How The IRS Works: Functions & Audits

By Prableen Bajpai AAA

Even the most enlightened citizen curses taxes at least once a year — possibly while simultaneously acknowledging that they're the price of a civilized, developed society. Even knowing the value of that bargain, loathing the taxman is as inevitable as...well...taxation itself. In the U.S., at the federal level, that unenviable duty falls on the Internal Revenue Service (IRS). As America's tax collector — and as close to a four-letter word as any three-letter acronym could ever come — the IRS has a well-defined mission:

“Provide America’s taxpayers top quality service by helping them understand and meet their tax responsibilities and by applying the tax law with integrity and fairness to all.”

First, A Little History

After becoming independent from Britain, America was wary of taxation and didn’t grant the federal government authority to levy taxes right away. The federal government, though, had the right to ask for tax payment from the states, but states were under no obligation to comply. With time, the government was given the right to levy taxes, but it lacked the agency to do so.

The onset of the Civil War changed everything — or more precisely, the need to pay for that conflict. Congress and President Lincoln enacted the nation’s first income tax with the Revenue Act of 1862, which created the office of the Commissioner of Internal Revenue. The law was temporary, but gave the office the right to levy excise taxes on commonly consumed and traded goods, as well as the means to collect those taxes. It also marked the first progressive tax in U.S. history. On incomes of between $600 and $10,000, a 3% tax was levied, while a 5% tax was levied on incomes of more than $10,000. The need to have an agency in place for enforcing and collecting these taxes gave birth to the Bureau of Internal Revenue (BIR), the predecessor to the IRS.

After the war ended and reconstruction was underway, the Revenue Act was allowed to expire in 1872. Between then and 1894, federal taxes remained but evolved. When the government attempted to further codify and expand taxation with the Income Tax Act of 1894, the Supreme Court ruled it unconstitutional. It wasn't until the the 16th Amendment was passed in 1913 under President William Howard Taft that Congress won the authority to impose an income tax. Soon after,  Form 1040 was born. The tax rate for personal incomes more than $3,000 was 1%; on incomes of more than $500,000 it was 6%. Income tax rates rose sharply during World War I (peaking at 77% for top-earners), and then again during the Great Depression (63% rate on top-earners).

The “tax collecting agency” was revamped in 1950s, first by President Truman as a part of his reorganization plans. The patronage system of the agency was replaced with a career civil service system. The move was endorsed by President Eisenhower, who in 1953 rechristened the Bureau of Internal Revenue the Internal Revenue Service.

One of the Largest Government Employers

The IRS, one of the world’s most effective tax administrators, is a bureau of the U.S. Department of the Treasury. It's one of the largest organizations of the federal government with an employee base of around 90,000 people. The Restructuring and Reforms Act of 1998, commonly referred to as RRA 98, revamped the structure, governance and powers of IRS to its present form. In effect,the IRS was reorganized on the lines of private sector models for greater efficiency and effectiveness.

The IRS is headed by a commissioner who has a five-year office term and is appointed by the President with the advice and consent of the U.S. Senate. Mr. John Koskinen is the current (48th) IRS commissioner of. The other position appointed by the President is the Chief Counsel, who is the chief legal advisor to the IRS commissioner on matters relating to interpretation, enforcement and administration of the laws.

The organization is headquartered in Washington, D.C., with regional campuses located around the country in select cities. The IRS has four primary divisions: Wage and Investment, Large Business and International, Small Business/Self-Employed and Tax-Exempt and Government Entities.

Who Audits The Auditors?

The IRS Oversight Board is a nine-member independent body which was created by the IRS Restructuring and Reform Act of 1998 to “oversee the Internal Revenue Service in its administration, management, conduct, direction, and supervision of the execution and application of the internal revenue laws or related statutes and tax conventions to which the United States is a party.” The board does not have any enforcement authority and has no role in developing policy. However, one important responsibility entrusted with the IRS Oversight Board is to review and approve the annual IRS budget request submitted to the Department of the Treasury.

The Taxman Cometh

The IRS collected almost $2.86 trillion in gross revenue in 2013. That revenue is used to fund the government operations. According to the IRS Data Book 2013 , the IRS processed approximately 240 million tax returns during fiscal year 2013 and provided about $364 billion in refunds to taxpayers. (For related reading, see: How Powerful Is The IRS?)

Collections & Refunds by Type of Tax (2012 and 2013)

Type of Return

Gross Collections (Thousands of Dollars) 2012 and 2013

Individual Income Tax

1,387,836,515

1,564,354,494

Business Income Tax

281,461,580

311,993,954

Employment Taxes

784,396,853

897,847,151

Excise Taxes

56,174,937

61,033,674

Estate & Gift Taxes

14,450,249

19,830,148

                                           Source: IRS Data Book

The Dreaded Audit

An IRS audit is a scrutiny of an individual’s or organization’s tax records and financial information to make sure that the tax amount and information reported is accurate. The probability of getting audited by the IRS works as a good enough reason for people to stay honest and pay taxes on time. However, timely and correct tax payments do not guarantee that you may not be audited, nor does it mean that a return which is selected for audit is sure to have an error. According to IRS, there are different methods used to select which returns will be audited. The common ways are:

  • The computer makes a randomized selection of people to be audited based on a statistical formula.
  • Mismatching documents and information. Say, the information reported in Form 1099 or W-2 doesn’t match.
  • The tax records may be audited since they show transactions with other’s whose name was selected for audit.

However, there are few triggers which are likely to land you on the list (See: Avoid An Audit: 6 “Red Flags” You Should Know and Surviving The IRS Audit). If your return is selected for audit, you will receive a notification by mail or telephone. The audit can conducted via mail or in person review (to learn more, see: What To Do If You Get Audited). In 2013, tax returns of approximately 1.4 million individuals were audited by IRS, which represents a drop of 5% from 2012 and the lowest number since 2008.

Bottom Line

Though the IRS is one of the most efficient tax administrators in the world, it's very nature attracts controversy. The complexity of the tax code and lack of understanding of tax laws by taxpayers also gives rise to confusion. And recent accusations of politically motivated audits mean that the IRS is low on the popularity list to more than a few taxpayers. To resolve such situations — and attempt to assuage taxpayers — there is the Office of Appeals, which helps to resolve disputes impartially and out of court. Around 100,000 seek the assistance of the Office of Appeals annually. In addition, the Taxpayer Advocate Service (TAS) provides free personalized help to taxpayers for IRS related problems.

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