Who’s Not Paying Their Federal Income Tax?

You’ve heard it before: all the uncollected taxes owed to the IRS are almost enough to eliminate the federal deficit. That would make additional money available to California taxpayers who pay more to the federal government than they receive in return. All of us in Los Angeles County, Santa Barbara County, Orange County and Ventura County might see improved infrastructure and services.

How much uncollected federal tax is there? To answer this, the Internal Revenue Service developed the concept of the tax gap as a way to gauge taxpayers’ compliance with their federal tax obligations.

The tax gap measures the extent to which taxpayers do not file their tax returns and pay the correct tax on time. I have not seen a state-by-state breakdown to tell you how much we in California underpay our federal income tax.

The IRS released preliminary results from a major research project assessing compliance with the tax laws. The study shows a majority of American taxpayers pay their taxes timely and accurately, but the U.S. still has a large tax gap.

Not surprisingly, individual income tax accounts for about half of all tax liabilities.

The preliminary findings show the gross tax gap – which is the difference between what taxpayers should pay and what they actually pay on a timely basis – exceeds $300 billion per year.

The tax gap can be divided into three components: underreporting, underpayment and nonfiling.

Underreporting of tax occurs when taxpayers either understate their income or overstate their deductions, exemptions and credits on timely filed returns.

Underpayment occurs when taxpayers file their return but fail to remit the amount due by the payment due date.

Nonfiling occurs when taxpayers who are required to file a return do not do so on time.

Of these three components, underreporting of income tax on Form 1040, employment taxes on Form 941 and other taxes represents about 80% of the tax gap. The single largest sub-component of underreporting involves taking improper deductions, individuals understating their incomes, erroneously claiming credits and overstating business expenses.

Individual underreporting represents about half of the total tax gap. Individual income tax also accounts for about half of all tax liabilities.

To update research done in earlier years and to reflect a changing economy, revisions to the tax code and more subtle shifts in individual behavior, the IRS launched the National Research Program (NRP) in 2001.

For no other reason than trying to obtain a statistical sampling, you may have been selected for audit. If at the end of the audit there was no change, then you probably incurred a great deal of expense either hiring your accountant or tax attorney to represent you. This sort of occurrence happens often and you will not be reimbursed by the IRS for your accounting or legal fees.

The NRP was designed to measure individual taxpayer reporting compliance for tax year 2001 (the latest year for which the study was done). Over the next three years, the IRS randomly selected about 46,000 returns for review and examination. These audits were largely completed by the fall of 2004. To gather statistically valid data, the return selection process for the NRP included an oversampling of high income returns.

For example, about 6% of individual taxpayers filed Schedule C as sole proprietors in 2001. These taxpayers reflect a wide range of economic activity. To draw valid conclusions on Schedule C filers, the NRP examined about 21,000 individuals who filed a Schedule C, slightly less than 46% of the total sample.

The most current data from the NRP are preliminary, so the results are shown as ranges. As refinements are made to the tax gap analysis, some of these estimates may change.

For Tax Year 2001, all taxpayers paid $1.767 trillion on time, a figure that represents from 83.4% to 85% of the total amount due. The 2001 tax gap, the difference between taxes owed and taxes paid on time is from $312 billion to $353 billion for all types of taxes.

Overall, the noncompliance rate is from 15% to 16.6% of the true tax liability. The old estimate, derived from compliance data for Tax Year 1988 and earlier, was 14.9%.

Late payments and other IRS enforcement and compliance efforts, including taxpayer audits and collection activities (payment arrangements, liens, levies and other legal actions) recover some of the Tax Gap. For Tax Year 2001, the IRS expects eventually to collect an additional $55 billion of the tax gap, reducing the net amount of the tax gap to between $257 billion and $298 billion.

Among the areas where taxpayer compliance appears to have worsened are:

Reporting of net income from flow-through entities, such as partnerships and S corporations
Reporting of proprietor income and expenses, such as gross receipts, bad debts and vehicle expenses
Reporting of various types of deductions

Overall, compliance is highest where there is third-party reporting and/or withholding. For example, most wages, salaries and tip compensation are reported by employers to the IRS through Form W-2. Preliminary findings from the NRP indicate that less than 1.5% of this type of income is misreported on individual returns.

More than establishing the overall extent of individual underreporting, the NRP study also offers IRS officials specific insight into the types of income reporting that have the greatest compliance problems. The study helps the IRS update the statistical formulas that assist IRS employees in selecting returns for audit.

When these updated formulas become available for use, IRS employees will be better positioned to select returns for examination that have the greatest likelihood of underreporting. Using such an approach better ensures that IRS audits are focused on the returns most in need of examination.

As the IRS gets busier, so will the tax attorneys who represent those who will confront their tax problem. To discuss your tax controversy, please call Mitchell A. Port at (310) 559-5259.