February 2012

The IRS conducts approximately 14,000 random audits each year.  One of their purposes is to determine the level of tax compliance, which the IRS calls the “tax gap”.  The IRS recently released a report of the tax gap based on 2006 returns.  The last time the IRS issued a similar report used 2001 tax returns.

The IRS concluded that 83.1% of taxes were voluntarily reported.  The corollary is that approximately 17% of taxes were not reported.  The IRS indicates its audits, matching, and other compliance efforts generated around 2.4% of the missing 17%, leaving approximately 14.5% of taxes unreported and uncollected.  In dollar terms, the tax gap is $450 billion before IRS compliance efforts, and $385 billion after IRS compliance efforts.   This is a staggering amount of money, even for the entire U.S. government.

Here are the largest items of unpaid taxes:

  1. By far, the largest amount of the tax gap comes from individual income tax underreporting of business income.  This involves individual-operated businesses such as a coin-operated Laundromat, owner-operated restaurant, a gardener or other service business.  An eBay reseller might also be representative of these types of businesses.
  2. The second largest type of underreporting involves those improperly classified as independent contractors, with payroll taxes not paid.  For more information, see this article that provides information regarding a federal amnesty program and the criteria of what constitutes an independent contractor.
  3. The third largest problem involves individual credits that are improperly taken.  As an example, see this article regarding inappropriate refundable tax credits.
  4. The fourth area of abuse is inappropriate personal income tax deductions and exemptions.

The estimated tax gap increased from what the IRS calculated based on 2001 tax returns.  However, the IRS indicates that this increase is primarily due to a methodology change that corrects a challenge in the 2001 work.  The IRS believes that the overall tax gap has not materially changed since its report using the 2001 tax returns.

Generally, where there is good information reporting of income (such as W-2s, and Form 1099s) to the IRS, or where there are larger businesses involved, the level of compliance is much higher.  When there is both information reporting and tax withholding, the level of tax compliance is even higher.

This points to a possible solution involving increased Form 1099 reporting for the personal underreporting of business income.  Congress attempted increased Form 1099 reporting as part of the Patient Protection and Affordable Care Act, but this additional effort was widely unpopular and viewed as too intrusive/expensive.  Consequently, additional Form 1099 reporting was repealed this past year, as is reported in this article.

The level of unreported income taxes is too large to ignore.  The programs referenced above demonstrate that the IRS is keenly aware of the issue.  Congress should consider:

  1. Increased Form 1099 reporting, albeit on a less intrusive approach that what was recently repealed.  Since businesses incur most of the cost of Form 1099 reporting but do not benefit directly from the increased taxes, an approach of partially reimbursing some costs of increased Form 1099 reporting might allow progress.  Since the initial implementation is  the most expensive, such subsidy for reporting might be temporary while technology and processes are being developed.
  2. Refundable credits have been a consistent challenge for the IRS to prevent the obvious temptation to file fraudulent claims.  Congress should acknowledge that much of the support they desire for needy persons is instead being stolen, so the support needs to be provided in another manner.
  3. Increased compliance efforts will pay off.  While no one wants to be audited, Congress should expand IRS resources.  The IRS should be allowed to put these resources where it will have large impact, not just for immediate revenue collection, but to re-instill the notion that middle income taxpayers get audited too.  The recent trend to audit larger businesses and the “rich” make good political sound bites, but the IRS data indicates that other sectors of our economy also deserve enforcement attention.
  4. The IRS whistleblower program should be expanded.  Whistleblowers represent one of the least expensive ways of identifying tax cheats, yet the IRS has not supported this area with frequent bounties, for smaller claims.

Fulcrum Inquiry performs forensic accounting and compliance-related accounting examinations.