The Tax Gap

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October 8, 2009

The "Tax Gap" is a very popular term nowadays in tax circles. Stated simply, the Tax Gap is the difference between what individuals and businesses are supposed to pay in taxes and what they actually pay. In the U.S., taxpayers voluntarily report their income, deductions, credits and amount of tax they owe (although, of course, the IRS uses a variety of information from employers and third parties to check compliance). As a result, there are three primary sources of the Tax Gap:1

• Underreporting (82%): stating that one's tax liability is less than it actually is. This most commonly results from reporting lower income (particularly business income) than actually received, but also stems from taking excessive tax deductions and credits.
• Underpayment (10%): not paying the full amount owed on time.
• Non-filing (8%) not filing required returns and not paying the associated income tax liability. For example, people who are paid "under the table" (they do not have wages reported to the IRS) usually do not file tax returns or pay taxes.

The IRS estimated the tax gap at $345 billion per year, using data from tax year 2001 and earlier. Given the size of the amounts involved and the ever-increasing federal deficits and debt, the Treasury Department and IRS are spending a lot more time focusing on this problem.

The Treasury Department and IRS have developed a fairly comprehensive strategy to deal with the Tax Gap. We won't bore you with the details, but, stated goals and strategies indicate:

• Require more information reporting. For example, credit and debit card processors will begin reporting to the IRS credit and debit card payments made to merchants in 2011. There is also a proposal requiring individuals owning rental property to file information returns (like a 1099-MISC) for services performed on rental properties.
• Step-up the use of technology. IRS is stepping up its use of technology to better weed out sources of underreporting and nonfiling. As an example, the Treasury Inspector General for Tax Administration (TIGTA) suggested that IRS use mortgage interest statements to weed out those who reportedly paid more in interest and estimated living expenses than they reported as income.
• Increasingly move toward e-filing of returns. About 40% of returns are still filed on paper, though that number is expected to decline rapidly. However, many corporations are required to e-file and paid tax preparers are being increasingly required to use e-file. Because e-file reduces errors and increases tax administration efficiency, it is likely that the Treasury Department will increasingly mandate the use of e-file.
• Instate more -- and higher -- penalties. Penalties for noncompliance are likely to become both more numerous and larger. Examples could include penalties for repeat non-filing, for use of abusive transactions or for failing to e-file when required.

Two recent examples come to mind when thinking about the change in attitude about the Tax Gap. First, and most publicly, the IRS recently obtained the names of some individuals who were hiding assets in offshore bank accounts, to investigate them for noncompliance. Smartly, the IRS instituted an amnesty program so that holders of offshore accounts could "come clean" about tax noncompliance and pay lower interest and penalties than they might have otherwise. Second, the IRS instituted large penalties against businesses that used listed tax shelter transactions. The IRS was so successful in instituting penalties that they had to suspend them because a number of small businesses were getting unintentionally penalized.

The end result of all this is that the IRS is likely to step-up examination, audit and collections efforts. We suspect that, as a result of new information reporting and technology enhancements, the IRS will likely issue many more automated notices and correspondence audits than they do currently.

How we can help. If you have recently found yourself on the receiving end of an IRS notice or audit, we can represent you to the IRS and help you resolve your issues with a minimum of hassle. If you have not been audited but know that you are in noncompliance (by, say, underreporting or not filing), we can help you fix your tax returns and bring you into compliance.

As always, you can contact us any time and we will be happy to assist you.