By George Jones and Alison L. Reynolds, CCH News Staff, and Paul N. Gada, CCH Financial Planning Toolkit Staff Writer
If you've ever wondered where your tax dollars go, you are not alone. It seems that the IRS is also wondering about where its tax money has gone.
The IRS has released the final 2001 tax gap figures based on estimates from the IRS's National Research Program (NRP). The tax gap is the difference between what taxpayers should have paid and what they actually paid on a timely basis. The new estimate reveals that a tax gap of $345 billion exists for tax year 2001. This is on the high end of the previously released estimates in March 2005 of $312 billion to $353 billion for the year.
Through enforcement activities, the IRS was able to collect $55 billion of that 2001 shortfall to reduce the gap to $290 billion for 2001. However, billions of dollars are still slipping through the IRS’s fingers and you can bet it will be looking to prevent this from happening in the future.
Findings
The latest numbers are the result of a three-year study of about 46,000 tax returns filed by individuals in 2001. The last major study of its sort was conducted in 1988. At a press briefing on February 14, 2006, IRS Commissioner Mark W. Everson reported that "the good news from the report is that 85.5 percent of the tax money owed is coming in correctly." He added that "the vast majority of Americans pay their taxes accurately; [however, they] are shortchanged by those who don't pay their fair share."
According to the results, 80 percent of the gap is due to underreported taxes, while nonfiling and underpayment of tax make up the remaining part of the tax gap. The study also examined the amount that was misreported on a given line item and compared it to what the amount should have been on that line, called the net misreporting percentage (NMP). This process revealed that the highest compliance rate was achieved in connection with income for which third-party reporting was required.
Highlights of the gap estimates chart include:
- Total Non-Business Income: $56 billion tax gap, 4 percent net misreporting percentage.
- Wages, salaries, tips: $10 billion tax gap, 1 percent net misreporting percentage.
- Total Business Income: $109 billion tax gap, 43 percent net misreporting percentage.
- Nonfarm proprietor income: $68 billion, 57 percent net misreporting percentage.
- Rents & royalties: $13 billion tax gap, 51 percent net misreporting percentage.
Everson remarked that the tax gap was largely the result of underreporting of income, rather than the overstating of deductions. He did not address whether, as a result, examinations of Schedule A, Itemized Deductions, would be fewer in the future.
In any case, those bored with the tax gap statistics above should perk up and read them again for good measure. It stands to reason that the IRS will focus its efforts in areas where it stands to recoup the most money. If you fall into one of the groups above, this means you. Now keep reading!
Contributing Factors
In addition, Everson pointed out that the complexity of the tax law is a major reason for the tax gap. He believes that, while "helping taxpayers better understand their obligation under the current tax law will facilitate compliance. . .simplifying the tax code would have a big impact on reducing the tax gap." As others at the IRS have observed, simplification of the tax code will not only reduce mistakes but also present fewer opportunities for intentional error.
Everson did not speculate on what percentage of underreporting was the result of willful noncompliance as opposed to a lack of understanding of the tax code. Nevertheless, he did emphasize that the areas in which underreporting was more prevalent were those for which third-party information reporting was not required. He pointed to business income in contrast to wage income as an example. There, instances of underreported business income were 100 times higher than underreported wage income: "a dramatic difference," he observed.
Whatever the cause, Everson believes the cure to be increased third-party reporting, coupled with a refinement of the audit process made possible through the new information gained from the NRP.
Improving the System
The IRS announced that it will continue to take all reasonable steps to improve compliance through targeted enforcement and increased help through taxpayer services. The Service has already updated the audit selection system with the new NRP information.
Nevertheless, Everson emphasized that the latest survey would influence how audits are conducted more than cause a reallocation of resources within the examination process. "We try to run a balanced program," he stated, insisting that he is satisfied with present enforcement allocations. He looks forward to using the results of the NRP, however, to improve enforcement procedures within each segment and to work with Congress to enact the president's latest enforcement proposals. That combination, he predicted, "will give us the lift" needed to continue to close the tax gap.
Repeated in the IRS news release was an outline of the president's fiscal year 2007 budget proposals design to reduce the tax gap, including measures to:
- expand third-party information reporting to include certain government payments for property and services;
- expand third-party information reporting on debt and credit card reimbursements paid to certain merchants;
- clarify liability for employment taxes for employees leasing companies and their clients;
- expand beyond income taxes the requirement that paid return preparers sign returns and impose penalties for failure to do so; and
- authorize the IRS to issue levies to collect employment tax debts prior to collection due process proceedings.
At the press briefing, Everson stressed that the enforcement proposals in the president's budget plan were still in the developmental stage; that the details must be worked out together with Congress. Nevertheless, he reported that action would be taken to move the first two proposals onto Capitol Hill as quickly as possible.
In the meantime, the IRS’s enforcement efforts are getting a major boost as a result of the Department of the Treasury Appropriations Act, 2006, enacted at the end of last year. In addition to funding the IRS at its highest level in history ($10.67 billion), the funding law provides $4.725 billion for enforcement, an increase of $362 million over FY 2005. A significant provision of the funding law also substantially limits the IRS's discretion to transfer funds from its enforcement budget. This means that the IRS will keep a tight and well-funded focus on audits, collections, and criminal investigations in 2006.
Reaction
Reaction to the report by members of Congress was mixed. Ranking Senate Finance Committee member Max Baucus (D-Mont.) said that the administration's current plan of action to close the ongoing "tax gap" is unacceptably weak. He advocated a number of much bolder steps by the administration and by the Congress to close the tax gap. "Unfortunately, the administration's budget plans won't take any real bite out of this unacceptable tax gap. . .the administration is proposing a $3.5 billion solution to a $3.5 trillion problem," Baucus said in a written statement.
Finance Committee Chairman Charles E. Grassley (R-Iowa) commented, "Today's tax gap numbers show that the only thing harder than measuring the tax gap is finding ways to solve it. There's been a tax gap as long as there's been taxes... There's no quick, easy solution."
Although there may not be a quick and easy solution as Sen. Grassley states, the IRS seems to be on the fast track for shrinking the tax gap in the future. As taxpayers, this means steering clear of IRS audits and other enforcement efforts. With this in mind, have a happy and audit-free tax filing season.
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Added to the news on March 8, 2006.
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