Need for More Red Flags and Enforcement to Pursue Tax Cheaters

Every week, there are several news releases from the Tax Division of the Department of Justice and the IRS Criminal Investigation (CI) unit about people caught in tax evasion and sometimes not only stealing from all of their fellow taxpayers but also employer or others. I encourage you to scan recent headlines for the reports of catching some of these bad actors.

• Department of Justice Tax Division news - https://www.justice.gov/tax/tax-division-news
• IRS CI news - https://www.irs.gov/compliance/criminal-investigation/criminal-investigation-press-releases

But, of course, many are not caught and some are caught after the statute of limitations has closed for some years of taking deductions they were not entitled to. If civil fraud is involved, the statute of limitations remains open, but some cases have not involved fraud but instead negligently claiming, for example, unallowable hobby losses as allowable business losses (and not getting caught until after doing it for many years) or claiming large charitable contributions of grossly overvalued property with the deductions carrying forward (recent example - 4th Circuit case with conservation easement charitable deduction claimed at $5.1 million on property bought a year earlier for $652,000. The court noted that because the initial years of the deduction are closed and the IRS had not examined the initial year, the taxpayers "received the benefit of having deducted $1.75 million").

A 9/26/24 news release from IRS CI describes a person who over three years made over $1.2 million as a software engineering manager. So he would owe some taxes on this $400,000 of annual income. But he greatly reduced his taxes by claiming over $1.1 million of medical expenses which were actually under $100,000. A jury found him guilty on three counts of tax evasion. Per the news release, this high paid person "deducted nonexistent medical expenses from his taxes for multiple years because he had not been 'caught' the first time he did it."

But why wasn't this person's return flagged by the IRS as needing an audit? Why is an employee with wages well beyond the median U.S. income (about $64,000 for the years involved), allowed a very large medical expenses exceeding 7.5% of his AGI when it is extremely likely he has good health insurance from his employer who pays his high salary?  This should be a "red flag" to trigger an examination - high paid employee with medical expense deduction.

For the overvalued charitable contribution deduction, why didn't data on Form 8283 trigger an audit in the initial year of the donation? While the taxpayers overstated the basis making it look just a little bit less overvalued, how can a $5.1 million deduction of property purchased a year earlier for about $650,000 not be a "red flag". These taxpayers improperly listed the basis as $1.35 million but even this spread should have still been a red flag.

Well, likely more "red flags" to trigger audits are needed. And, of course, funding for IRS enforcement is needed. Examinations of high income individuals can be complex and human resource intensive. The IRS has reported that recent additional enforcement dollars bring in tax owed. For example, a September 2024 press release from the IRS notes that with better funding of enforcement, they "launched an initiative to pursue 125,000 high-income, high-wealth taxpayers who have not filed taxes since 2017"!!  Yes, go after these people. Also, Congress has noted that enforcement dollars bring in revenue because additional funding allocations are scored by government agencies as revenue raisers (the IRS will bring in more tax dollars than the budget allocation). Per a 2/29/24 CBO report: "A $20 billion rescission [of IRS funding] would reduce revenues by $44 billion and increase the cumulative deficit by $24 billion."

Congress cut $21 billion of the additional $80 billion provided to the IRS over 10 years by the Inflation Reduction Act of 2021 and the cut came from the enforcement dollars!  How odd. Doesn't Congress want to bring in tax dollars for which it already passed laws saying the taxes were owed?  Why should compliant taxpayers subsidize tax cheats who, like the person just found guilty of tax evasion by a jury, kept cheating because they got away with it (until now)?

Besides the medical expense and high valuations of donations on Form 8283, what additional red flags do you think would catch non-compliant filers?

Some Tax Figures Should Not Be Adjusted for Inflation

Inflation adjustments to tax rules such as the individual tax brackets and standard deduction make sense to avoid "bracket creep" where inflation might put an employee into a higher bracket despite no increased earning power and ensures an appropriate amount of income is removed from taxation (the role played by the standard deduction and personal and dependent exemptions).

But some figures, such as filing thresholds for information reports such as 1099-INT and 1099-NEC, should not be adjusted for inflation as doing so will increase non-reporting otherwise known as the tax gap (amount of tax owed less what is actually collected). There are often proposals to increase the 1099-NEC filing threshold from $600 which was set in 1954 to its inflation adjusted amount of about $7,000 today. For example, see the proposed Small Business Paperwork Savings Act introduced 6/9/23 to increase the filing threshold for Form 1099-NEC from $600 to $5,000.

According to the IRS, the tax gap is about $500 billion a year. It stems from non-reporting of income and non-payment, as well as various tax errors made in filing. The GAO, IRS and others have known for many years that "compliance is higher when there is a third-party information reporting and withholding" (page 3 of Pub 5364). More specifically, the IRS reports that where income is subject to both information reporting and withholding, the compliance rate is about 99%! In contrast, where there is little to no information reporting or withholding, the compliance rate is about 45%!  [page 6 of Pub 5364]

A tax gap means that compliant taxpayers are paying more to cover what non-compliant taxpayers are not paying that they actually owe. Since it has been shown for many years that information reporting reduces the tax gap, raising the filing threshold for Form 1099-NEC will mean far fewer forms will be issued and some taxpayers such as those who keep poor records or think that if they don't get an information form, the income isn't taxable, will not report the income - the tax gap will rise. Compliant taxpayers will have to cover more of total taxes.  

Improvements in technology can make it easier to file information reporting forms. Last year, the IRS released IRIS that helps small businesses prepare most types of information returns and file them with the IRS. Hopefully this system will expand to allowing the filers to also get the 1099s to the recipients electronically, such as the IRS sending the information directly to the taxpayer's account that the IRS will be creating for taxpayers per the recent strategic plan under the IRA 2022 funding (page 24).

While 1099-NEC forms are provided to self-employed individuals who should be keeping business records, not all do or don't keep complete records. Thus, 1099-NEC forms are important. Could an alternative be some type of required recordkeeping by businesses? Possibly, but that is more challenging. Can rules be changed to reduce penalties on 1099-NEC filers? Yes. For example, if the recipient provided a wrong address or EIN, the penalty should be on the recipient, not the issuer. Should 1099-NEC filers be compensated for their efforts? Why not?

What do you think?

Odd Tax Proposal Harms Tax Gap and Tax Transparency

H.R. 6937, Shifting Limits on Thresholds (SLOT) Act, is a bipartisan proposal to increase the information reporting threshold for slot machine winnings from $1,200 to $5,000 and adjust it for inflation. The sponsors note that the threshold has been $1,200 since 1977.

Per co-sponsor Rep. Anthony G. Brown, this proposal "is a necessary modernization of our tax code."

Really?  This proposal would harm our tax law by reducing gambling winnings that get reported (that is, it would increase the tax gap) and make many people think that such winnings are only taxable if they exceed $5,000. 

The reality is that winnings are taxable regardless of the dollar amount (unless the recipient's total income is below the standard deduction amount). Information reporting is good and the dollar amount should be lowered rather than raised as there are decades of data from the GAO and others that tax compliance improves with information reporting.

Is the $1,200 threshold burdensome for casinos? Likely not as they have many laws to deal with and likely good reporting systems (including for player and loyalty cards) that would allow for a lower threshold for information reporting rather than a higher one.

What do you think?

Wow! IRS Comm'r Rettig Estimates Annual Tax Gap at $1 Trillion!

Today (April 13, 2021) the Senate Finance Committee held a hearing on The 2021 Filing Season and 21st Century IRS.  The sole witness was IRS Commissioner Charles Rettig. 

There are three takeaways I want to share:

1. The IRS is Overburdened! I encourage you to at least skim Commissioner Rettig's written testimony. He lays out numerous challenges that that IRS has faced for years and even more due to COVID-19 tax law changes. Consider the three rounds of Economic Impact Payments they had to issue while sheltering in place (each round went to about 160 million individuals), new tax forms for employers to get new refundable payroll tax credits, the need to issue guidance quickly because most changes were almost immediately effective, and the American Rescue Plan enacted March 11 included two changes to 2020 forms millions of which had already been filed!

The IRS is overburdened with a declining workforce due to lots of retirements and problems of funding cuts and dealing with decades old technology.  And the reality is that we all need more from them. We need more audits and we need more guidance. 

Congress needs to increase funding for the IRS - this will be significant revenue raiser (more on that in my #3 below).

2. The IRS and Some Lawmakers Want to Regulate Return Preparers - This is not new as the IRS implemented a system in 2010 that was then found beyond statutory authority. President Trump's budgets included the need to regulate return preparers. This topic seems to have bipartisan support. In response to a question from SFC member Senator Cardin, Commissioner Rettig said "we absolutely need the ability to regulate paid tax preparers" particularly those serving underserved taxpayers. He noted that paid preparers tend to make more mistakes with the EITC than occurs on self-prepared returns! He also noted that most preparers are "amazing" but there are some that the IRS needs to after in a more efficient manner that could occur with regulation. I assume he means through testing and annual continuing education in order to be allowed to obtain a PTIN.

3. Commissioner Rettig Estimates that Annual Tax Gap is About $1 Trillion Per Year! IRS data on its tax gap website is based on 2011 and way out of date. It estimates the net annual tax gap at about $381 billion. That is a lot of money (more than we brought in even from the pre-TCJA corporate income tax). When SFC Chairman Senator Wyden asked Comm'r Rettig what his personal opinion was on the actual size of the tax gap, the reply "it would not be outlandish that the annual tax gap could approach or possibly exceed $1 trillion per year".  WOW!!!

I say "wow" (and we all should) because our annual tax revenues collected are about $3.1 trillion. President Biden's American Jobs Plan is estimated to cost $2.7 trillion over 8 years (see Committee for a Responsible Federal Budget estimate). And many question how we'll pay for that plan. Let's collect even half of what is owed as represented by the tax gap and we can also pay down the federal debt! [hear Comm'r Rettig's tax gap estimate at about 43 minutes into the hearing video]

There are many things that can be done to reduce the tax gap. Here are a few of them:

• Hire more revenue agents at the IRS.
• Provide adequate training to those hired (like it was back in the 1980s when I worked there - months of training in the classroom and in the field provided by a well-prepared education office).
• Expand information reporting and lower the filing thresholds. And, make it easy to file these forms using online portals. Also, provide an incentive for non-business payors (such as households) to file these forms.
• Allow voluntary withholding on non-employee compensation and mandate it for non-filers.
• Work with states to include tax education in high school so more people understand their taxes and the obligation to pay them.
• Let's get 21st century technology and practices into the IRS! Too many aspects of the entire compliance process are still using 20th century technologies and thinking. This is something we all need to focus on, not just the IRS. I said this at a 2013 hearing of the Senate Small Business Committee - Filing should be as simple as ordering from Amazon!

What do you think?

How about making April 30th Celebrating Taxpayers Day?

How about making April 30th Celebrating Taxpayers Day? 

A few things lead me to suggest this. The reasons mostly tie to my recent research and writing on improving transparency of our tax systems.*  I like all principles of good tax policy (I hope we all do). I think that two on the AICPA set of principles of good tax policy need more attention because doing so will help tax systems to better meet the other ten principles the AICPA promotes. These two principles:

• Transparency and visibility - Taxpayers should know that a tax exists and how and when it is imposed upon them and others.
• Accountability to taxpayers - Accessibility and visibility of information on tax laws and their development, modification and purpose are necessary for taxpayers.

If people better understand our tax rules and policies, they are more likely to question why, for example, a special rule exists or was introduced or enacted, why permanent or temporary, how a deduction benefits those in higher brackets more than those in lower brackets (unless there is a phase-out), marginal tax rates and relevance, and that the amount of one's refund has little to do with their total tax liability. They would ask better questions of elected officials and those running for office. They would be better aware of the taxes they and others owe. And, hopefully, compliance would improve and be something we are proud of and celebrate.

Here are three recent events that lead me to suggest starting a Celebrating Taxpayers Day.

1. IRS Commissioner Rettig issued a message on April 12 thanking taxpayers. The first two paragraphs follow:

"As the tax filing deadline approaches on April 15, I’d like to thank taxpayers for taking the time to file and pay their taxes. Our nation’s tax system is built around the concept of voluntary tax compliance, meaning citizens comply with their civic duty each year by preparing and filing their taxes – without direct government intervention.
  This principle has helped make our tax system a model for the entire world. Thanks to taxpayers, this system helps fund our great nation. Each year, 95% of the gross receipts of our country flows through the IRS – about $3.5 trillion last year – funding critical aspects of the U.S., ranging from roads and schools to the nation’s military."

Why not make this "thank you" an annual event on a specified date with an explanation of why taxpayers should be thanked, the importance of voluntary compliance, and seize an opportunity to build and support positive tax morale.

2. In my research I came across a 2015 OECD report, Building Tax Culture, Compliance and citizenship: A Global Source Book on Taxpayer Education. It lists activities of 28 developing countries for promoting tax compliance. A few of them have celebration days. For example, Rwanda has an annual Taxpayers Day celebrating compliance and helping citizens understand and appreciate how taxes and the country's development are connected. The president officiates at the event and a report on tax revenue data and tax agency challenges is released. Bangladesh holds a National Income Tax Day 15 days before the tax due date. There are street processions, workshops, conferences and tax clinics. They also show documentaries and dramas on taxation. 

   Celebrating Taxpayers Day in the U.S. could be educational and a reminder of the importance of taxes to our economy and society. It could also be a day where state and local governments help explain their taxes and budgets to their citizens, an opportunity for debates on current tax issues, and release of important government reports about our tax and budget systems. All levels of government release many tax and budget reports throughout the year, why not highlight some key ones on April 30 to draw greater attention to them?

3. Our tax gaps are growing - The IRS estimates the federal tax gap at $458 billion per year. This is more than we collect from the corporate income tax even before the corporate rate was lowered by the Tax Cuts and Jobs Act. A report from the Treasury Inspector General for Tax Administration (TIGTA), Expansion of the Gig Economy Warrants Focus on Improving Self-Employment Tax Compliance (2/14/19) reports some alarming data that indicates we need greater taxpayer education and to better support positive taxpayer morale. Among many findings was that 25% of individuals in a sample of 3.8 milion gig workers filed a 1040, but didn't report their gig income on either the other income line or Schedule C. And, 13% with self-employment tax income who received Form 1099-K did not include Schedule SE or pay their SE tax with their 1040. The IRS also found a 237% increase from 2012 to 2015 in discrepancies between Forms 1099-K filed and what was reported on Forms 1040. 

    A 2018 report from the California Franchise Tax Board found that about 70% of gig economy service providers receive no tax reporting form, which increases non-compliance. With understanding of tax rules and recordkeeping low, compliance without reporting forms become a bigger challenge and frustration. A 2018 QuickBooks survey found that 32% of self-employed individuals admit they don't report all of their income.

The above threee items indicate to me that a Celebrating Taxpayers Day would be a positive step in building respect for our tax systems, building a culture of filing and paying and being proud of that fact, and improving understanding of our tax systems. And, hopefully have some fun with it!

Why April 30?  Well, people are still busy on April 15 filing and sometimes due to weekends and Emancipation Day, filing day falls on April 16 or 17 or 18.  April 16 is Emancipation Day (the day in 1862 when President Lincoln signed an emancipation decree for the District of Columbia). April 30 gives preparers time to recover, and individuals getting refunds to hopefully have them in time for the celebration. In history, April 30 is the day George Washington was inaugurated (1789), the U.S. Navy was formed (1798), San Jose State University formed** (1857), the ice cream cone was unveiled in the U.S. at the World's Fair in St. Louis (1904), and the World Wide Web emerged in the public domain by Tim Berners-Lee (1989) and its source code was released to the public in 1993.

On April 30, we still have income tax filings on our mind and have time to reflect on such things as, "well, next year, I'll keep better records," or "perhaps I should adjust my withholding." So April 30 would be a good day to help taxpayer get their tax compliance needs in order (January 1 would be better, but we all have too many other things we're focused on then). Also, bills are making their way through Congress, and June and November elections are coming up, and K-12 is still in session.

Yes, there is something called Tax Freedom Day® by the well-respected Tax Foundation. They describe this day as the one marking "how long Americans as a whole have to work in order to pay the nation’s tax burden." For 2019, it is April 16. It isn't a national celebration day though. Also, this information is useful, but I find it is easily misunderstood. Most people do not work until April 16 to pay their taxes but think they do when they hear this information, which harms understanding of our tax system. But it would be a good topic for discussion for April 30 Celebrate Taxpayers Day, to help improve tax literacy and transparency.

So, Celebrating Taxpayers Day on April 30. What do you think?


*See for example, Nellen, "'Oh, I See': Suggestions for Greater Tax Transparency," State Tax Notes, 11/20/17. Also, Nellen, Suggestions for Improved Transparency and Accountability of California Taxes and Related Information, 10/12/18.

**I'm not suggesting April 30 for the SJSU connection. In fact, I wasn't focused on the exact date of the founding of Minns' Evening Normal School (how SJSU started in San Francisco); on campus, we all just say SJSU was founded in 1857 (btw, I'm one of SJSU's historians).

Top Ten Items of Tax Policy Interest for 2015 - #2

Continuing with my list of ten news items and activities from 2015 that I think have particular tax policy relevance. 

#2 - IRS Funding Challenges - Despite an aging workforce resulting in many retirements, a tax statute that is made increasingly more complicated each year, and the need to modernize operational and technology practices, the IRS budget has been cut by over $1.2 billion from FY2010 to FY2015. [See 5/18/15 TIGTA report, Center for Budget and Policy Priorities article on the cuts of 9/30/15 and USA Today article of 6/17/15.]

The May 2015 TIGTA report includes the following graphs showing the decrease in the number of collection officers and a 95% increase in computer downtime due to use of old technology (hardware and software).

Soruce: TIGTA, 5/8/15 Reduced IRS Budget report, page 9

Source: TIGTA report of 5/8/15, page 14

Commissioner Koskinen made statements in two speeches in 2015 that I want to highlight.

1. 11/3/15 at the AICPA National Tax Conference - Government revenues will decline due to reduced workforce and reduced audits. Per Koskinen: "We are especially concerned about the effect that the reduction in our workforce has had on audits. The IRS completed about 1.2 million individual audits in Fiscal 2015. That’s 13,700 fewer than the previous year.
     Even more disturbing, the decline in audits in 2015 was not a one-year aberration. The number for 2015 was 350,000 below five years ago. That’s a drop of 22 percent, and corresponds exactly to the number of revenue agents, which is also down 22 percent since 2010. During that same period, the number of income tax returns filed by individuals topped 146 million, an increase of almost 3 percent from 2010.
     Not surprisingly, we’re seeing clear evidence of a longstanding decline in revenue coming from audits. Between 2005 and 2010, the revenue generated from audits averaged $14.7 billion annually. But since 2010, it has averaged only $10.5 billion a year, which is a drop of nearly 30 percent, and translates to more than $20 billion in uncollected revenue over the past five years.
     These numbers show that when you have fewer employees doing compliance work, you end up leaving tax revenue on the table. In cutting the IRS budget, the government is forgoing billions just to achieve budget savings of a few hundred million dollars, since we estimate that every $1 invested in the IRS produces $4 in revenue. Some estimates are even higher. No one in all my hearings and private meetings on Capitol Hill has ever disagreed with our assertion that if you give us $1, you will get at least $4 back. Nonetheless, the IRS’s budget continues to be cut."
   
2. 3/31/15 before the National Press Club - Problems of an aging workforce and inadequate hiring in recent years. Per Koskinen: "the portion of our workforce over 50 years of age has been growing steadily during the last several years. Today more than half of our employees are in that age group. And we estimate that by next year, more than 25 percent of the IRS workforce will be eligible to retire. By 2019, that number will be over 40 percent. Meanwhile, the number of IRS employees under 30 has been steadily declining, and is now less than 3 percent of our workforce. We only have about 1,900 employees under age 30 – and about half of those are only part-time. And we have only 650 employees who are 25 or younger. Essentially, the IRS is facing its own version of the Baby Bust.
     This situation makes it extremely difficult, if not impossible, for the IRS to properly develop its next generation of leaders. We estimate that by next year 41 percent of our front-line managers and 61 percent of our executives will be eligible to retire.

I am shocked that less than 3% of today's IRS workforce is under age 30.  Obviously, budget cuts and new budget needs (technology needs and dealing with new laws such as the Affordable Care Act) have prevented hiring.  I know it has been a long time since I've had a student tell me they got a job at the IRS, yet many would like to work there. (I worked at the IRS for five years when I was in my twenties!)

Tax Policy Implications of IRS Funding Problems:

• Complexity - Our already complex tax rules that affect all income levels of taxpayers will be even more complex in practice when the IRS does not have the resources to provide the levels of assistance needed to help individuals and businesses comply. I think the IRS has done a good job with the complications of the Affordable Care Act, but more is needed for individuals and both small and large businesses. The level of complexity in this one law alone is staggering.
• Compliance / Minimum Tax Gap - Unfortunately, as more of the public realizes that their chance of audit is even more unlikely than before, some will reduce the level of care regarding the accuracy of their tax return.
• Reduced Revenues - When IRS examination rates go down, revenue collections go down.
• Fairness - If revenues go down due to reduced audit and collection activity, and lawmakers make it up with tax increases on compliant taxpayers, the system loses a lot of its fairness, and taxpayers lose respect for the system.    
• Effect on State and Local Governments - State and local governments that impose an income tax rely heavily upon IRS income tax exams to find errors on the state and local returns. With reduced IRS examination activity, states will need to either accept their reduced revenues or increase their audit activity levels (and to increase the budget of their tax agencies). 

What do you think? 

My list so far of news and activities of 2015 with tax policy relevance (no ranking involved):

1. Congress can alter out tax system via a lot of non-tax bills - here

Guest Post - The True Cost of The American Shadow Economy

A policy goal for a good tax system is that it should minimize the tax gap. The IRS estimates that the gross federal income tax gap is $450 billion. Collection efforts brings that down to about $385 billion per year. That's still a lot and it might be a low estimate.

Here is a guest post from Simon Andrus of Wallace & Associates in Los Angeles on a reason for part of the tax gap.

Every year hundreds of billions of dollars owed to the IRS are never paid. That difference in taxes owed and taxes paid is known as the tax gap. Those unpaid taxes come from one of three categories: underreporting, underpaying, and not filing. Between these three, the tax gap is formed.

As you can see below in the infographic describing the shadow economy, which includes activities that are not declared for tax purposes while cash is exchanged (including, but not limited to the black market), the United States brought in $2.449 trillion in tax revenue in 2012. That’s an incredibly large sum of money, but it would have been even larger if it weren’t for the shadow economy. If all owed taxes were paid, it’s estimated that an additional couple hundred billion dollars would be added to the federal government’s coffers.

That’s nothing compared to our expenditures though. You might think additional revenue of that amount would go a long way towards curing our budget mess, but it’s not even close. In 2012, the U.S. government spent just over $3.5 trillion. So even if the IRS were able to accomplish the near impossible task of collecting all owed taxes, the large deficits would continue.

Surprisingly enough, unfiled taxes don’t contribute very much to the tax gap. The IRS estimates that only 7.8% of the gross tax gap is due to individuals and businesses not filing. The real contributor is underreporting, which accounts for over 80% of the tax gap, but underreporting is almost impossible for the IRS to detect and act on, especially when it involves the self-employed. Because of this, the discrepancy in taxes owed and taxes paid isn’t going anywhere.

The tax gap will persist through time as it always has. Even though many offenders are locked up or fined every year, the practice continues on unhindered. In fact, the IRS estimates that it’s stayed very steady over the last 10 years, and there isn’t much they could do to lower that. For the IRS, there is a silver lining: The United States has the lowest tax gap in the world, when measured as a percentage of GDP.

Infographic on Shadow Economy from Wallace & Associates - click here to see larger version.

 This infographic was designed and created by Wallace & Associates APC – CPA, a certified Los Angeles taxation and accounting agency.

What do you think?

Small businesses, IRS notices and the tax gap - repeal 6050W

A recent article in the Wall Street Journal noted that about 20,000 small businesses (out of millions of them) received notices (Letter 5036) from the IRS that they may have underreported their income ("Small Business in IRS Sights," 8/9/13). The article includes quotes from some small business owners rightfully upset that the IRS presumes they have underreported their income and makes them take the time to explain (again - they already did this on their original filed return) what their gross receipts are. The IRS has acknowledged the sending of notices and offers guidance on how to respond.

The problem ties to Form 1099-K, a requirement added to the law in 2008 (IRC Section 6050W). It requires the companies that process credit and debit card transactions for merchants to issue a 1099-K to the merchant and the IRS showing the amount processed.  Paypal and similar processors also have to file, but there is a de minimus threshold for those types of transactions.

There are reasons why the 1099K might not tie to the merchant's proper amount to report as gross receipts. For example, the small business might be a C corporation using a tax year other than the calendar year used for 1099 reporting. Or, as one merchant notes in the WSJ article, the 1099-K includes the sales tax charged to customers - an amount not reported in the small business's gross receipts because the sales tax belongs to the state, not the business.

When 1099Ks were first issued for 2011, the IRS considered adding lines to business returns to make taxpayers separately show gross receipts from 1099Ks versus other forms (such as cash). They dropped that effort though and the tax from said to enter zero on the 1099K line. Forms for 2012 did not ask for any breakdown. (Compare the gross receipts line on the 2012 Schedule C compared to that of 2011.)  So, it looked like the IRS would not be using the 1099K forms it received. That must have been upsetting to the the issuers who incurred significant costs to be able to issue the forms and to actually issue them.

But the IRS said they did have uses for the forms. For example, if the 1099K amount is greater than what was reported for the gross receipts line on the return, they should ask the owner why.  As noted in the WSJ article, the IRS is also asking why the 1099K amount represents a high proportion of gross receipts (or really, that a small amount of cash receipts were reported).  Perhaps the IRS has some industry data on average percentages of receipts from cash versus credit card.  One person interviewed for the WSJ story indicated he sells items that cost $1000 or more so people tend to use credit cards.

This is all troubling for many reasons that indicate a need for improvements to the filing process and congressional efforts to reduce the tax gap.  Here are a few of my concerns and suggestions:

1. A big part of the tax gap (taxes owed but not collected) is due to cash transactions. So, why in 2008 did Congress enact a provision to make credit card processors issue 1099s?  These transactions already have a paper trail. They should have enacted a measure to help identify unreported cash transactions.
2. It is time consuming and frustrating to have to respond to IRS notices.  And worse here is that the IRS could have asked for the information when the return was filed.  Why not ask businesses to describe their billing and customer payments practices. Also ask what the price range is of services or goods sold and the options customers are given for how to pay (cash, check, debit card, credit card, Paypal, barter). This would/should have prevented sending a 1099 to the business that charges $1,000 or more to each customer.  Also, ask on the return how sales tax is reported and the average sales tax rate used. Then the IRS can better understand whether there might be any underreporting.
3. The IRS should be spending more time finding non-filers and auditing cash businesses - sounds like a better way to reduce the tax gap.
4. Section 6050W should be repealed.  It isn't doing much to help reduce the tax gap. I think this is mainly because it is asking for information that already has a significant paper trail (so is likely to be reported). Also, it interferes with better efforts to reduce the tax gap. For example, a long standing rule (IRC Section 6041) requires businesses to issue a 1099 to someone who provides services to the business and is paid $600 or more.  But what if that service provider is paid via credit card? Then there is double reporting on 1099s (1099 and 1099K).  The effort to prevent this duplicate reporting is error prone, confusing and requires extra recordkeeping by the payors. Repeal 6050W and enact more effective measures to reduce the tax gap.  The GAO has suggested many ideas over the years (as have others).

The House Small Business Committee has sent a letter to the IRS Acting Commissioner with its concerns noted.

What do you think?

Understanding the $600 Billion Annual Federal Tax Gap

A Time magazine article of March 27, 2013, "The $600 Billion the IRS Can’t Collect," by Christopher Matthews, suggests that the federal tax gap is much larger than the IRS estimates. The IRS estimates the gross tax gap at about $450 billion per year brought down to a net gap of $385 through enforcement actions. 

The tax gap is the amount of taxes owed that are not collected, due to both intentional and unintentional errors. The IRS categorizes the federal tax gap as due to three causes: "
non-filing, underreporting and underpayment."

The article refers to research that suggests:

• Taxpayers are more compliant in good economic times than in bad.
• The gap increases when taxes are lower.

These are interesting observations because they indicate the tax gap is due to more than complexity of the tax system and challenges of tracking cash sales. 

$600 billion is a lot of money!  Consider the following comparisons:

• It is about 60% of the roughly $1 trillion annual deficit we've had for each of the last few years.
• It is 25% of the roughly $2.4 trillion of federal taxes collected annually.
• It is about three times larger than the amount of corporate income tax collected annually. 
• The National Taxpayer Advocate describes the $385 billion annual tax gap estimate of the IRS as meaning that "each household [is] effectively paying a "surtax" of some $3,300 to subsidize noncompliance by others." [Click here, page 7.]

While there is budget debate in Congress on whether tax reform should be revenue neutral or also raise revenue for deficit reduction, I hope that there is at least consideration of how reform should result in a lower tax gap.  For more, see my 3/17/13 post on this topic.

What would you suggest be done to reduce the tax gap?

Fixing the tax gap as part of tax reform

Source: IRS Tax Gap - http://www.irs.gov/uac/The-Tax-Gap

How does the net annual tax gap of $382 billion fit into tax reform?  This is a lot of money that is not collected due to both intentional and unintentional errors. For perspectives on understanding the significance of this amount, consider the following:

• Per OMB, the deficit for fiscal year 2011 was $1.3 trillion. The net tax gap represented about one-third of that amount (OMB, Table 1.1).
• Per IRS data, for FY 2011, the net tax gap exceeded net tax collections for the corporate income tax and tax-exempt unrelated business income tax ($175 billion), excise taxes ($47 billion), and estate and gift taxes ($7.3 billion) combined (IRS, Data Book, Table 1).

But, how can this gap be reduced? Much of it is from some businesses not reporting cash revenues. Some suggestions from GAO in a 2007 report include:

• Have the IRS provide assistance to first time Schedule C filers.
• Require Schedule C filers to have a separate bank account for business activity versus personal activity.
• Require consumers to issue 1099s to service providers if they provide a service that will increase the basis of the consumer's property (such as a new roof on your home).
• Require 1099s for payments under $600.

What about having businesses withhold on payments made to non-corporate businesses?  What about more audits of cash businesses?

For more on the tax gap and tax reform, please see my article - Narrowing the tax gap for tax reform, AICPA Tax Insider, 3/14/13.

What do you think? Will Congress consider tax gap measures as part of tax reform work? What do you think will help reduce the tax gap?

Tax Gap and Budget Solutions

In California, SB 1185, the Centralized Intelligence Partnership Act, calls for information sharing and a partnership among various state agencies to reduce the tax gap. The goal is for the agencies "to collaborate in combating illegal underground operations by, among other activities, providing a central intake process and organizational structure, with an administrator and support staff, to document, review, and evaluate data and complaints."

Per the bill, California's underground economy is between $60 and $140 billion each year causing an $8 billion annual tax gap! The bill defines the "underground economy" as:

the activities of individuals, businesses, or other entities that knowingly and intentionally use practices designed to conceal illegal or fraudulent activities that negatively impact legitimate businesses, workers, and consumers, as well as deprive the state and local governments of vital resources."

Governor Brown expects that his November ballot initiative tax increase will generate $8.5 billion in for 2011-12 and 2012-13 (see page 6 of the LAO report on May 2012 budget revision).

And much of that $8.5 billion will come from compliant taxpayers. His initiative includes a 1/4 cent sales tax hike, which unlike a personal income tax hike, is harder for tax evaders to evade (they will pay it when they purchase something, although there are ways people evade the sales tax such as using tax exemption certificates inappropriately or buying out-of-state and not paying the use tax). His initiative also includes an income tax increase for individuals with more than $250,000 of income.

Will SB 1185 bring in that lost tax revenue?  Not all of it, but better efforts are needed to collect at least some of this amount as that is obviously a lot of money. The tax gap results in higher taxes for compliant taxpayers.  

The Revenue and Taxation Committee's analysis (6/29/12) includes a comment from the Franchise Tax Board noting that SB 1185 needs to include funds for the program (!) so as not to delay work. The report includes some helpful information on California's underground economy and the problems it creates for the state. 

At the federal level where we have $1 trillion deficits, we have an annual tax gap of $450 billion!   

I think any tax increase bill to address the deficit needs to include some realistic measures for reducing the tax gap.  Continuing to balance a budget from only compliant taxpayers is neither fair nor sufficient.

What do you think?

Tax gap, tax-cheating software tools and what to do

Zappers are a device that allows some sales to just not get reported. They are also known as “automated sales suppression devices." An article in August 2011 in Governing magazine noted the reality that business owners could remove millions of dollars of sales and income from their records ("In An Uphill Battle, States Fight Tax 'Zappers'" by Holeywell).(Also see this August 2008 New York Times article.)

To help combat them, BloombergBusienssweek reports that five states have enacted legislation outlawing them ("State governments target tax-cheating software" by Adams, 4/3/12). The states: Florida, Georgia, Maine, Utah and West Virginia. This article also notes:

"Boston University tax law professor Richard Ainsworth, an authority on the issue, estimates that 30 percent of the predominantly cash businesses in the states are using tax zappers."

Of course, it is not only the states losing money - so is the federal government. I wonder if any of this is factored into the recent tax gap estimates from the IRS of a $450 billion annual tax gap.

Legislation outlawing the sale or use of these devices sounds like a good first step, but the problem is that people already willing to break the law are unlikely to be deterred by another law they might also find is easy to skirt. The devices can also likely be purchased from outside of the U.S. And there are alternatives such as the old-fashioned approach of just not reporting cash sales.

Additional solutions? There have been proposals in the past to require small businesses to use a single bank account for their revenues and deductible expenses so that reporting from the bank can help the IRS and state tax agencies know what happened. See for example, page 261 of this 2011 GAO report. This isn't perfect, but should help.

What do you think?

Tax Morale and Compliance

The other day I received an email from Dr. Andreas Peichl, Senior Research Associate with IZA (Institute for the study of labor) in Germany. Dr. Peichl directed me to a recent co-authored study - "Nice Guys Finish Last: Are People with Higher Tax Morale Taxed More Heavily?" (Jan. 2012).

"Tax morale" is the "intrinsic motivation to pay taxes" and is influenced by "a cultural aspect" and "national pride" as well as the administrative structure and its enforcement approach (Torgler and Schaltegger, "Tax Morale and Fiscal Policy").

In the Peichl paper, the authors conclude that evidence exists "of efficient taxation of groups with heterogeneous levels of ‘tax morale’." They used a model "where high tax morale implies a high subjective cost of evading taxes. The model predicts that ‘nice guys finish last’: groups with higher tax morale will be taxed more heavily, simply because taxing them is less costly. ... Income groups with high tax morale systematically face higher average and marginal tax rates."

You'll find their 38-page paper here.

In the US, we have a $450 billion annual tax gap much of which is from small businesses. Wage-earners are most compliant with the W-2 reporting form and paycheck withholding helping to give this group high tax morale. That tax morale is bolstered by the W-2 form they receive. Perhaps these folks are also the "nice guys" in the US since the tax on labor is higher today than the tax on investment since 2003 when the rate on qualified dividends dropped from a high of 39.6% to 15% and capital gains from 20% to 15%. Plus, for most workers, all of their wage income is subject to payroll tax of 7.65% paid by them and another 7.65% paid by the employer (total of 15.3%).

What do you think?

New Tax Return Details for 2011 Returns - Closing the Tax Gap

Who wouldn't want to see the $345 billion annual federal tax gap reduced? That's a lot of money! One way to make that happen is to be sure more taxable transactions are reported to the taxpayers and the IRS. In the past several years, we have seen a few of these items added, such as the requirement for brokers to report basis on Form 1099-B for stock sales. We also saw Section 6050W enacted to require processors of credit and debit cards have to report the amount processed for merchants to both the merchants and the IRS (Form 1099-K which is new).

Well, these forms are really only useful to the IRS if they can match them against information on taxpayer's returns. So, for 2011, we'll see a few changes in tax forms. For example, gross receipts lines for businesses will have 2 lines - one for amounts shown on 1099-K (credit and debit cards and Paypal) and amounts not on 1099-K (cash and transactions that did not require a 1099-K or someone failed to provide a 1099-K to the merchant).

New forms and lines are also needed for the basis reporting.

I have a short article on the AICPA website (for the Individual Taxation Technical Resource Panel) that explains the new forms and suggests extra activities taxpayers will likely want to undertake to be sure they are properly reporting these new 1099s and reducing the chance of notices from the IRS. Click here.

Continuing EITC Problems Contribute to Tax Gap

On February 9, the Treasury Inspector General for Tax Administration (TIGTA) released a report on EITC compliance problems. Per TIGTA:

"The Internal Revenue Service (IRS) has made little improvement in reducing improper Earned Income Tax Credit (EITC) payments since 2002, when it was first required to report estimates of these payments to Congress, ... The IRS estimates that 23 to 28 percent of EITC payments are issued improperly each year, which equated to $11 billion to $13 billion in EITC improper payments in Fiscal Year (FY) 2009."

TIGTA's recommendations mostly sound to me like "try harder." I think part of the problem is due to complexity (the EITC eligibility and calculation are some of the more difficult provisions in the law). Some of it may also be due to the EITC built-in incentive to try to claim a high credit, including increasing your taxable income to generate the largest credit amount. For an example of some of the EITC complexity, take a look at this IRS website on the EITC - it seems a bit daunting to me.

Why no better solution? Is the EITC just fundamentally flawed as a way to deliver benefits to low-income workers? Well, it does work for the majority of filers, but a 25% error rate is too high.

Back in 2001, I had an EITC proposal included in the Joint Committee on Taxation's simplification study for Congress (here - summary of page 7 and full text on page 205). It called for a mechanism to get the benefit to workers through reduced or zero Social Security withholding. Part of the concept would have been similar to the Advanced EITC which was repealed recently. I also noted that if we ever went to a return-free system for a majority of individuals, EITC reform would be helpful.

What do you think would reduce the tax gap resulting from EITC errors?

The 1099 Drama Continues

The expanded 1099 filing requirement brought about in the March 2010 health care legislation and calls for its repeal are starting (continuing?) to look like soap opera drama. There have been a few efforts to repeal the requirement, but with the need to find an offset for the roughly $2 billion per year it was expected to generate, it is difficult to repeal. Also, conventional wisdom is that information reporting helps reduce the tax gap. So, what message is being delivered when a 1099 requirement is repealed? Of course, it needs to be appropriate information reporting to have any significant impact on the tax gap.

The latest news is that two efforts to repeal it this week have failed. See a New York Times article of 11/29/10 by Carl Hulse, "Senators Cannot Agree on Fix to the Health Law."

It is also a bit comical perhaps in that there are arguably more pressing matters, such as what to do about the 72 provisions that expired in 2009 as well as the 2001/2003 tax cuts - all matters that greatly affect filing 2010 returns which starts in less than six weeks! The 1099 requirement doesn't start until 2012. Of course, given the challenge of finding revenue to cover repeal, it very well might need to be considered before renewing provisions that expired in 2009.

What a mess!

For more:

• 1099s - The Good, the Bad and the Ugly, AICPA Corporate Taxation Insider, 11/11/10
• Blog post of 11/19/10

Tax Gap in Congress

In case you missed, the Washington Post ran a story on 9/9/10 - "Capitol Hill employees owed $9.3 million in back taxes last year, data show" by T.W. Farnum. It details (without names) how much in back taxes is owed by people who work for Congress including in the Office of Government Ethics. Here is an excerpt:

"638 employees, or about 4 percent, of the 18,000 Hill workers owe money.
The average unpaid tax bill is $12,787 among the Senate's delinquent taxpayers and $15,498 among those working in the House."

What is surprising to me is how many government jobs (apparently most) do no require the applicant to show that they are up to date in paying their taxes. When I worked for the IRS years ago, I had 3 years of tax returns audited as part of the hiring process. I'm not saying that every government job applicant needs to be audited, but there should be a requirement to check that they have filed their federal and state income tax returns. State applicants should be required to also show they paid their use tax!

Also, we should be asking those running for federal, state and local offices to show they have paid their income and use taxes. I mean "we the public" should be asking.

Why not also have an annual check to be sure workers are up to date with tax filings and if not, offer help in getting them filed - referrals to VITA sites, for example.

When paid return preparers register to get their PTIN this month, they will need to confirm that they are current with their filings. At some point, the system won't issue the applicant a PTIN if they have not filed their federal tax return.

Two bills have been introduced in the Senate to address this problem. S. 3790 would make people with "seriously delinquent" tax debt ineligible for federal employment. S. 3791 would "require Members of Congress to disclose delinquent tax liability, require an ethics inquiry, and garnish the wages of a Member with Federal tax liability."

I think these bills are good ideas. As Congress talks about reducing the tax gap, they should be sure that their members and those working to create and support federal laws are following them. Lead by example. And, there are approaches available to most delinquent taxpayers, such as installment agreements, to get past due taxes paid.

What do you think?

S Corporations and the Tax Gap

In December 2009, the GAO released a report, Actions Needed to Address Noncompliance with S Corporation Tax Rules, detailing a variety of errors found on S corporation returns. These include:

• misreporting income
• shareholders claiming losses greater than their basis
• deduction of personal expenditures
• not paying adequate compensation to employee-shareholders

The income misreporting problem generates at least an $8.5 billion annual tax gap. The GAO found that the error rate among returns prepared by paid preparers was not much different from returns that were self-prepared.

I've got a short article on the report, and the relevance of the key findings - S Corporations, Complexity and the Tax Gap, AICPA Corporate Taxation Insider (1/28/10).

President Obama's Task Force on Tax Reform to be Formed

On 3/25/09, Peter Orszag, Director of the White House Office of Management & Budget announced that the President's Economic Recovery Advisory Board (PERAB), chaired by Paul Volcker, will form a Task Force on Tax Reform with a report due 12/4/09. Per Orszag, PERAB's tax group will have 3 tasks:

"one is tax simplification; the second is closing tax loopholes and reducing tax evasion; and the third is reducing corporate welfare. And it's worth noting that with regard to that first category, one of the key things that the Volcker board will be examining is ways of unifying, streamlining, making more consistent the various credits that are out there: Making Work Pay, the Earned Income Tax Credit, the Child Tax Credit, and what have you. And in addition, with regard to the tax gap, there are hundreds of billions of dollars in uncollected taxes each year."

Further, "The Task Force on Tax Reform that will be formed by the Volcker board will be examining ways of being even more aggressive on reducing the tax gap, which could provide funding for tax provisions, including an extension of the Making Work Pay tax credit."

Orszag also noted that President Obama viewed these PERAB members are suitable for the task force: Laura Tyson, Bill Donaldson, and Marty Feldstein.

Well, certainly, the federal tax system is in need of reform - it is too complicated, has a large tax gap and does not necessarily tie to some of our nation's goals such as reducing GHG emissions and improving international competitiveness of US companies.

What can a task force do? Hopefully they will spend time with the thousands of pages of analyses and reports that have been created in recent years - much of it from government agencies, such as CBO, GAO and Joint Committee on Taxation. President Bush had his Federal Tax Advisory Panel - it's report, which is really quite good in the background data on the problems and bold solutions - but was shelved soon after issuance. They can get a good sense of the problems and proposed solutions from these reports to derive what is hopefully a cohesive set of proposals that meet the principles of good tax policy.

Comments on the 3 areas to be addressed:

Simplification:

• In 2001, at the request of Congress, the Joint Committee on Taxation released a simplification study that examined every Code section and made recommendations.
• The AICPA and ABA and others have offered many simplification proposals.
• The current budget proposals from the White House and Congress, as well as current tax proposals should be evaluated to be sure the law isn't made more even more complex while a task force attempts to craft proposals to simplify the tax law.
• How many different energy deductions and credits do we need? Same for education incentives. The desire to solve every problem with a tax provision needs to end or simplification is unlikely to be achieved.

Tax Gap:

• The IRS and GAO has done and continue to do extensive studies on reducing the tax gap. Just do a search at the GAO website on tax gap and you'll find about 3 decades of reports and recommendations. The GAO's January 2009 tax gap report focused on 1009-MISC.
• Information from the IRS can be found here.
• Recent efforts to address the tax gap, such as requiring basis reporting by securities dealers, are good steps, but they avoid the bigger aspects of the tax gap such as the 20% attributable to sole proprietorships (see data and links here). Here is a link to a short piece I wrote recently on the "slow pace" in closing the tax gap and reasons for that slow pace.

"Corporate Welfare":

• I use quotes because I find this term troublesome. Usually it prefers to provisions purposefully added to the tax law to provide a benefit or incentive. Many companies that legally use these rules also pay lots of taxes. If these provisions were not enacted as giveaways to corporations, they should not be labelled that way later when they might get repealed. Many of these provisions were enacted as permanent provisions and may no longer be appropriate. Or perhaps a majority have come to view a lower tax rate as a better (simpler and usually more efficient way), to reduce corporate taxes.
• Reform of the corporate tax rules including provisions pertaining to international transactions and entities sounds like a better label for this third area.
• Another matter to address in corporate tax reform is how other business entities should be taxed - should they all be taxed the same?

While the three areas identified for review are important - particularly simplification and the tax gap (it is hard to know what "corporate welfare" is), so are some additional areas, such as:

• Efforts to have a tax system that supports economic growth, a clean environment and social welfare - rather than running counter to these goals. Some provisions today do run counter to these goals, such as a gasoline excise tax that is too low, education tax incentives that don't help those most in need because they may not owe income tax, and that encourage savings.
• Corporate integration (for more info - click here)
• Improving worker classification rules

The Task Force has big job before it. They will need good ideas. What would you tell them?