Tuesday, July 3, 2012
A $450 billion annual tax gap prompts Treasury to pursue aggressive compliance techniques. Earlier this month, I attended the AICPA Practitioners Symposium and TECH+ Conference, along with more than 1,600 CPAs and marketing professionals. The three-day conference offered more than 150 interesting technical and marketing sessions. One such session was presented by Jim Buttonow, vice president of product development, and Brian Howell, product manager, for Beyond415, a web-based software developed by New River Innovation Inc. of Greensboro, N.C. Buttonow started his presentation by asking the participants a question: “What does an average firm spend 66 days a year on, but only bills for 28% of the work?” His answer: “The flood of hundreds of millions of IRS notices being sent annually.” The IRS sends more notices annually than the number of taxpayers, so businesses and individual taxpayers can all expect to be contacted more than once by the IRS. The increased volume of notices sent and audits conducted by the IRS and state and local tax authorities unnerves almost any client, and it can put a strain on the CPA-client relationship—even when the CPA didn’t make any errors. Buttonow outlined the ongoing “tax gap” problem faced by Treasury. The problem is complex. The United States has one of the highest tax-compliance rates in the world, with an estimated underground economy of 8.7%, versus other countries’ higher rates, e.g., Russia, 45%; China, 20%; and Great Britain, 16%. However, because of the massive U.S. economy, the combined cost of noncompliance from underreporting, nonfiling, and nonpayment is projected to be a whopping $450 billion annually. With an estimated U.S. deficit of more than $1.3 trillion for fiscal year 2012, according to the White House Office of Management and Budget, collecting a substantial portion of the $450 billion tax gap would allow Congress to keep tax rates down and/or retain certain programs—so the IRS is clearly focused on reducing the tax gap. According to the IRS’s latest study, the projected federal tax gap has three causes: 84% is related to underreporting of taxable income and taxes on returns; 10% is related to underpayment of taxes reported by taxpayers or assessed by the IRS; and 6% is related to nonfiling of tax returns. Because state taxable income is generally tied to reported federal taxable income (assuming a return is filed), tax gaps are also present at the state level—as well as growing deficits resulting from the four-year economic downturn. To close the federal tax gap and help reduce the federal deficit, the IRS is continuing to focus on some of its tried-and-true compliance enforcement techniques. It is also testing some new techniques. The following is an overview of areas the IRS is likely to focus on during the next decade, according to Buttonow: 1.Do more with less. For fiscal year 2012, the IRS’s budget was cut by $305 million. Even though the IRS is expected to receive a budget increase in 2013, it will have more programs to administer, including implementing provisions of the new health care law. The IRS employs more than 90,000 people and has more than 192 data systems. Streamlining these systems and using technology for compliance initiatives are some of the IRS’s primary objectives. Technology provides the IRS with the best return on investment (ROI). The cost for GS-4 agents to handle mail audits is as low as $11.75 per hour, yet these audits can average returns of $4,578 per hour. Auditors who handle field audits are paid approximately $24 per hour, and these audits yield an average of $330 per hour in new assessments. Therefore, we can expect to see more computer-matching and mail-driven compliance programs now and in the future as the IRS seeks to leverage information and technology to close the tax gap. 2.Increase compliance rate to 90% by 2017. The voluntary compliance rate is the amount taxpayers actually pay versus what they should report and pay. The most recent IRS study of U.S. taxpayer compliance rates was completed in January 2012 and measured noncompliance on 2006 tax returns. The study reported a voluntary compliance rate of 83.1%, which falls within the 83% to 84% range that has prevailed for the past 27 years. The IRS goal for 2009, which will be measured in three years, is 86% voluntary compliance. The IRS hopes to raise the compliance rate to 90% by 2017, which would reduce the current $450 billion tax gap by about 40% to $266 billion. Every 1% increase in compliance would generate at least $27 billion—so a 6% improvement in the most recently published compliance rate of 83.1% would be expected to increase revenue by $184 billion. 3.Focus on high-yield assessments. Areas in which the IRS has found significant underreporting noncompliance will continue to be a focus of compliance activity, including audits, in coming years. These areas include: ◦High-income individuals. ◦Worker classification: W-2 vs. independent contractor. ◦S corp. losses claimed in excess of basis. ◦Rental property losses: passive vs. active, as well as basis issues. ◦General small business underreporting of taxable income. ◦Form 1099 filing compliance. ◦Review of international taxpayers/FBAR, etc. 4.Increase tax document matching. The IRS is pleased with its ability to computer match documents such as Forms 1099, W-2, etc., which results in a 99% compliance rate in reporting those amounts. However, for certain small businesses (e.g., S corps., partnerships, Schedule C filers), the compliance rate is only 44% because not all small business revenue is subject to computer matching of tax documents. As reflected above, automated compliance systems and office audits can produce significant ROI. In 2011, 70% of compliance audits were conducted via mail, and 30% were field audits. In 1995, the ratio was 54% mail audits to 46% field audits. Based on ROI, this trend toward more automated, higher ROI compliance activity will continue. It is interesting that the annual volume of IRS notices has increased sevenfold since 2001. The IRS issued 201 million taxpayer notices in 2009, up from 30 million in 2001. These are invariably hardcopies, so we can conclude the IRS does not have a very effective paperless program. 5.Simplify the Code. There have been 4,426 tax law changes in the past 10 years, and the Internal Revenue Code gets more complex every year. Some portion of the tax gap is related to valid confusion among taxpayers as well as some CPAs. Simplifying the Code would greatly reduce unintentional errors. Buttonow noted that any progress toward tax simplification this year is highly unlikely, but late congressional activity to extend the Bush tax cuts is more likely. Any late changes to the Code would add to unintentional errors. 6.Regulate and deputize tax professionals. The IRS is spending resources in educating and regulating tax preparers to remove “bad players” in the tax preparation arena and, where necessary, is imposing and expanding significant penalties on preparers and their clients. The IRS’s focus on requiring tax preparers to meet certain requirements and register to be part of a database has thinned the ranks from 1.2 million tax preparers to 850,000 registered tax return preparers. In theory, this raises the bar and compliance level of those remaining tax preparers. Of course, there will always be a “gray market” element with tax preparers who aren’t registered in the database, but the IRS is watching. 7.Mandate disclosures. Over the past few decades, the IRS has increased the level of detail tax preparers must include in their returns. Failure to make those disclosures can result in civil penalties and sometimes even criminal penalties. Examples include: ◦Schedule UTP, Uncertain Tax Position Statement. ◦Form 8275, Disclosure Statement. ◦Form TD F 90-22.1, Report of Foreign Bank and Financial Accounts (FBAR). Buttonow points out that these trends will also be adopted in whole or in part by state and local tax authorities. There are 50 states, 3,033 counties, 19,492 municipalities, and 16,519 towns throughout the United States—all looking to plug increasing deficits. The bottom line? CPAs need to inform their clients that the IRS and other tax authorities are aggressively auditing taxpayers, and that clients can expect an increase in notices and audits. In many circumstances, compliance activity has little to do with how the return was prepared. The IRS and states are increasing compliance activity because they now have the ability to do so easily with more information and more sophisticated, automated compliance systems. With a $450 billion annual tax gap, those efforts could go a long way to reducing annual $1 trillion deficits. Expect the compliance activity to remain high as the government looks to balance its budget.