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Blake Christian
Blake Christian
Congress Targets Federal Tax Gap

$350 billion per year and growing.

August 27, 2009
by Blake Christian, CPA/MBT

In 2006, the U.S. Treasury’s Office of Tax Policy issued a report called the Comprehensive Study for Reducing the Tax Gap that set a seven-component strategy for reducing the U.S. tax gap. The goal at that time was for an 80-percent voluntary-compliance rate, meaning 80 percent of federal taxes would be collected without audit or other direct intervention by the Internal Revenue Service (IRS). According to the IRS the actual compliance rate is slightly above their 2006 goal — but it may slip in the current economic climate.

The Treasury Department released an updated report on July 8, 2009 reflecting the federal tax compliance results and the related “Tax Gap” — the difference between what individual and business taxpayers actually remit versus what they owe in various federal income taxes. With ballooning deficits, the tax gap has become a very hot topic in Congress.

The IRS collects approximately 96 percent of all federal gross receipts ($2.7 trillion for FY 2008) through the "voluntary" income tax reporting system. The term "voluntary" refers to taxpayers who are effectively on the honor system when it comes to reporting many income and expense items on their business and personal tax returns.

The IRS estimates that there is currently an 84 percent tax-reporting compliance rate, which means that 16 percent of federal income taxes are estimated to be under-reported and/or underpaid by individual and business taxpayers. Less than one in five (20%) of these under-reported taxes, which total over $350 billion annually, are ever collected by the feds through their audit and collection arms.

The tax gap comes in three basic forms — in ascending order of seriousness:

  • Underpayment of tax liabilities reflected on the return — due to cash-flow or other taxpayer issues;
  • Under-reporting (not reporting one’s full tax liability on a timely-filed return). This can be from under-reported income, mischaracterization of income (e.g. ordinary vs. capital gains), over-reported deductions or a combination thereof;
  • Non-filing (not filing required returns on time and not paying the full amount of tax that should have been shown on the required return).

In light of trillion-dollar annual deficits and record spending in Washington, Congress is increasing their scrutiny on non-compliant taxpayers and is exploring a variety of ways to narrow the gap.

Tax Compliance Enhancement

Following are the fiscal 2010 and 2011 proposals currently being evaluated by the Senate Finance Committee:

  1. Reporting of credit and debit card payments to businesses

    Starting in January 2011, organizations that process credit and debit card payments for merchants must annually report the amount of these payments to the recipient businesses and to the IRS.
  2. Cost-basis reporting

    Starting in January 2011, brokerage firms must annually report cost basis and holding period information to customers and to the IRS in addition to gross proceeds from securities transactions. Currently only gross proceeds are reported to the IRS. Many practical issues, such as stocks received via gift, options, inheritance, etc. will need to be sorted out.
  3. Payments to Corporations

    The FY 2010 budget proposals would require businesses to file information returns for payments to virtually all taxpayers, including all C and S Corps for any services, or certain gains aggregating $600 or more per year. This would end current practice under a longstanding regulatory regime that exempts certain payments to many corporations from the general 1099 requirements.
  4. Rental Property Expense Payments

    The FY 2010 budget proposals would require taxpayers who receive rental income and deduct expenses on rental activities to file information returns for rental property expense payments to any service provider or contractor that performs work on rental properties.
  5. Certain Government Payments for Property and Services

    Some government vendors fail to meet their tax filing and payment obligations, and compliance levels would likely increase significantly if those payments were automatically reported by the governmental entity making the payment. The FY 2010 budget proposals would therefore require federal, state and local governments to report information on non-wage payments made to taxpayers for the procurement of property or services.
  6. Private Separate Accounts of Life Insurance Companies

    This proposal would require life insurance companies to report account information for any contracts invested in a private separate account. The reporting of this information would help the IRS determine whether earnings on investments in separate accounts are taxable income to the holder or are tax-free or tax-deferred.
  7. Requiring Certified Taxpayer Identification Numbers (TINs) from Contractors

    Without accurate taxpayer identifying information, the effectiveness of information reporting requirements is limited. Therefore, the FY 2010 budget proposal would require contractors to provide TINs to the businesses from which they receive payments, and require those businesses to verify the TINs. The IRS’s long-term 1099 matching program has contributed greatly to tax compliance.
  8. Increased 1099 Penalties for Failure to Properly Report Information

    Penalties for failure to properly report information have not been increased since they were first established in 1989. Increasing those penalties will provide a stronger incentive for compliance with information reporting requirements. Accordingly, the FY 2010 budget proposal would double the current per-return penalties ($15 to $50 per late 1099, depending on the number of months late) for failure to file most information returns.

Other Proposed IRS Improvement Measures

In addition to the aforementioned tax compliance improvements proposed in the report, the following IRS operational enhancements are also being considered:

  1. Multi-Year Commitment to Taxpayer and Audit Procedure Research
  • The most recent data is from the tax year 2001. The IRS desires more up-to-date audit results and taxpayer data in order to improve its audit selection and audit procedures;
  • Includes ongoing compliance studies of S Corps and Individuals for the tax years 2003-2004 and 2006-2007, respectively. The IRS is currently conducting detailed audits to gather critical compliance date and audit statistics similar to the old TCMP audit process.
  1. Continued Improvements in Information Technology
  • Increase the e-file rate by simplifying the filing process, reducing processing errors and expediting the refund process.
  • Reach an 80-percent e-file rate.
  1. Improve Agency Funding to Support Compliance Activities
  • Increase of $332.2 million in the FY 2010 budget to support compliance programs.
  • Seek increased compliance in the areas of international enforcement with businesses and high income individuals.
  • Increased personnel to support analysis and enforcement of policies and to combat the underreporting of taxes.
  1. Enhance Taxpayer Services
  • Increase use and support of online services. The IRS is proud of their Web site, which has received a 74-percent increase in traffic between FY 2005 and FY 2008 — probably more related to general Web access trends as opposed to a dazzling site. To be fair, there is some excellent content available.
  • Increase the efficiency and effectiveness of written communication to taxpayers. The IRS Web site is light-years ahead in terms of clarity and grammar.
  1. Reform and Simplify the Tax Law
  • The IRS is currently working on revising various tax forms to reduce the amount of errors involved in filings and to simplify various procedures.
  1. Improved Coordination with Partners and Stakeholders
  • Increase collaboration with IRS partner agencies and improve the use of information such as state audit reports.

Conclusion

Based on these proposals, which will very likely be implemented in the next couple of years (assuming the IRS can effectively integrate their IT systems and these databases), the 16 percent (or more) of taxpayers who are under-reporting income and/or over-reporting expenses are being given fair warning to follow Vice President Biden's call “to be patriotic …” and pay their fair share of taxes otherwise, the IRS will be turning up the heat and make sure they do in the coming years.

Forewarned is Forearmed!! 

Download 2009 Treasury Tax Gap Report

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Blake Christian, CPA/MBT, is a Tax Partner in the Long Beach, California office of HCVT, LLP. Christian is also Co-Founder of National Tax Credit Group, LLC.