Introduction to How the IRS Works
Taxes are a sore spot for Americans. The United States was founded, in part, as a result of the revolt against what colonists considered unfair and exorbitant taxes. The rallying cry of "No taxation without representation!" fueled the ire of colonists and instigated the successful Revolutionary War against Britain. Yet, even Americans recognized that a government would find it difficult to survive without them. As the founding father Benjamin Franklin quipped, "Nothing in this world is certain, except death and taxes."
Even if people come to terms with the idea that paying taxes is one's civic duty, it's hard to appreciate a tax collector. This is why the U.S. government's tax collection agency, the Internal Revenue Service (IRS), isn't exactly the nation's most popular organization. When April rolls around and it's time to pay up, it's easy to imagine the IRS as a soulless agency that is out to suck you dry of your hard-earned income. However, it's good to keep in mind that Congress actually creates and enacts tax code (and extremely complicated tax code at that). The IRS simply enforces it.
Nevertheless, one could argue that the agency's reputation isn't entirely unwarranted. The IRS doesn't have the cleanest history: It's been embroiled with corruption, undergone multiple reforms and still faces problems and controversy. To understand its storied past is to understand many of the difficulties inherent in tax collection and tax law itself.
Although taxes might be as certain as death, the U.S. federal government hasn't always found a need for a tax collection agency. In fact, it operated without one for some time. Now, the IRS pulls in trillions of dollars in revenue for the federal government each year and fights crime on the side, helping to attain convictions for notorious gangsters, among others. Before we find out how it does this, we'll take a look at the history of the IRS to see how this once unnecessary agency ballooned in scope and importance in a relatively short time.
IRS History: Beginnings
After gaining independence from Britain, Americans were wary of abusive taxes and didn't even grant the federal government authority to enforce taxation at first. Under the Articles of Confederation, the federal government could request taxes from states, but this was essentially voluntary. When this system proved to be ineffective, the framers of the U.S. Constitution made sure that that Congress could indeed "lay and collect" taxes.
But even then, it didn't require an agency to collect these taxes. The states were responsible for collecting federal taxes on goods like sugar, liquor and tobacco. For decades, Americans had to pay taxes on various domestic products (excise taxes), imports (custom taxes) and exports (tariffs), but didn't have to pay any portion of their incomes to the Federal government.
This all changed with the onset of a national crisis: the Civil War. To pay for this war, President Abraham Lincoln pushed the nation's first income tax, along with high excise taxes, which Congress passed in 1861. Although modest by current standards, the 3 and 5 percent income tax on people with over $800 and $10,000 in annual income, respectively, meant an enormous increase in tax revenue. Enforcing and collecting so much tax required an entire agency [source: U.S. Treasury]. So this is how the first federal tax collection agency -- the Bureau of Internal Revenue (BIR) -- was born.
This income tax that necessitated the BIR was short-lived, however. While taxpayers stomached steep taxes in wartime, tolerance dwindled after peace was restored. Taxes decreased significantly, and the income tax completely disappeared by 1872. Meanwhile, the BIR had shrunk, but stuck.
Some years later in 1895, Congress tried to pass an income tax again. But the Supreme Court quickly declared it unconstitutional because the Constitution only allowed direct taxes to be imposed in proportion to state population. Clamor to change this provision eventually won out, and in 1913, Congress passed the 16th Amendment which says that Congress has the power to lay and collect taxes.
Although it started small, the income tax dramatically grew in the coming years due to war and Congress's responses to drastic economic fluctuations. In addition, Congress also passed a tax on corporations during this period. This translated into an enormous increase in revenue that the BIR would be responsible for collecting.
Significant growing pains accompanied this unprecedented growth. The BIR was unprepared for the influx in responsibility it would face in the twentieth century.
Federal IRS Growth, Corruption and Reform
Ever since the beginning of the Internal Revenue Service (IRS), taxpayers have suspected it of abusing its power, showing favoritism and invading privacy. In some cases, these accusations have been well-founded. Arguably, however, many of these problems stemmed from the difficult and unprecedented responsibilities Congress put on its shoulders.
As the nation shifted its focus toward Progressive reform politics, it brought fundamental change in the nature of tax law. Using taxes to support the "general welfare" of the nation no longer meant just funding defense and the costs of merely keeping a small federal government running. Now, taxes became an important factor in the health of the economy, curbing the influence of the rich -- people and corporations -- and redirecting that wealth to try to care for society's less fortunate. As taxes grew to meet these goals in this new wave of reform, the BIR soon found itself drowning in work.
Growth and increasing complexity in federal taxes before and during World War I led to many problems. The agency had to grow and organize its administration to interpret and enforce new tax legislation. The BIR quickly fell behind in processing the paperwork. Soon after the war, Congress scaled back taxes, but they were still significant. In the 1920s, a congressional investigation into the BIR found the sources of problems and also evidence of corruption within the agency.
Insufficient regulations, a high staff turnover and increasingly complex tax legislation meant that the BIR was not living up to its responsibilities. In addition, the BIR became wrought with instances of favoritism and questionable practices on the part of its agents. Many pointed to suspicious hiring practices as a source of the problem, saying patronage -- not merit -- decided who got jobs there [source: Thorndike].
The BIR implemented some changes to counter the corruption uncovered in the 1920s. Significant reform, however, came in the 1950s. The BIR again struggled to handle increased taxes during World War II, and instances of corruption moved into the national spotlight soon after. Reforms purged the BIR of many officials, got rid of the patronage in hiring and dramatically decentralized the organization of the agency. To emphasize the change of focus as a service to the taxpayer, the agency changed its name to the Internal Revenue Service in 1953 [source: U.S. Treasury].
Reforms didn't end there, however. Despite its efforts in the following decades, the IRS failed to sufficiently modernize and automate tax processing. Coupled with growing political animosity toward taxes and more revelations of corruption, this led to another reform effort in the 1990s [source: Thorndike]. The resulting IRS Restructuring and Reform Act of 1998 reorganized the IRS. The act based much of the reorganization on successful structures in the private sector [source: IRS] It also established an oversight board and a Taxpayer's Bill of Rights. Among other things, this Bill of Right shifted the burden of proof -- in some cases -- to the IRS rather than the taxpayer when disputes arose.
Next, we'll look at what the IRS looks like today, after undergoing these multiple reforms.
The Organization of the IRS
The Internal Revenue Service (IRS) is estimated to be the largest federal bureaucracy. It employs about 115,000 people [source: Daily]. Although it might seem daunting to understand such a large organization, let's break down the structure of the IRS.
The IRS falls under the Department of the Treasury. The only two appointed positions in the IRS are the Commissioner of Internal Revenue and the Chief Counsel. The president appoints and the Senate confirms candidates for both of these roles. The Commissioner is the head of the IRS and serves a renewable five-year term. The Chief Counsel advises the IRS on legal matters, including interpreting and enforcing tax laws. A nine-member IRS Oversight Board ensures that the agency is treating taxpayers fairly and reviews IRS plans [source: CCH Incorporated].
Although its national headquarters is in Washington, D.C., much of the collections and auditing of individuals and corporations happens in regional offices [source: Daily]. The nine main regional offices or campuses are located around the country -- in Andover, Ma.; Atlanta, Ga., Austin, Texas; Cincinnati, Ohio; Fresno, Calif.; Kansas City, Kan.; Memphis, Tenn.; Ogden, Utah; and Philadelphia, Pa. [source: IRS]. These campuses support the Wage and Investment Operating Division -- which we'll learn more about -- by processing tax return forms [source: CCH Incorporated].
Since its reorganization in 2000, the IRS's responsibilities have been divided into four Main Operating Divisions -- rather than by geographic region as they were previously -- to promote efficiency. These divisions are:
- Wage and Investment: Located in Atlanta, Ga., this is the division most taxpayers -- about 88 million filers -- deal with [source: Smith]. It handles the 1040 forms that people hand over in April.
- Small Business/Self-employed: An office in the D.C. area that addresses self-employed people and small businesses with $10 million or less in assets.
- Large and Midsize Business: This division, in central New Jersey, deals with business whose assets total more that $10 million.
- Tax-exempt and Government Entities: This office in the D.C. area works with a variety of organizations like universities, state governments and small nonprofit corporations.
The four main divisions of the IRS handle things when all goes relatively smoothly. But, as you may know, this doesn't always happen. Because the tax code is so complex, confusion and disputes between taxpayers and the IRS happen all the time. For this reason, the IRS also manages the IRS Appeals Office, which attempts to provide an impartial resolution to tax disputes without having to go to court. In addition, the National Taxpayer Advocate Office works within the agency and assists taxpayers in IRS problems.
And then there's the Criminal Investigation (CI) unit, which investigates violations of the tax code. It has also become involved in crimes seemingly unrelated to taxes because people must pay taxes on income, even when that income is illegally obtained. Although sly criminals might elude elite detectives, they find it more difficult to hide their riches. Since the IRS is the only agency authorized to investigate crimes related to Internal Revenue Code, investigators from other branches of government can turn to the IRS's CI unit to obtain hard evidence for a conviction, even if it's just a conviction of dodging taxes [source: IRS].
Average cases don't call for the CI unit. So let's find out how the IRS usually enforces the tax code.
Who Woulda Thunk It?In addition to the income tax, Congress specifically charged the BIR with enforcing another Progressive-era reform: Prohibition. The BIR was also highly involved in enforcing tax laws relating to narcotics crimes and in convicting "Public Enemy Number One," gangster Al Capone.
IRS Tax Enforcement
The Internal Revenue Service (IRS) reports that it collected $2 trillion in revenue and dealt with $224 million in returns in 2004 [source: IRS]. This is an enormous task, especially considering some people's reluctance to fork over money to the government. So, how does the IRS convince taxpayers to hand over hard-earned cash every year? As is the case with most laws, much of the tax system relies on people's willingness to voluntarily comply. Of course, employer withholding of income tax is one of the most effective tools, but fear of being audited and solicited by tax collectors helps ensure enforcement otherwise.
An IRS audit is an examination of your tax records to make sure you paid all you owed. If the IRS selects you to be audited, it doesn't necessarily mean they suspect you of underpaying your taxes. The possibility of being audited, however, is a good reason to stay honest and make sure you keep good records -- especially of the deductions you claim. A randomized computer selection determines who gets audited, but it isn't entirely random. Some people, including those who are self-employed or often get tips, are more likely to be selected [source: Schmitz].
But getting randomly audited shouldn't be your only fear. If it's clear you've failed to pay all you owe or claim you can't afford to pay your debt, IRS tax collectors might come knocking on your door. They'll assess your situation and decide whether to take a lien on something of value you own to settle your debt to the IRS. In general, if you can't afford to pay your debt to the IRS, collectors are willing to negotiate with you and find a plan that works.
Despite its efforts to successfully enforce taxation, the IRS has faced criticism for inefficient collection. For instance, the IRS reported that it failed to collect about $345 billion in taxes in 2001. Essentially, this is the gap between what taxpayers owed and what they actually paid. As has been the case so many times in its history, the IRS simply doesn't have the manpower to address all of these unpaid taxes [source: Layton]. So, Congress has been making efforts to help the IRS close this gap by outsourcing the work.
In 2004, it implemented the Private Debt Collection Program to do this. Under this program, the IRS uses private debt collection agencies to collect low-profile tax debts. Specifically, the IRS only assigns these private debt collectors delinquent accounts that aren't disputed and that concern debts of less than $25,000 [source: Kelley]. This type of solution isn't unique -- many states also outsource tax collection to private collectors.
The federal program, however, remains highly controversial. Opponents claim that private collectors are less willing to negotiate debt and are prone to using nasty tactics. They also charge that sharing tax information with private collectors violates taxpayer privacy [source: Kelley]. One of the biggest complaints against the program, however, has been cost efficiency. Opponents point to how the program has been costing more than it's pulling in and that the IRS doesn't expect the program to break even until 2010 [source: Layton].
In any case, if you want to avoid problems with the IRS, take a look at the links on the next page and learn more about taxes.