How the IRS Works: Functions and Audits

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 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.” 1

KEY TAKEAWAYS

 Founded in 1862, the Internal Revenue Service (IRS) is a U.S.

federal agency responsible for the collection of federal taxes and
enforcement of tax laws.
 Most of the work of the IRS involves income taxes, both corporate
and individual, processing nearly 253 million tax returns in 2020. 2
 The IRS is responsible for conducting audits to ensure that
taxpayers are claiming or paying what is owed and not cutting
corners or hiding assets or income.
 After peaking in 2010, the number of IRS audits has been on the
decline each year.
First, a Little History
After winning independence from Great Britain, the framers of the
Constitution gave Congress the power to levy and collect taxes and
duties.3  Most of the country's revenue came from tariffs on trade and
excise taxes.4

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. 5

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, the predecessor to the IRS. 6 7

Following the Civil War, political opposition to the Revenue Act mounted
while collections from the income tax fell. The act was allowed to expire in
1872. Thereafter, the government relied primarily on tariffs on imported
goods. Between the Civil War and World War I, as much as 60% of federal
receipts came from custom duties, which generated significant annual
budget surpluses for the government.8

However, a reduction in sugar tariffs under the McKinley Tariff Act of 1890
led to a decline in revenue. The Department of the Treasury forecast a
budget deficit of $70 million for 1894, the first in 30 years. This led to
renewed support for an income tax. The end result was the adoption of the
Wilson-Gorman Tariff Act of 1894, which imposed an income tax on
primarily the wealthy—estimates suggest 1-2% of the population were
subject to the income tax.9

The income tax was challenged on constitutional grounds. In March of

1895, the Supreme Court in Pollock v. The Farmers' Loan and Trust
Company ruled the income tax conflicted with Article I, Section 9, Clause 4
of the Constitution, which prohibits Congress from collecting income taxes
without apportioning them among the states on the basis of population. 1 0  In
1909, Congress adopted a resolution calling for a Constitutional
amendment, which the states ratified in 1913.1 1

In October of 1913, President Woodrow Wilson signed into law the

Revenue Act of 1913, which imposed a 1% tax on incomes above an
exemption of $3,000 for single taxpayers and $4,000 for married couples.
An additional 1% was applied to income above $20,000 and 6% on
incomes above $500,000. The first Form 1040 appeared in 1913. Less
than 2% of households would have been required to fill one out. 1 2 1 3

Income tax rates rose sharply during World War I, peaking at 77% in 1918
for those making $1 million per year, when it was just 15% two years
earlier. By 1925 the top rate had fallen to 25%, which applied to incomes
of $100,000 or more. Then the Great Depression came and with it the
return of high rates. In 1932, incomes greater than $1 million were taxed at
63%.1 4

The “tax-collecting agency” was revamped in the 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. 5
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
73,500 people.1 1 5  The IRS Restructuring and Reform 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.1 6

The IRS is headed by a commissioner who has a five-year term of office

and is appointed by the president with the advice and consent of the
Senate. Charles Rettig is the current (49th) IRS commissioner. 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 the
interpretation, enforcement, and administration of the laws. 1 7 1 8 1 9

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.2 0

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.”1 6 2 1

The board does not have any enforcement authority and has no role in
developing policy. One important responsibility entrusted to the IRS
Oversight Board had been to review and approve the annual IRS budget
request submitted to the Department of the Treasury. However, the board
does not have enough members confirmed by the Senate and has
suspended operations. Its last budget recommendation report, for fiscal
year 2015, was issued in May 2014. 2 2 2 3

The Taxman Cometh

The IRS collected almost $3.5 trillion in gross revenue in 2019, the latest
year for which figures are available. That revenue is used to fund
government operations. The service processed more than 253 million
taxpayer returns and issued $452 billion in refunds.