Results of recent academic research may aid practitioner planning

Each year, the External Relations Committee of the American Taxation Association (ATA) Section of the American Accounting Association (AAA) reviews recent research articles published in the academic literature for planning suggestions and current trends that may interest accounting and tax practitioners. This year, the committee identified five papers relevant to those preparing individual tax returns, planning for international transactions, interested in the effects of both IRS and shareholder attention to tax positions, and interested in whether private firms take more aggressive tax positions than public firms.

Prefilled tax returns

Davidson B. Gillette, James G. Lawson, and Shane R. Stinson published an article in the Spring 2024 issue of The ATA Journal of Legal Tax Research (Vol. 22, No. 1) titled “Fill in the Blank? A Discussion of Prefilled Tax Returns in the U.S.”

The ability of the government to provide prefilled tax returns for citizens has long been debated in the United States. Basically, a prefilled tax return could draw upon information already reported to the IRS by third parties. Afterward, a draft tax return would be provided to the taxpayer to either add information that had been omitted or to attest to its completeness and accuracy. Prior literature has estimated that 45% of U.S. taxpayers would require no adjustments to their prefilled return, while most of the remaining 55% would need minimal changes, such as filling out one additional schedule. Therefore, examining the feasibility of implementing a system of prefilled returns seems important.

As background, prefilled returns were discussed as early as 1985, when President Ronald Reagan called for a “return–free system.” Opposition from Treasury and the IRS stalled this effort as further attempts were made in 1996, the late 2010s, and early 2020s. In addition to governmental agencies pushing against the provision of some form of prefilled returns — as these agencies believe that the increased technological and logistical burden would be too significant — additional opposition has grown from private companies in the tax filing and preparation industry as they worry about lost revenue streams. However, the authors point out that, internationally, many countries, including most other top 10 GDP countries, offer at least some form of partially prefilled returns. Therefore, the United States is an outlier in requiring taxpayers to prepare full returns.

The authors examine the benefits and issues surrounding implementing a prefilled return system in the United States. Potential benefits include taxpayer cost savings and higher accuracy and efficiency in the tax filing process. Further, a prefilled return system could potentially increase taxpayer goodwill and decrease both intentional (by reducing taxpayer frustration) and nonintentional (by reducing the possibility of input errors) noncompliance.

On the other hand, issues include implementing a prefilled program at an IRS that already suffers from backlogs in current returns and lacks sufficient technology to maintain the current system. New systems would be required, with funding becoming exceedingly difficult to obtain. Outside the IRS, general distrust of what could be perceived as additional regulatory intrusion by the government, as well as lobbying efforts from for–profit companies, could derail the public’s acceptance of a new prefilled return system and delay taxpayers from opting in.

The authors’ recommendations include implementing a prefilled program in phases through requested taxpayer opt–ins, allowing technological systems to be updated in stages. Taxpayers could receive correspondence from the IRS informing them of their eligibility and asking them to participate in the system. The IRS should focus on single, individual taxpayers and middle–income filers to avoid beginning with the more complex returns of taxpayers in lower–income tax brackets (which could include earned income tax credits) and higher–income groups (with, potentially, more schedules and complexity).

In this regard, the initial need for information not already provided by third–party sources would be lessened. For taxpayers with more complex tax situations, the authors recommend that the IRS send out partially prefilled returns and then allow these taxpayers to complete their filing, with an added emphasis from the IRS that the returns are unfinished and that taxpayers retain responsibility for their accuracy and completion.

Finally, the authors recommend that the IRS proactively seek to mitigate opposition from for–profit companies, perhaps through including these companies in the filing process on a flat–fee–per–return basis. Therefore, revenue streams could be somewhat retained, and these companies’ incentives to upcharge clients could be reduced. Overall, the authors conclude that, while instituting a prefilled tax return system in the United States could offer substantial benefits, numerous challenges would need to be addressed.

The BEAT

The second paper reviewed looks at taxpayers’ efforts to mitigate the cost of the base–erosion and anti–abuse tax (BEAT) imposed by the Tax Cuts and Jobs Act of 2017, P.L. 115–97 (Sec. 59A). Stacie O. Kelley, Christina M. Lewellen, Daniel P. Lynch, and Daniel M.P. Samuel published an article titled “‘Just BEAT It’ Do Firms Reclassify Costs to Avoid the Base Erosion and Anti–Abuse Tax (BEAT) of the TCJA?” in the Journal of Accounting and Economics (Vol. 77, 2024). The authors explore how multinational companies use a key loophole to minimize their BEAT liability by reclassifying related–party payments as cost of goods sold (COGS) to take advantage of the COGS exclusion allowed in computing gross receipts for purposes of the tax.

The authors analyzed financial data from thousands of foreign subsidiaries and found clear evidence of this tax planning strategy. Foreign subsidiaries of U.S. companies subject to the BEAT showed 6.8% higher sales growth post–TCJA than control groups, indicating that parent companies are shifting related–party payments from deductible expenses to COGS. The financial impact is substantial, with an estimated $6 billion in tax savings in 2018 alone among sample firms. This research helps explain why BEAT collections have fallen dramatically short of projections. Treasury noted that BEAT collections were less than half of the original estimates ($1.8 billion collected versus over $5 billion projected for 2018).

This current study provides the first large–sample empirical evidence documenting previous theoretical research that raised concerns about possible widespread BEAT avoidance through cost reclassification, resulting in overstated revenue projections. These findings demonstrate tax savings associated with this strategy and inform regulators that Sec. 59A potentially needs review. With ongoing policy discussions surrounding the elimination of the COGS exception or replacing the BEAT entirely, tax professionals should closely monitor legislative developments that may affect this strategy for specific clients.

Tax planning and litigation

The third and fourth papers examine how increased attention to tax positions by both the IRS and corporate shareholders could affect a company’s willingness to take aggressive tax positions. In their paper titled “The Effect of Shareholder Scrutiny on Corporate Tax Behavior: Evidence From Shareholder Tax Litigation,” published in Contemporary Accounting Research (Vol. 41, No. 1, p. 163 (Spring 2024)), Dain C. Donelson, Jennifer L. Glenn, Sean T. McGuire, and Christopher G. Yust examine the relationship between tax avoidance and shareholder tax litigation. Shareholder tax litigation includes both federal securities class–action suits, which are filed on behalf of the shareholders and claim a violation of the Securities Acts of 1933 or 1934, as well as state–level derivative suits, which are initiated by shareholders but filed against management or directors on behalf of the company. The issues in these suits involve either explicit tax payments, financial reporting of tax accounts, or both. Shareholder tax litigation increased over the sample period for the study, while IRS and SEC litigation decreased over the same period.

The authors identify 143 tax litigated cases filed against 115 public companies during 1996 through 2016. Of the 143 cases, 48% are security class–action lawsuits and 52% are derivative lawsuits. Approximately 65% of the cases involve explicit tax payments, 38% involve tax reporting issues, and 9% involve other tax issues. The authors estimate tax avoidance using financial statement data to calculate both a cash effective tax rate (ETR) and a GAAP ETR for the companies subject to tax–related litigation and for a control group of companies in the same industries that were subject to shareholder litigation related to nontax issues.

The authors examine whether companies with lower cash and GAAP ETRs (indicating higher levels of tax avoidance) face a higher likelihood of tax litigation. They find that a one–standard–deviation decrease in cash ETR increases the likelihood of tax litigation by 40%, while a one–standard–deviation decrease in GAAP ETR increases the likelihood of tax litigation by 28%.

Next, they examine whether companies subject to tax litigation change their tax–avoidance behavior after the revelation of misbehavior leading to litigation. They find that control companies do not significantly change their tax–avoidance behavior after their non–tax–related misbehavior is revealed. In contrast, treatment companies significantly decrease their tax–avoidance behavior after their tax–related misbehavior comes to light. Specifically, the cash and GAAP ETRs increase by 3.3 and 2.8 percentage points, respectively. In addition, they find that when examining only cases involving payment of explicit taxes, the effect size for the increase in cash ETR is nearly three times as large as when considering all cases, while there is no subsequent change in GAAP ETR.

Finally, the authors consider whether there are industry spillover effects in response to the news of the tax issues leading to litigation. They construct treatment and control samples of companies in the same industry as those experiencing tax–related litigation. The treatment sample comprises peer companies subject to high litigation risk, while the control sample comprises peer companies subject to low litigation risk. They find that treatment companies increase their cash ETR by 2.4 percentage points and their GAAP ETR by 3.2 percentage points after the sued company’s litigation. In addition, they find evidence that the effect is most significant for companies in the top one–third of tax avoidance prior to the litigation.

A fascinating finding is that shareholder scrutiny can function to constrain aggressive reporting behavior. This is especially important in an environment where regulatory enforcement is increasingly resource–constrained.

IRS examinations of small corporations

The fourth paper examines the effect of IRS audits on smaller companies (those with less than $250,000 in assets on their balance sheet). Andrew Belnap, Jeffrey L. Hoopes, Edward L. Maydew, and Alex Turk published “Real Effects of Tax Audits” inthe Review of Accounting Studies (Vol. 29, No. 1, p. 665 (March 2024)). The paper examines the “survivability rate” of audited firms versus a nonaudited control group, whether benefits accrued to the firm as a result of the audit, and whether the audited firm changed the aggressiveness of its tax positions post–audit.

The study uses output from the National Research Program (NRP) conducted by the IRS from 2012 through 2016. All the firms audited under this program reported less than $250,000 of assets and were corporations taxed under Subchapter C, giving the authors a unique insight into the effects of IRS audits on small firms. The average audit lasted 417 days and involved 67 hours of IRS employee time, a significant economic burden on the firms subject to the audits. The authors first tested whether the audited firms were less likely to survive than a control group of peer firms that were not audited.

The researchers measured survival in two ways: (1) the continued filing of future tax returns (including successor firm tax returns) or (2) being classified as “defunct” by the IRS, having unpaid, uncollectible tax liabilities. Compared to similar firms, audited firms are 6% more likely to stop filing tax returns and 1.2% more likely to be considered defunct. The effect is more substantial for audited firms found to owe additional tax; those firms were 12.6% more likely to cease filing tax returns and 2.7% more likely to obtain defunct status. In addition, longer–lasting audits are associated with higher levels of business failures regardless of assessment outcome, suggesting that the administrative cost of the audit itself can sometimes affect firm survival.

The study then considered whether being audited affected future reported revenue, wages, employment, or investment. Future reported revenue of audited firms decreased by 21.8% compared with similar firms, but there is no detectable difference in wages, employment, or investment. Compared to the other measures, revenue may be easier to underreport, so the authors speculate they may be observing underreporting in the years after an audit, due to the “bomb–crater” effect (firms might believe that they are less likely to be audited again immediately). Another possibility the authors point out is that the administrative cost and distraction generated by an audit can harm the sales growth of small firms.

The study’s last finding looks at the silver lining of having gone through an audit and cautions the government as to the overall economic costs of examining small firms. Post audit, most firms appear to focus on efficient tax strategies, in part evidenced by the fact that 68% of the firms with positive tax adjustments elected to be taxed under Subchapter S going forward.

Overall, small firms provide a large proportion of U.S. employment growth and job creation. In addition, many of today’s largest enterprises started as small firms. Policymakers must balance the revenue raised by tax audits against the costs incurred by small firms, including potential firm failures.

Firm size and tax planning ‘aggressiveness’

The final paper compares the “aggressiveness” of tax planning between publicly owned and privately held corporations. Jeffrey L. Hoopes, Patrick T. Langetieg (IRS), Edward L. Maydew, and Michele S. Mullaney published”Are Private Firms More Aggressive Tax Planners?”in The Accounting Review (Vol. 99, No. 4, p. 197 (July 2024)). The study explores whether lower transparency and fewer reputational risks in private firms encourage more aggressive tax strategies. It builds on prior research suggesting private firms might prioritize cash savings from taxes over reporting high accounting earnings, unlike public firms, which face more scrutiny from investors and media. The authors tested two hypotheses:

• Basic assumption: Private firms are not more aggressive in tax planning than public firms.
• Alternative assumption: Private firms are more aggressive in tax planning than public firms.

Researchers compared confidential tax data from the IRS for private and public U.S. corporations with over $10 million in assets, covering 2007—2015. They examined aggressive tax strategies such as uncertain tax positions, involvement in reportable transactions, and the use of subsidiaries in tax havens. They also looked at broader tax strategies, differentiating between strategies that reduce both taxes and reported profits (conforming planning) and those that reduce taxes without lowering reported profits (nonconforming planning).

Somewhat surprisingly, they found that private firms are generally less aggressive in tax planning than public firms, challenging the widespread belief that private companies aggressively minimize taxes. Specifically, the authors found that private firms:

• Are less likely to take uncertain tax positions or engage in questionable transactions than public firms;
• Do not use significantly more tax havens than public firms; and
• Have higher effective cash tax rates than public firms, indicating they generally pay more in taxes relative to their profits.

Not surprisingly, the authors found that private firms frequently use tax strategies that reduce both taxes and accounting profits (conforming strategies), such as certain inventory methods and debt financing. Given these findings, the IRS may wish to increase scrutiny of public companies while committing fewer resources to auditing privately held companies.

Practice relevance

This small sample of academic tax research from the past year illustrates the broad range of topics explored by academic researchers. From increasing the efficiency of individual income tax filings to cross–border tax planning for multinational corporations subject to the BEAT, this year’s research has direct implications for many practitioners and their clients.

Additionally, long–standing beliefs about the relative aggressiveness of private versus public companies have been challenged, the activism of shareholders has been found to be a controlling influence on company tax aggressiveness, and the negative overall economic consequences of auditing small businesses have been examined. Practitioners and academics can work together to effect more efficient and beneficial tax policies and procedures.