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Long Term Effects of Tax Audits

Long Term Effects of Tax Audits

Interesting article in the Financial post this morning discussing the long-term effects of tax audits on reporting behaviour. The authors of a study published by the International Monetary Fund found that where self-employed Americans underwent audits, taxpayers reassessed at the end of the audit declared substantially more income (64%!) in later years, while un-assessed taxpayers declared less (about 15%).

The authors of the original paper refer to a wide range of income sources, some of which are calculated on a “net” basis, and the “taxable income” of the taxpayers. Because the study extends to deductions, some of which can be quite complex, I think that the Post overstates the extent to which understated income is a result of intentional misrepresentation or conscious risk taking.

The study deals with self-employed taxpayers (or sole-member LLCs in the States), as opposed to multiple-member LLCs or incorporated businesses. These businesses are less likely to have sophisticated accounting divisions managing their day-to-day books. I would expect that a portion of the change represents taxpayers correcting for errors they did not know they were making (a Canadian example could be using cash accounting and excluding bad debts from income).

Taxpayers having particularly bad years may be more likely to be audited (as they declare less income, which may raise suspicions) and so some of the increased profits may simply be a reversion to the mean.
As the study appears to cast a wide net in defining audits, it would be interesting to see if the value of reassessments affected the results here. I would not be surprised if for some audit issues, the number jumps by much more than 64%. It would be challenging given the limits of underlying data, but it would be interesting to see similar results separated by number of years covered or tax balances.

– James Alvarez, Tax Counsel

© Kalfa Law 2019

The above provides information of a general nature only. This does not constitute legal advice. All transactions or circumstances vary, and specified legal advice is required to meet your particular needs. If you have a legal question you should consult with a lawyer.

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