Tax Uncertainty and Voluntary Real-Time Tax Audits

Abstract

ABSTRACT This study examines the empirical relation between voluntary participation in the Internal Revenue Service's (IRS) Compliance Assurance Process (CAP) audit program, and tax uncertainty disclosed in financial statements pursuant to Financial Interpretation No. 48 (FIN 48). Based on the findings of prior analytical and empirical research, we formulate and test hypotheses about the likelihood of voluntary CAP participation and the resulting effect on FIN 48 tax reserves. We find that firms with moderate-sized FIN 48 reserves are more likely to participate in CAP than firms with either small or large reserves, indicating an inverted U-shaped relation between CAP participation rates and firms' tax reserves. After controlling for non-random sample selection, we find that CAP firms significantly reduce their FIN 48 reserves by about 16.5 percent relative to non-CAP firms. However, this reduction is concentrated among firms with moderate-sized FIN 48 reserves. These cross-sectional differences are consistent with FIN 48 reserves reflecting both tax uncertainty and tax aggressiveness. JEL Classifications: M41; M42; M48; H25. Data Availability: FIN 48 data and confidential tax data on CAP participants are obtained from the Internal Revenue Service (IRS) Large Business & International (LB&I), Planning, Analysis, Inventory, and Research Division (PAIR). The CAP data are not publicly available; the FIN 48 data were compiled and validated by the IRS and made available to one of the authors. All other data are available from public sources identified in this treatise. Because tax data are confidential and protected by data nondisclosure agreements under the Internal Revenue Code, all statistics are presented in the aggregate; no statistics with three or fewer observations are disclosed. Any opinions are those of the authors and do not necessarily reflect the views of the IRS.