The National Taxpayer Advocate reports to Congress each year on the state of the tax system and the burden on the taxpayer. The latest report, released today, includes some tidbits about the underground economy, sources of the tax gap, and unkind enforcement follies like this one:
- Criminal Investigation Refund Freezes. The IRS Criminal Investigation function (CI), through its Questionable Refund Program (QRP), places a “freeze” on hundreds of thousands of refund claims each year that it believes may contain indicia of fraud. CI personnel currently review the refund claims and “determine” whether they are fraudulent — without notifying taxpayers that their claims are under review and without giving taxpayers an opportunity to present documentation supporting their positions. , the Taxpayer Advocate Service (TAS) received more than 28,000 requests for assistance from taxpayers whose refunds had been frozen. TAS studied a randomly selected sample of nearly 500 cases to determine the ultimate disposition of these cases. When TAS assisted the taxpayers, CI ultimately agreed to issue the full amount of the refund claimed (or more) in 66 percent of the decided cases and to issue a partial refund in an additional 14 percent of the decided cases. Thus, taxpayers received a full or partial refund in 80 percent of frozen-refund cases brought to TAS. The median Adjusted Gross Income (AGI) of these taxpayers was $13,330, and the median refund was $3,519. Thus, the refund constituted, on average, more than 26 percent of the claimant’s AGI for the year, and the taxpayers were required to wait, on average, more than 8½ months to receive their refunds. The National Taxpayer Advocate believes that the QRP is an important program to protect against tax fraud, but the IRS must implement procedures to notify taxpayers that their refunds have been frozen, provide taxpayers with an opportunity to submit documentation, and bring cases to a quicker resolution.
This certainly affects those of us using the DON Method of tax resistance — particularly those of us who rely on getting our refunds before April 15th so we can make an IRA deposit in time to declare it on the previous year’s return.
The report also notes:
- The Cash Economy. Underreported income (and related self-employment tax) from the so-called “cash economy” is probably the single largest component of the “tax gap.” It may exceed $100 billion per year. Because income from the cash economy is not subject to information reporting, many of the IRS’s traditional means of enforcement are unlikely to be effective in addressing it. The IRS has a number of initiatives that could be effective if coordinated and pursued more aggressively. However, no single function coordinates research, outreach, and compliance initiatives aimed at improving reporting compliance among cash economy participants. Nor does the IRS give these initiatives the same level of attention as other initiatives, such as those addressing tax shelters or the Earned Income Tax Credit (EITC). The IRS must develop a comprehensive strategy for addressing the cash economy if it is to significantly reduce the tax gap.
Expanding on this summary, the full report says:
According to the IRS, taxpayers report:
- 99 percent of the income subject to withholding (e.g., wages),
- 96 percent of the income subject to third-party information reporting (e.g., interest), and
- 68 percent of the income not subject to withholding or information reporting (e.g., inventory sales proceeds).
This percentage drops to 20 percent for income earned by certain sole proprietors (called “informal suppliers”) who operate “off the books” on a cash basis in areas such as street vending, door-to-door sales or moonlighting in a trade or profession.…
The IRS has no direct estimate of the portion of the tax gap attributable to the so called “cash economy.” However, according to IRS estimates:
- More than 60 percent of the tax gap is attributable to self-employed individuals.
- Eighty percent of the tax gap is attributable to underreporting of tax.
- About 43 percent of the tax gap, $134 billion to $155 billion, is attributable to underreporting by self-employed individuals.
- Over 80 percent of all individual underreporting is attributable to understated income rather than overstated deductions.
These estimates suggest that self-employed taxpayers who file returns but underreport their income (or self-employment taxes) represent the single largest component of the tax gap, accounting for more than a third of the gap and over $100 billion per year. Further, the IRS’s estimates may understate the portions of the tax gap attributable to the cash economy because such noncompliance is inherently difficult to detect. Taxpayers, including the self-employed, primarily underreport income that is not subject to third-party information reporting, i.e., income earned in the cash economy. Practitioners confirm that the IRS is frequently unable to deter or detect underreporting among cash economy participants.
Research suggests that the cash economy is growing. According to one estimate the “underground economy,” which includes both the cash economy and illegal activities, increased from four percent of the U.S. Gross National Product in to nine percent in . A recent study suggests that between nine and 29 percent of the workers in Los Angeles County California are paid in cash and do not have federal or state payroll taxes withheld. The cash economy may grow even faster as cash transactions move to the Internet.
To address some of this, the Advocate’s office suggests:
- Measures to Reduce Noncompliance in the Cash Economy. The IRS estimates that the annual federal tax gap for was between $257 billion and $298 billion. The IRS receives about 130 million income tax returns each year. Thus, every taxpayer is forced to pay an average $2,000 “surtax” each year to subsidize noncompliance. IRS data show that the highest rate of noncompliance by far is attributable to transactions that are not reported to the IRS on a Form W-2, Form 1099, Schedule K-1, or similar form. These unreported transactions occur largely in the so-called “cash economy.” To reduce the tax burden on compliant taxpayers, we recommend that Congress (1) create a three-pronged reporting and payment system that encourages compliance in certain cash economy transactions by (a) instituting backup withholding on payments to taxpayers who have demonstrated “substantial noncompliance”; (b) releasing backup withholding on payments to “substantially noncompliant” taxpayers who have demonstrated “substantial compliance” and agree to schedule and make future estimated tax payments through the IRS Electronic Funds Transfer Payment System (EFTPS); and (c) providing that payors will not be required to institute backup withholding on payments to independent contractors that present payors with a valid IRS “compliance certificate”; (2) require the IRS to promote the making of estimated tax payments through EFTPS; (3) authorize voluntary withholding agreements between independent contractors and service recipients; and (4) require third-party information reporting for certain payments to corporations with 50 or fewer shareholders.
Probably easier said than done, but I wouldn’t be at all surprised to see some moves in this direction.
Another tax-gap source mentioned in the report is misreporting capital gains and losses on the sale of stocks and mutual funds. Apparently there is no reliable reporting mechanism for the price at which an investor buys such a thing (the “basis”), so when the taxpayer reports the difference between the sale price and the purchase price, the IRS has to either take it on faith or perform a full-scale audit to force the taxpayer to cough up documentation:
Many financial institutions through which investors own stocks and mutual funds (“brokers”) do not currently keep track of an investor’s basis in the stocks or mutual funds, and no brokers report basis information to both taxpayers and the IRS on a Form 1099-B. The absence of information reporting creates serious problems for many taxpayers and the government alike. For taxpayers, tracking basis can be extraordinarily complex and many taxpayers seeking to comply with the law find that they simply cannot do so with accuracy, leaving them exposed if audited. From the government’s perspective, the absence of information reporting enables underreporting by taxpayers who deliberately overstate their basis (thereby reducing their gain or even generating a loss), because they know the IRS generally cannot detect errors in basis reporting in the absence of an audit. One recent estimate puts the revenue loss to the government from such underreporting at $250 billion over the next 10 years.