The IRS just released their latest study of the “tax gap” covering tax years 2008 through 2010, which offers a broad view of the nation’s compliance with federal tax laws. The IRS now estimates the average annual tax gap at $458 billion, and the voluntary compliance rate at 81.7 percent. The last tax gap study performed in 2006 estimated the annual tax gap at $450 billion, and the voluntary compliance rate at 83.1 percent. The gross tax gap is the difference between the amount of tax imposed on taxpayers for a given year and the amount that is paid voluntarily and timely. It represents, in dollar terms, the annual amount of tax noncompliance.
The current estimated gross tax gap is $458 billion. The net tax gap is the gross tax gap less tax that will be subsequently collected, either paid voluntarily or as the result of IRS administrative and enforcement activities; it is the portion of the gross tax gap that will not be paid. It is estimated that $52 billion of the gross tax gap will eventually be collected resulting in a net tax gap of $406 billion. The 2008–2010 gross and net tax gap estimates ($458 billion, $406 billion) are 1.8 percent and 5.5 percent higher, respectively, than the previously released 2006 estimates ($450 billion, $385 billion).
The voluntary compliance rate (VCR) is a ratio measure of relative compliance and is defined as the amount of tax paid voluntarily and timely divided by total true tax, expressed as a percentage. The VCR corresponds to the gross tax gap. The estimated VCR is 81.7 percent. The net compliance rate (NCR) is a ratio measure corresponding to the net tax gap. The NCR is defined as the sum of “tax paid voluntarily and timely” and “enforced and other late payments” divided by “total true tax”, expressed as a percentage. The estimated NCR is 83.7 percent.
The tax gap results confirm that the compliance rate is high for income that is subject to third-party information reporting, and even higher when there is withholding of estimated future tax obligations. The extent of coverage by information reporting and/or withholding is called “visibility” because incomes that are reported to the IRS are more “visible” to both the IRS and taxpayers. Misreporting of income amounts subject to substantial third-party information reporting and withholding is only 1 percent; of income amounts subject to substantial information reporting but not withholding, misreporting is 7 percent; and for income amounts subject to little or no information reporting, such as nonfarm proprietor income, misreporting jumps to 63 percent.
The IRS believes that differences between the 2008-2010 tax gap estimate as compared to the estimate for 2006 are mostly a result of the overall decline in the nation’s tax revenues due to the severe recession, as well as improved estimation techniques. IRS efforts to enhance the voluntary compliance rate include increased educational efforts aimed at preparers and taxpayers; ongoing efforts to improve compliance in the international tax arena; and working with businesses on employment tax issues.
Roadmap to Future Tax Enforcement Efforts. The gross tax gap map for 2008 though 2010 (and for 2006) is composed of three components: nonfiling, underreporting, and underpayment. The estimated gross tax gaps for these components are $32 billion, $387 billion, and $39 billion respectively. The gross tax gap estimates can also be grouped by type of tax. The estimated gross tax gap for individual income tax is $319 billion, for corporation income tax is $44 billion, for employment tax is $91 billion, and for estate and excise tax combined is $4 billion. The estimated net tax gap for individual income tax is $291 billion, for corporation income tax is $35 billion, for employment tax is $79 billion, and for estate and excise tax combined is $1 billion.
Since the “Tax Gap” represents unpaid taxes any estimate is, at best, a WAG (wild-guess). However, it represents the best WAG currently available and provides significant guidance in defining the present allocation of limited IRS tax enforcement resources and assists in making future tax policy decisions seeking more cost-effective ways to increase overall voluntary tax compliance.
The bigger tax enforcement targets are, quite obviously, the tax gap components having the most significant compliance problems underreporting ($382 billing), underpayment ($39 billion) and nonfiling of required returns ($32 billion). By type of tax, those most concerned should be individuals ($319 billion), those with employment tax issues ($91 billion), corporations ($44 billion) and those facing estate and excise tax issues (a combined $4billion).
Employment tax issues are currently receiving a heightened look from both the Department of Justice and the IRS. IRS Commissioner John Koskinen recently stated “The IRS is committed to working with the Justice Department to protect this important area, and there’s a long list of efforts we’ve taken in both civil and criminal investigation areas when employers try to evade their legal responsibilities and, in the process, gain an advantage over their competitors who are honoring their legal responsibilities.” According to statistics provided by IRS Criminal Investigation, in the 2015 fiscal year, individuals convicted of employment tax crimes were sentenced to an average of 24 months in prison.
Increased information reporting to the IRS and expedited reporting by the IRS with state and foreign governments have a significant impact on the federal and state versions of the tax gap. As a result of various electronic matching programs, the government can better identify taxpayers who have underreported or not reported income or have otherwise failed to file returns. Hunting for under-reporters and non-filers has gotten significantly easier as we move further into the electronic age lessening the historical need for “in person” audits tax returns by the IRS.
Will Increased Tax Penalties Help Enforcement Efforts? The “kinder, gentler” IRS of years ago led to an unprecedented decline in IRS enforcement. Declining enforcement relies on a strong voluntary compliant constituency. Increased penalties do not increase compliance; increased tax enforcement increases compliance. Increased penalties only increase penalties on a smaller class of taxpayers actually discovered by a relatively ineffective taxing agency. A low examination rate may only encourage certain taxpayers and practitioners to push the compliance envelope since a low risk of detection could then be deemed worthwhile.
Reduced IRS Budget and Now Increased Enforcement Staffing. Significant reductions to the IRS budget over the last several years have had a negative impact on their tax enforcement efforts. Current IRS funding is now $900 million below what it was in 2010, and IRS has 17,000 fewer full-time employees – more than 5,000 of those employees have been in the area of tax enforcement.
After Congress provided $290 million specifically for taxpayer service, identity theft and cyber-security, IRS was able to add more than 1,000 Wage & Investment employees to assist taxpayer phone lines. The large number of retirements and attrition among enforcement employees is now going to be partially replaced by a just announced addition of between 600 and 700 new IRS employees in the area of tax enforcement – representing the first significant new enforcement hiring in more than five years!
The first wave of new hiring announcements will be in the next few weeks, with announcements being posted internally and externally for many entry-level positions, primarily in SB/SE. These revenue agents, revenue officers and other enforcement positions will be posted in locations around the country. Criminal Investigation special agents and some positions in W&I and Chief Counsel will also be part of this initial wave of hiring. As more personnel are brought on board, IRS anticipates a second wave of hiring later in 2016, providing employees with promotional opportunities for higher-level enforcement positions, including in LB&I, SB/SE, TE/GE as well as positions in IRS Appeals. Employees in the second wave of hiring will assist with high-profile enforcement areas, including international tax issues, refund fraud and identity theft.
Additional resources are essential for the IRS to hopefully reduce the annual tax gap. When you look at the IRS overall, every dollar invested returns at least $4 to the Treasury. The numbers are even higher when it involves enforcement. Each enforcement position typically returns almost $10 to the U.S. Treasury for every dollar spent — and in many instances, much more. Congress and the IRS must determine an appropriate level of tax enforcement resources taking into account the balance between taxpayer service and enforcement activities, and competing federal priorities. The perception of fairness (or unfairness) and complexity of our current tax system also contribute to the tax gap – fundamental tax reform and simplification is necessary to achieve significant reductions in the overall tax gap.
The IRS continues to be resource-challenged. It must maintain an appropriate presence in each taxpayer and professional neighborhood – not only in the high rent district. Initiatives administered without strong detection and enforcement efforts will not likely succeed. However, perceptions as to detection and enforcement are keys to an effective compliance response. The strategic placement of an empty police car will have a more significant impact than a motorcycle officer hiding in the bushes.
Improved Audit Selection Process. Tax law is complex; tax returns are incredibly complex. Complex, detailed examinations of taxpayers are not easily concluded. Neither the taxpayer nor the IRS examiner have any desire to unnecessarily prolong the audit process and there is frequently a good working relationship developed that somewhat accelerates the overall examination process. However, the IRS often has little if any information initially available to help it determine whether the tax returns were substantially accurate as filed.
Auditors audit, that is the purpose of an IRS examination. Audits directly detect and correct noncompliance by the audited taxpayers and indirectly create an environment to encourage non-audited taxpayers to voluntarily comply. The presence and visibility of the IRS among varying taxpayer communities creates an inherent deterrent effect to those who might otherwise ignore their filing and reporting requirements. Again, even an empty police car parked in a visible location will cause people to slow down or stop, where appropriate.
Tax gap data assists the IRS in filtering potentially noncompliant returns for audit using a multiphase process intended to narrow the large pool of available returns to those that most merit investment of limited audit resources. For audits to be conducted in the field, this process generally includes (1) identifying an initial inventory of tax returns that have audit potential (e.g., reporting noncompliance), (2) reviewing that audit potential to reduce the number of returns that merit selection for audit (termed “classification”), (3) selecting returns by assigning them to auditors based on a field manager’s review of audit potential given available resources and needs, and (4) auditing selected returns.
The IRS Small Business / Self Employed operating division the SB/SE uses 33 separate methods, called work-streams, to identify and review filed tax returns that may have significant audit potential. SB/SE initially identifies returns through seven sources which include referrals; computer programs that run filters, rules, or algorithms to identify potentially noncompliant taxpayers; and related returns that are identified in the course of another audit.
The IRS Wage & Investment operation division conducts correspondence audits—an audit conducted through mailed correspondence between the IRS and the taxpayer being audited. Audit programs in W&I mainly cover refundable credits reported on the Form 1040, Individual Income Tax Return. Most W&I returns are selected via computer systems that automatically send notices to taxpayers based on certain criteria, such as the validity of dependents. Most are selected with a specialized computer tool called the Dependent Database (DDb), while the remainder are selected through a combination of referrals and manual selection methods.
Improved Classification of Returns Actually Selected for Audit. IRS classifiers use their technical expertise, local knowledge, and experience to identify hidden, as well as obvious, issues within a return. Classifiers also consider whether the taxpayer has insufficient income for the lifestyle indicated on the return, including efforts to determine family size and personal living expenses in relationship to the income stated on the return.
Classifiers use various guidelines when identifying individual returns issues for examination. They will review the amount by which the itemized deductions exceed the standard deduction and verify that itemized deductions are not claimed elsewhere on the return when the standard deduction has been elected (e.g., personal real estate taxes and mortgage interest deducted on rental schedule). Exemptions claimed by the non-custodial parent often have a significant audit potential. When married persons file separately, both taxpayers may not have made the same election for standard or itemized deductions. If dependent children are claimed, there will be an effort to determine whether the other spouse might also be claiming them.
Changes in address will be considered when reviewing real estate taxes (e.g., Form W–2, Form 1040, Form 2119). Classifiers will check to see if charitable contributions exceed 50 percent of adjusted gross income (AGI), large donations made to questionable miscellaneous charities, payments which may represent tuition, and large dollar non-cash contributions. Gains on sales of rental and other depreciable property, where the taxpayer has been using an accelerated method of depreciation are often questioned since the taxpayer may have to report ordinary income. Loss on the sale of rental property, recently converted from a personal residence, is also a frequent issue. Current year installment sales and exchanges of property are also scrutinized given the potential errors in computing the recognized gain. There may also be issues to determine whether the reported gain is large enough to require the alternative minimum tax computation.
When reviewing issues involving rental properties, the classifier will consider whether repairs might instead be capital improvements, whether the cost of land is included in the basis, and consider passive activity rules if rental losses are greater than $25,000. In searching for potential unreported income, the classifier might look to determine whether the income is sufficient to support the claimed exemptions; tip income for those having a stated occupation as waiter, cab driver, porter, beautician, etc., tip income is a productive issue; substantial interest expenses with no apparent source of funds to repay the loans; claimed business expenses for an activity that shows no income on the return (e.g., beautician supplies, but no Form 1099 or Form W-2, Wage and Tax Statement, for that occupation). Expenses for clubs, yachts, airplanes, etc., are often productive audit issues as failing to satisfy the facilities definition of IRC 274. Claimed employee business expenses should be reasonable when compared to the taxpayer’s occupation and income level.
Future Tax Enforcement Efforts? Few other countries can boast of a tax compliance rate of over 80%! However, all agree that a non-compliance rate approximating 20% amounting to several hundred billion dollars per year is clearly unacceptable in our self-assessment tax system. Consider that a one-percent increase in voluntary compliance will increase tax receipts by about $30 billion in tax receipts! Appropriately funding appropriate IRS tax enforcement efforts can significantly impact the tax gap going forward. . .