January 2011

Nina E. Olson is the current head of the U.S. Taxpayer Advocate. This is a government office dedicated to helping taxpayers solve their problems with the Internal Revenue Service (IRS). On January 5, 2011, she issued her required annual report to Congress (hereinafter called the “Report”).

The Report is really long, with merely the Executive Summary totaling 72 pages, and the entire report including hundreds of pages more. The Report includes the following:

  1. Identifies 21 of the largest problems faced by the IRS;
  2. Provides updates on four problems contained in earlier reports;
  3. Makes a large number of recommendations for IRS improvements on how to administer the IRS’s responsibilities;
  4. Makes eleven suggestions for legislation changes; and
  5. Discusses the ten most litigated issues in the federal courts

Here are two of the most important themes and interesting aspects. Although long, the Report is clear, so we will let the Report itself do most of the talking.

First, the tax code requires far too much unproductive compliance effort and should be enormously simplified. When combined with taxpayer recordkeeping costs, tax preparation is one of the largest single economic activities in the country. No one would seriously suggest that taxpayer compliance adds any immediate economic satisfaction. If compliance costs could be reduced, those being forced to incur these costs would be better in terms of their life satisfaction.

“What is left to be said about tax reform and simplification? We all know we need it. … Our number one most serious problem and number one legislative recommendation … provide a good sense of what tax complexity does to each and every one of our lives. It is not good.”

The Report provides numerous alarming statistics regarding the cost of income tax compliance by U.S. citizens. Here are a few of them:

  1. “U.S. taxpayers and businesses spend about 6.1 billion hours a year complying with the filing requirements of the Internal Revenue Code. And that figure does not include the millions of additional hours that taxpayers must spend when they are required to respond to IRS notices or audits. … If tax compliance were an industry, it would be one of the largest in the United States. To consume 6.1 billion hours, the “tax industry” requires the equivalent of more than three million full-time workers.”
  2. “Compliance costs are huge both in absolute terms and relative to the amount of tax revenue collected. Based on Bureau of Labor Statistics data on the hourly cost of an employee, TAS estimates that the costs of complying with the individual and corporate income tax requirements for 2008 amounted to $163 billion – or a staggering 11 percent of aggregate income tax receipts.”
  3. “Individual taxpayers find return preparation so overwhelming that about 60 percent now pay preparers to do it for them. Among unincorporated business taxpayers, the figure rises to about 71 percent. An additional 29 percent of individual taxpayers use tax software to help them prepare their returns, with leading software packages costing $50 or more. IRS researchers estimate the monetary compliance burden of the median individual taxpayer (as measured by income) rose from $220 in 2000 to $258 in 2007, an increase of 17 percent.” .
    [Notably, this cost is for out-of-pocket costs alone, and do not include the time of taxpayers in the process.]

The Report lists several examples of tax provisions that anybody (except perhaps the recipients of the lower taxes) would have difficulty justifying. The examples would be humorous if they were not true. Elsewhere, the Report provides a refreshingly candid assessment of the challenges in simplifying the Internal Revenue Code, as follows:

“But if we all agree that tax reform is necessary, why hasn’t it happened? Well, our answer to this question is that we are all unwilling to acknowledge the strong vested interests each of us has in the current structure. Tax complexity doesn’t occur just because of “big money” special interests. It occurs because of the tax provisions that benefit each one of us. We are the special interests. And until we acknowledge that, tax reform discussions will deteriorate into shouting matches and finger pointing about cutting “their” special tax breaks and not “ours.”…

“There is a widespread belief that the influence of “special interests” is the biggest roadblock to comprehensive tax reform. There is no doubt that many provisions in the tax code benefit narrow groups of taxpayers, including several described above. But the dirty little secret is that the largest special interests are us – the vast majority of U.S. taxpayers.”

A recent blog entry from Fulcrum’s website (www.betweenthnumbers.net) discusses one approach to a comprehensive simplification of the federal income tax system.

Second, IRS collection procedures are “hard-core”, yet do not accomplish anything and are actually counterproductive in many cases. The IRS has automated many of its processes in order to improve efficiency. But these automated processes can go awry, with little or no meaningful human check in place. When the IRS suspects that additional taxes are owed and the taxpayer has not provided a what the IRS considers a suitable response. the IRS is quick to file a tax lien – again using mostly automated processes.

These tax liens are a bit troubling because the report is full of statistics and examples of how this large agency (i) has trouble keeping track of communications from taxpayers, (ii) is challenged with millions of pieces of undelivered mail that prevents communications with taxpayers in the first place, and (iii) has administrative difficulty ensuring that everything is correct before proceeding with filing a public tax lien. Perhaps more troubling, the IRS’s hard-core approach may not be generating a lot of money. This may be OK if a primary purpose of IRS collection is to make an example of those who do not pay their taxes. However, the longer-term impact of the additional collection effort and related public tax lien process may be to make it harder for certain citizens and small businesses to get back on their feet, become more productive, and thereby ultimately pay more taxes to support the government. Here is what the Report says:

“With respect to collection – we have covered this area of tax administration so much over the last ten years that the footnote containing our writings fills up nearly half a page. Why have we focused so much on collection? Well, because collection is when taxes cease to be abstract and become personal and real for millions of taxpayers. And collection is where, if not handled appropriately, real and lasting harm can be visited upon taxpayers – destroying people’s lives and businesses. It is also where the IRS’s dedication to taxpayer rights is the most tested.

Collection requires a delicate balancing of the government’s interest in collecting revenue and ensuring that all taxpayers pay their fair share of tax, on the one hand, and the legitimate interests of taxpayers with financial difficulties, on the other. Congress articulated this balance in a section of the tax code that directs the IRS, albeit in the context of Collection Due Process hearings, to consider whether any proposed collection action “balances the need for the efficient collection of taxes with the legitimate concern of the person that any collection be no more intrusive than necessary.” At present, many IRS collection practices do not require much balancing. For example, IRS lien filing policies focus almost exclusively on tax collection without regard for the legitimate concern of affected persons that collection actions be no more intrusive than necessary.

Since 1999, the IRS has increased annual lien filings from 168,000 to 1,096,000, a rise of 550 percent. Lien filings can badly damage or destroy a taxpayer’s creditworthiness because they are picked up by the credit rating agencies and retained on the taxpayers’ credit reports for seven years from the date the tax liability is resolved, or longer if it is not resolved.

If lien filings were clearly correlated with substantial increases in revenue collection, one could at least understand the IRS’s position. But over the same period that the IRS has increased lien filings by 550 percent, revenue collected by the IRS’s Collection function has remained flat. … In fact, the IRS must pay filing fees to local county clerks’ offices and incurs its own costs, making it questionable whether liens generate much, if any, direct revenue. By damaging taxpayers’ creditworthiness, the IRS may even be reducing long-term revenue collection.”

These two themes are important to our voluntary reporting of taxes, and the view that Americans have towards their government. Improvement in these areas deserves Congress’ and the IRS’ attention.

Fulcrum Inquiry performs forensic accounting, business valuations, and economic litigation analyses, including in complex tax matters.