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Friday, January 16, 2009

Complexity and the Tax Gap - We Can't Just Blame Cheaters for the Gap

When we hear that the annual federal tax gap is about $345 billion, our first thought it that is likely mostly due to tax cheaters. But, as the tax law continues to grow by leaps and bounds in terms of its complexity (and its size), complexity has to be a big part of the reason for this large amount of unremitted taxes. Lawmakers should be working to reduce the gap. While we have had a few legislative changes on that matter, they are really diminished by the massive complexity of the law which continues to grow more complex as more special provisions are added to the law.

Well over 50% of individuals hire a preparer to complete their tax return for them. In her annual reports to Congress, the National Taxpayer Advocate (NTA) continues to remind Congress that complexity is the biggest problem. (click here for the links to the annual report issued in January 2009 and here (pg vi) for the complexity comment):

"In earlier Annual Reports to Congress, we have highlighted the “confounding complexity of the Internal Revenue Code” as one of the most serious problems facing taxpayers. We do so again this year."

Yet despite the annual dire warnings about this complexity, the tax law continues to get even more complex. There are a growing number of energy incentives that operate in varying ways with numerous definitions and effective dates; economic stimulus provisions, etc. The NTA points out a new area of complexity that surpasses the complexity of AMT is cancellation of debt income affecting many taxpayers.

The NTA report also notes: "If tax compliance were an industry, it would be one of the largest in the United States. To consume 7.6 billion hours, the “tax industry” requires the equivalent of 3.8 million full-time workers." (page 3) While this "industry" employs many people, the time they spend on tax compliance isn't growing our economy.

In September, the GAO released another report on the tax gap. This one was focused on the roughly 4% of the $345 billion annual gap that is due to misreporting of rental real estate. About 53% of individuals with rental real estate had some type of misreporting on their return for 2001!! And, it really didn't matter if the return was self-prepared or a paid preparer was used. I think this really indicates a complexity problem not just a tax gap problem.

The rules on rental real estate are complex. A variety of loss limitation rules could apply (such as Sections 280A(c)(5), 469 or 183). And a different rule could apply from year to year. If you fall under Section 280A(c)(5) and need more guidance, you'll find a few court cases and a set of proposed regulations that have remained proposed (and ineffective) for over 20 years!!

It is well past time to simplify the federal income tax law. Unfortunately, current proposals before Congress will just complicate it further. This will lead to increased disrespect for the law, frustration, and an even larger tax gap.

The NTA report lists a set of principles to help legislators move towards a simpler tax law (page 12):

"1. The tax system should not “entrap” taxpayers.
2. The tax laws should be simple enough so that most taxpayers can prepare their own returns without professional help, simple enough so that taxpayers can compute their tax liabilities on a single form, and simple enough so that IRS telephone assistors can fully and accurately answer taxpayers’ questions.
3. The tax laws should anticipate the largest areas of noncompliance and minimize the opportunities for such noncompliance.
4. The tax laws should provide some choices, but not too many choices.
5. Where the tax laws provide for refundable credits, they should be designed in a way that is administrable; and
6. The tax system should incorporate a periodic review of the tax code – in short, a sanity check."

The AICPA has long advocated for simplifying the tax law. The AICPA simplification principles can be found here.

For more on the GAO's rental real estate tax gap information and their recommendations for addressing it, as well as a few ideas of my own, please see a recent short article of mine from the AICPA Tax Insider - here.

What do you think?

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