IRS Needs Help to Decrease $450 Billion in Annual Losses

            The IRS has reported new figures to shed some light on the problem of the ever increasing tax gap, which is now an astonishing $450 billion a year, a 30% increase from five years ago. For those who may be confused, the tax gap is the amount of taxes that are owed but not paid to the US Treasury. This most recent update comes from a measurement of 2006 return data that the IRS compiled and examined from 14,000 random tax returns.

To put the numbers in perspective, many Americans are concerned about the national budget deficit, which was $248 billion in 2006. The tax gap data from the same year for $450 billion is unnerving, to say the least. The IRS is concerned about these figures, so they broke it down to determine where the losses are coming from. They found that $28 billion of the losses came from non-filing taxpayers, or those who don’t file required tax returns. $376 billion was lost to underreporting, or those who don’t report income or overstate deductions and credits on tax returns. And a whopping $46 billion in annual losses came from underpayment from taxpayers who pay less than what they owe.

The IRS set a goal for an 86% voluntary compliance rate for 2009, and Congress’ goal was 90% voluntary compliance by 2017. However, it is becoming clear that the usual methods that the IRS uses, such as notices, audits and voluntary disclosure programs, are not enough. The IRS needs Congress’ help in order to achieve new means of preventing such substantial losses from the tax gap.

In another effort from Congress, the IRS will now receive information from merchant card payers that may help with the compliance issues, set to take effect this year. The IRS is expecting around 56 million new Forms 1099-K that will be used to report credit card payments and third-party payments from banks and other sources such as PayPal. These reports may help trigger more unreported income inquiries by the IRS. Although difficult to determine exactly how much this will help, it is estimated that these new Form 1099-K requirements will generate about $1billion a year in additional tax revenue, and the IRS believes it will have an impact on voluntary compliance for small businesses.  Though hopeful, the legislation is typically unpopular with taxpayers and businesses, and heading into an election year means the IRS will not likely be able to look to Congress for much immediate help.

The IRS has begun streamlining its own compliance efforts. From 2007 to 2010, the IRS used information from the previous two tax gap studies to focus on certain compliance areas. These areas include worker reclassification, where the objective is to properly classify workers and will target small business employers who file more than 85% of all employment tax returns. Another area of focus is S Corporations, where the IRS is particularly interested in taxpayers who deduct S corporation losses, which proved to be overstated on returns by an average of $21,600 per return. Small business audits have become more thorough; the IRS has been examining small business electronic files to hopefully produce better outcomes. Another focus is foreign bank accounts. In 2009 and 2011, the IRS used offshore voluntary compliance initiatives, which found 33,000 taxpayers with unreported foreign accounts, a discovery which brought $4.4 billion to the US Treasury. On Jan. 9, the IRS announced that it has reopened this initiative to foster the taxpayer compliance with foreign bank account reporting. The IRS has also been looking into deputizing practioners. Since 60% of individuals use a tax preparer, and 90% of S corporations and partnerships use a paid professional to do their taxes, compliance is best leveraged through the practioners. The IRS has increased annual educational preparer requirements, increased penalties for preparer negligence, increased due diligence requirements for the Earned Income Tax Credit, and eliminated the IRS “debt indicator” that preparers used for refund-anticipation loans.

The IRS must use a cost-effective approach to face all of these issues. It will use insight from the past two tax gap studies in order to aim and focus its compliance efforts in areas where it can be improved. But, as the new tax gap study reveals, the IRS does not have the means to increase compliance with this approach alone. Substantially narrowing the tax gap will mean legislative chances, such as new information statement requirements and simplification of the tax code, without which future tax gap numbers are likely to continue to increase.