How Generative AI can help in reducing Tax related errors?

Generative AI can dramatically reduce tax errors, which are one of the main triggers for audits and financial penalties. Here's how AI enhances accuracy in tax compliance:

1. Automatic Error Detection

• Example: A business reports revenue as $500,000 but mistakenly inputs $455,000 on their tax return. Without AI: The discrepancy may go unnoticed, leading to underreported income and possible penalties. With AI: Generative AI cross-checks tax returns against financial records, flags the $45,000 difference, and prompts corrections, ensuring compliance.

2. Cross-Referencing Financial Records

• Example: A contractor forgets to include 1099 income of $20,000 in their tax filing. Without AI: This omission may result in an IRS notice or an audit. With AI: AI reviews all financial inputs (e.g., W-2s, 1099s, invoices) and identifies missing income before submission.

3. Ensuring Correct Tax Rates and Brackets

• Example: A single filer earning $100,000 applies a 22% tax rate instead of the correct 24% rate for their income level. Without AI: They underpay taxes by $2,000, leading to potential penalties and interest. With AI: AI ensures the correct tax rate is applied, recalculating taxes owed to ensure compliance.

4. Catching Misclassified Expenses

• Example: A business owner incorrectly categorizes personal expenses (e.g., a gym membership of $1,200) as a business expense. Without AI: The IRS flags the deduction as non-compliant, leading to penalties. With AI: Generative AI flags non-deductible expenses and suggests proper adjustments before filing.

5. Real-Time Updates for Tax Code Changes

• Example: A tax deduction limit changes mid-year, reducing allowable deductions for certain business expenses by $5,000. Without AI: The taxpayer unknowingly claims the outdated amount, risking penalties. With AI: The system automatically updates calculations to reflect new laws, ensuring accurate filings.

Generative AI empowers individuals and businesses to file error-free returns, minimize audit risks, and stay compliant with ever-changing tax regulations.

Here are simple examples with calculations showing how Generative AI can help preclude tax errors and improve accuracy in U.S. tax compliance:

Example 1: Misreported Income

Scenario:

David, a freelancer, earns the following for the year:

• Client A: $50,000 (reported on a 1099)
• Client B: $30,000 (reported on a 1099)
• Online Sales: $15,000 (not reported on a 1099 but recorded in his personal logs)

Total Income: $95,000

Without AI:

David forgets to include the $15,000 from online sales on his tax return. He reports only $80,000 in income.

• Taxable Income = $80,000
• Tax owed (Assuming a 22% tax bracket) = $80,000 × 22% = $17,600

With AI:

Generative AI scans his financial records and cross-checks the 1099s and personal logs. It identifies the missing $15,000 and updates the return accordingly.

• Correct Taxable Income = $95,000
• Correct Tax owed (22% bracket) = $95,000 × 22% = $20,900

Savings Identified by AI: AI ensures the correct income is reported, preventing a possible audit and ensuring that David’s tax return reflects his actual income. The corrected tax owed is $20,900, while the initial underreporting would have led to a smaller refund or potential penalties.

Example 2: Catching a Misclassified Deduction

Scenario:

Sarah, a business owner, claims the following expenses for the year:

• Office Rent: $10,000
• Employee Salaries: $50,000
• Spa Membership (personal expense): $1,200

Total Expenses: $61,200

Without AI:

Sarah misclassifies her spa membership as a business expense. The IRS could flag this non-deductible expense during an audit.

• Taxable Income = $100,000 (income) - $61,200 (expenses) = $38,800
• Tax owed (Assuming a 24% tax bracket) = $38,800 × 24% = $9,312

With AI:

Generative AI scans Sarah’s expense categories and flags the spa membership as a personal expense. It suggests removing the $1,200 from the business deductions.

• Correct Taxable Income = $100,000 - ($61,200 - $1,200) = $39,400
• Correct Tax owed (24% bracket) = $39,400 × 24% = $9,456

Savings Identified by AI:

• The AI prevents Sarah from making an error that could trigger penalties for improper deductions. By removing the spa membership, her taxable income increases, and the correct tax owed is higher.
• Difference in Tax Owed: $9,456 - $9,312 = $144

Example 3: Incorrect Tax Rate Application

Scenario:

John is a single filer with an income of $100,000. He incorrectly applies the 22% tax rate instead of the 24% rate for his income level.

Without AI:

John reports his taxable income as $100,000 and applies the wrong tax rate (22%).

• Tax owed = $100,000 × 22% = $22,000

With AI:

Generative AI cross-references John's income level with the correct tax brackets and identifies that he should be in the 24% tax bracket for $100,000 of taxable income.

• Correct Tax owed = $100,000 × 24% = $24,000

Difference in Tax Owed: AI ensures John applies the correct tax rate, and he now owes an additional $2,000. However, by using AI, he avoids potential audit triggers for underpayment of taxes.

Example 4: Depreciation Error

Scenario:

A small business purchases a machine for $50,000 and is using MACRS depreciation over 5 years.

Without AI:

The business owner applies a 10% depreciation rate for each year instead of the correct 20% in Year 1 under MACRS.

• Depreciation claimed = $50,000 × 10% = $5,000 in Year 1
• Taxable Income after depreciation = $100,000 (income) - $5,000 (depreciation) = $95,000
• Tax owed = $95,000 × 24% = $22,800

With AI:

Generative AI identifies the correct MACRS depreciation rate for Year 1 as 20% and recalculates the depreciation.

• Correct Depreciation for Year 1 = $50,000 × 20% = $10,000
• Correct Taxable Income = $100,000 - $10,000 = $90,000
• Correct Tax owed = $90,000 × 24% = $21,600

Savings Identified by AI:

• The AI helps the business owner claim the higher depreciation deduction of $10,000, reducing taxable income and saving $1,200 in taxes.

Summary of Impact

These examples illustrate how Generative AI can help ensure accuracy, prevent errors, and improve compliance with tax laws. By automatically detecting misreported income, misclassified expenses, and incorrect calculations, AI can help taxpayers avoid audits, reduce penalties, and identify potential savings.