IRS, Treasury, and Congress Attempt to Identify Problem and Find Solutions
The Tax Gap is the difference between taxes owed and taxes actually collected. The IRS estimates the Tax Gap in 2001 was $345 billion. With roughly 71% of this “gap” attributed to individual non-compliance and errors, Congress is putting pressure on the IRS to find ways to bring more individual taxpayers into compliance and collect over $245 billion in legally owed taxes, thus increasing revenues without raising taxes.
Congress Demands Answers
In April 2007, U.S. Treasury Secretary Henry Paulson testified before Congress that reducing the Tax Gap may not be possible without “draconian and painful requirements on all taxpayers.” Senators did not receive this news well, with Senator Max Baucas expressing his frustration that the IRS did not have, in his opinion, a real plan to close the Tax Gap. Baucas requested the Treasury revise its current plan to include benchmarks, timetables and goals by mid-July 2007.
In a July letter to Senator Baucas, Paulson indicated the Treasury will have such a plan to present in “the next few weeks.” Senator Bacucas indicated he was fine with the delay, saying, “I’d rather the Treasury Department take the time necessary to get it right than to provide the committee with an incomplete plan.”
Responsibility for the Gap
The IRS estimates the majority of noncompliant returns belong to self-employed individuals who do not report their businesses’ entire income. One IRS official has estimated that cash-based businesses report as little as 19% of their actual income. As a result, the IRS has submitted a strategy to Congress, focusing on small businesses and individual taxpayers. Underreporting of business income cost the Treasury $109 billion in income tax in 2001. By comparison, IRS figures show it lost just $14 billion to individuals inflating their deductions.
IRS Offers Possible Solutions
One interesting suggestion by the IRS is to require credit card companies to report payments to any sole proprietor of more than $600 in a year, similar to the 1099 reporting rules. Proprietors would be required to provide their tax identification numbers to the credit card companies or face the prospect of being subject to backup withholding.
The IRS has also acknowledged that the complexity of our tax code is the single biggest factor affecting taxpayer compliance. One of their recommendations does include simplifying the tax code, but enforcement appears to be the plan of attack in the meantime.
The IRS also has suggested that brokerages and other third parties boost reporting on individuals’ investments, and they would like to make repeat offenders who willfully fail to file their returns eligible for a felony charge rather than a misdemeanor.
We have certainly not seen the end of this debate, and as tax professionals, we should make our clients aware of potential changes coming in the near future.
Individual Income Tax is the Single Largest Source of the Annual Tax Gap
Individual Tax Gap includes:
- nonfiling
- underreporting
- nonbusiness income
- business income
- overstated deductions, credits, exemptions
- underpayment
Preliminary NRP results indicate that the individual income tax accounts for about two-thirds of the Tax Gap.