Cut in IRS funding may limit bond audits

As the new administration starts to take shape, old legislative battles over the size of the Internal Revenue Service budget could impact the number of audits visited on municipal issuers.

"There is a correlation between the IRS budget funding and enforcement, and this relationship will carry over to the tax-exempt bond enforcement side," said Ed Oswald a partner at Orrick.

"My general take is that if there is a curtailment in IRS funding, we will see a reduction in the frequency and duration of municipal bond audits."

The IRS budget is an unpredictable bouncing political football that started with an $80 billion, 10-year funding boost from the Inflation Reduction Act in 2022. During the debt ceiling negotiations in 2023, the increase was cut by about $20 billion via the Fiscal Responsibility Act.

In April IRS Commissioner Danny Werfel made his case for extending the budget increase through 2034 to $104 billion over 10 years, a boost that he said would "generate at least an additional $341 billion in revenue."

Muni market experts equate larger IRS budgets with more audits.

"A higher budget means more agents and more agents mean more examinations," said Rich Moore, who's also a partner at Orrick. "It also provides the agents with more resources to conduct the examination, including undertaking a site visit of the bond-financed project."

Last week the IRS issued its yearly financial report which includes self-graded performance measures on the, "Timeliness of Critical Tax Exempt and Government Entities & Business Tax Products to the Public."

The numbers measure the percentage of critical tax products available to the public seven calendar days before the official IRS start of the individual filing season and shows a 95.8% grade, which beats the agency target of 94%.

But the positive numbers don't have much relevance when it comes to audits. "The communication and interaction in connection with a bond audit is a bit unique," said Oswald.

"Communication between an IRS agent and the bond issuer can be protracted. My take is that the efficiency numbers stated in the IRS report are intended to address front line customer service response rates."

As Republicans take over the administration, the size of the IRS budget and how it spends the money may get a closer look. The biggest chunk of the 2023 cut was made for the enforcement arm of the agency.

Before and after the cut, both lawyers detected an uptick in examinations.

"I have seen more audits in 2023 and 2024 than I have during any other two-year period since about the middle of the 2010s," said Moore.

"The increase in IRS funding over the last few years has given rise to a modest uptick in tax-exempt bond audits," said Oswald. "Consistent with IRS messaging in this area, many of the revenue agents in this space are new hires and are still being trained."

Most of the agency's financial report is dedicated to it's commitment to improve its performance with taxpayers.

"Over the past year, our office has made progress in modernizing financial management systems and processes," said Teresa R. Hunter, CFO, IRS, via the report.

"These efforts are part of a broader strategy to enhance efficiency, improve data accuracy, and ensure the highest standards of accountability in the use of taxpayer dollars."

The ongoing modernization efforts includes expanding the agency's Direct Pay program.

Last year, Direct Pay was launched as a pilot program which caused some Republican lawmakers to question why the agency was offering a free online filing system that is already available through privately owned tax preparation companies.

As the new administration takes over more assaults on IRS funding is expected.

"I expect that funding of the IRS budget will be cut by the Trump administration," said Oswald. "Any such cutbacks would be consistent with GOP messaging and talking points over the course of Biden's term."