“Most people don’t like paying taxes,” says Rebecca Lester, associate professor of accounting at Stanford Graduate School of Business. “But we can probably all agree that if we’re going to have a tax system, it should at least collect the full amount that’s due.
“Unfortunately, the estimated annual tax gap in the United States — or the difference between the amount the government believes it’s owed and the amount it receives — is more than half a trillion dollars.
In the latest episode of our Quick Study video series, Lester explains how her team uncovered billions in missing revenue, in a collaborative study conducted with the Internal Revenue Service (IRS) and Stanford RegLab.
Lester examined partnerships, one of the most opaque business structures in the U.S. tax code. These structures, which first appeared in the 1980s, now outnumber corporations two to one. And while most are small and straightforward, about 15% are sprawling, multi-tiered entities with hundreds or thousands of owners. Think of them like spiderwebs — intentionally complex, and difficult for an auditor to untangle.
But when the IRS does take a close look at a partnership, the results can be eye-popping: for every dollar spent, the agency claws back twenty, and auditing complex partnerships yields eight times the return compared to auditing large C-corps.
“Our research implies that giving tax collectors more resources will recover much more money for the country,” Lester says. “It pays for itself and then some.”
Full Transcript
Note: Transcripts are generated by machine and lightly edited by humans. They may contain errors.
Becky Lester: I’m Becky Lester, an associate professor of accounting at the Stanford Graduate School of Business. Almost every country in the world collects taxes. This essentially serves three purposes, to raise revenue for the government, to redistribute wealth, and to change the behavior of individuals and businesses. Most people don’t like paying taxes, but we can probably all agree that if we’re going to have a tax system, it should at least collect the full amount that’s due. Unfortunately, in the United States, it’s falling way short. Every year when people and businesses file their taxes, the Internal Revenue Service investigates who might not be paying enough. There’s a lot of money at stake. The estimated annual tax gap between what’s owed to the government and what it actually receives is more than half a trillion dollars, but the IRS doesn’t have enough staff and resources to audit everyone.
Out of more than 250 million tax returns filed every year, less than one half of 1% get audited. So in order to improve its efficiency, the IRS invited our team at the Stanford Graduate School of Business and the Stanford RegLab to take a rare peek at more than 12 million tax returns of a specific type of company that’s a major contributor to the tax gap, partnerships. There are basically four ways to run a business in the U.S. The oldest form and the simplest is a sole proprietorship, just one person, that could be a local plumber, a cafe owner, or a freelance journalist. At the other end of the scale are C corps, these are usually big public corporations like Ford, Amazon, and Microsoft. And between these two are S corps and partnerships, these two types of businesses have exploded in number since the 1980s when new tax laws were passed to benefit small business owners.
The changes came with good intentions, but they also opened the door for some complicated business models, especially among partnerships. There are now more than twice as many partnerships as C corporations, but still not much is known about them. So that’s what we studied. First, we wanted to understand how these partnerships are structured. Most are pretty straightforward with just a few business partners, but about 15% of these businesses are much more complex with multiple tiers of ownership. A partnership can own a partnership, which in turn can own another partnership. Each partnership can have thousands of owners. There’s no legal limit. Some of the more complicated partnerships can even look like a spiderweb with layers of interconnected partners and owners.
And as you might imagine, for a tax auditor, that spiderweb can be very time-consuming to untangle. We found that when the more complex partnerships are picked for an audit, they’re less likely to be asked to pay additional taxes. That’s because sometimes the auditor just takes a quick look and then backs off. They’re trying to be efficient, so auditors can be wary about potentially wasting lots of time getting stuck in those webs, which is too bad. Because we also found that when the IRS really digs into these complex audits, it often determines that large amounts of underpaid taxes are owed. The return on investment is huge. We calculated that for every dollar it costs the IRS to audit complex partnerships, it gets back 20 in revenue. That’s billions of dollars to help close the tax gap. In 2023, the IRS released a new strategic operating plan. Part of it was to pursue large C corporations and complex partnerships that are not paying the taxes they owe. But while auditing a giant corporation might make a good David vs Goliath headline, it’s not so efficient.
Auditing complex partnerships actually yields eight times the return compared to auditing big C corps. Using the patterns we identified, maybe with some assistance from AI, the IRS could visually picture these complex partnerships and use the complexity as a guide for audits. How many owners are there? How many partners? How many degrees of separation or tiers of ownership are there before we get down to the final taxable entity? All of this data can serve as clues to which tax filings may be coming up short. So long as these webs are allowed, the best way to find the taxes hidden within them is to have a better sense of what types of tax avoidance or even tax evasion they can enable. Our research implies that giving tax collectors more resources will recover much more money for the country. It pays for itself, and then some.
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