By George G. Jones, CCH Staff Writer
The IRS is committed to doing more audits, and better audits, in an effort to clamp down on unreported and underreported income, known as the tax gap. But ultimately, audits alone are not the answer.
"We are not going to audit our way out of this problem of the tax gap," said Kevin Brown, IRS commissioner for Small Business/Self-Employed (SB/SE) Division, at the American Institute of Certified Public Accountants (AICPA) National Conference on Federal Taxes in Washington, D.C., on November 8, 2006. Brown stated that he is looking to more comprehensive third-party reporting as a major solution to underreporting.
Unreported Income
Underreporting is the number-one compliance problem contributing to the tax gap, which reached $290 billion in 2001. Approximately three-fourths of that amount is pegged to small businesses and the self-employed, whose income reporting can be more difficult to verify. Brown observed that taxpayers are 90-percent compliant when income is reported on Forms W-2 or 1099. And compliance rises to 98 percent when withholding is present.
Brown suggested that underreporting could be eliminated significantly through third-party information returns. He further stated that research shows the amount of unreported and underreported income is growing.
As an example of third-party reporting, Brown pointed to the George W. Bush administration's fiscal year 2007 budget proposal to require credit card companies to report to the IRS the credit card transactions of each small business that it services. From the amount reported, Brown reasoned that it would be relatively easy for an IRS examiner to extrapolate--based on the type of business--not only the credit card sales but also what cash likely came into the business. That, in turn, would discourage underreporting in the first place.
To require more third-party reporting, the IRS needs the backing of Congress since additional reporting can be mandated only through legislation. While the IRS saw no success on the Hill in 2006 with regard to increased third-party reporting, Brown is hopeful that Congress will see the logic of the argument in favor of its implementation for credit card reporting and other areas.
Smarter Audits
Brown said that he is not giving up on improving audit performance, even as he calls for increased third-party reporting. He highlighted a number of ways in which audit performance would be improved and is also a proponent of managing audit selection and conduct to drive down the no-change rate to make audits count.
Generally, audits focus on situations in which there is a high probability that something is missing, but Brown also sees merit in the "balanced approach" that "touches" as many taxpayers as possible, either through direct examination or word of mouth by friends or colleagues. He recommends that a portion of IRS audit resources be spent on audit coverage of every sector of the economy and every geographic area.
According to Brown, effective audit management also entails knowing "when enough is enough." He observed that, statistically, 80 percent of the dollar effectiveness of an audit takes place in the first 20 percent of an examination. Rather than spending further time on a complete audit after harvesting that 80 percent, Brown recommends that the examiner move on to the next taxpayer. He also observed that Congress would be more inclined to provide the IRS with additional funds if the IRS could show wise use of existing resources.
S Corporation Audits
Brown responded affirmatively to a question from the audience on whether there has been a step-up in S corporation examinations. He pointed out several reasons for the trend. First, the number of S corporations has more than quadrupled over the past 15 years, while the number of C corporations has remained flat. Second, a National Research Project now in progress calls for thorough audits of 5,000 S corporations to gain statistical information on the size of the tax gap in this area. Brown reported that some audits under the project will be closed out by the end of 2006 and the rest by the end of 2007.
Brown's general impression of S corporations is that "there is a good degree of compliance." However, he did recognize that some troublesome areas exist. One that he highlighted was low salary amounts purportedly being drawn by S owner/employees in order to save on employment taxes and claim additional distributions as "dividends" subject to the lower capital gains rate. He warned that examiners are aware of the practice.
Audit Quality
Brown added another reason why the IRS is not going to solve the tax gap problem through audits alone. Because of turnover and reform, one-third of all revenue agents in the IRS workforce now have fewer than three years of experience. While, previously, no revenue agent with fewer than three years experience would be assigned a corporate audit, Brown reported that the experience squeeze has forced the IRS to abandon that requirement.
- Related items:
- IRS Releases First Fact Sheet To Address Business Income Tax Gap; More To Come
- IRS Reports $345 Billion in Taxes Went Unpaid for 2001 Tax Year
Added to the news on December 5, 2006.
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