptocurrencies.  

Cryptocurrency already poses a significant detection problem by facilitating illegal activity and tax evasion, according to the IRS. Despite constituting a relatively small portion of business income today, cryptocurrency transactions are likely to rise in importance in the next decade. 

For tax enforcement agencies, financial intelligence units and others investigating financial crimes, trying to track the movements of bitcoin and other cryptocurrencies “is a complex, 21st century cat-and-mouse game,” according to the Wall Street Journal.  “Because the scammers know their movements can be traced, they typically move their illicit gains across hundreds, or even thousands, of transactions. They might control dozens of other wallets and move the money back and forth.” 

All bitcoin transactions are traceable in the permanent ledger of blockchain – the underlying technology that enables bitcoin.  But account ownership information is not public.  With advanced analytic tools like the Quantexa platform, investigators can analyze cryptocurrency transactions and linkages to IP addresses, cryptocurrency wallets and a range of third-party data in order to find tax evasion, money laundering and other illegal activity.