DeConcini McDonald Yetwin & Lacy, P.C. - Attorneys at Law

Tax Law Special Report
June 2005

YOUR TAX DOLLARS AT WORK EVALUATING
COMPLIANCE WITH THE TAX CODE

By Nathan Hannah

I know tax season is over, but I just couldn’t resist telling you about a new report from the Internal Revenue Service about tax compliance. I wonder if they released it right around April 15 on purpose.

The IRS has released preliminary results from a major research project assessing compliance with the tax laws. The study, which involves tax year 2001, finds that the national net tax gap (that’s just federal taxes) is over a quarter trillion dollars. The IRS says that it intends to reduce the gap with increased enforcement efforts. The initial tax gap findings came from a three-year study called the National Research Program, which audited 46,000 individual income tax returns for 2001.

The preliminary findings show that the gross tax gap, i.e., the difference between what taxpayers should pay and what they actually pay on a timely basis, is more than $300 billion per year. IRS enforcement activities, coupled with late payments, should recover about $55 billion of the gross tax gap, leaving a net tax gap of between $257 billion and $298 billion. Overall, the noncompliance rate is from 15% to 16.6% of the true tax liability, up from the old estimate of 14.9% according to data for 1988 and earlier.

The IRS has increased enforcement revenues, that is, the amount collected through enforcement efforts, by nearly 28% from $33.8 billion in 2001 to $43.1 billion in 2004. That's because, since 2001, IRS has taken a number of steps to bolster enforcement. One area of increased enforcement is in audits of individual tax returns. The IRS increased audits of taxpayers earning $100,000 or more annually to over 195,000 taxpayers in fiscal year 2004, which is more than double the number conducted in 2001. Total audits topped 1 million in 2004, representing a 37% jump from 2001.

The tax gap has three components: underreporting of income, underpayment of taxes and non-filing of returns. The new study shows some decline in tax compliance among individual taxpayers since the last study was conducted in '88. Preliminary findings of the study include the following:

Underreporting accounts for more then 80% of the total tax gap, with non-filing and underpayment at about 10% each.
Individual income tax is the single largest source of the annual tax gap, accounting for about two-thirds of the total.
More than 80% of individual underreporting comes from understated income, not overstated deductions.
Most of the understated income comes from business activities, not wages or investment income.
Compliance is highest where there is third-party reporting or withholding.

The IRS has received an increase in funding for enforcement and says it is moving aggressively to reduce the tax gap. The next stage of the National Research Program will be to finish the data analysis and refine the tax gap data in late 2005. The IRS will use the data to update its statistical tools for selecting individual returns for audit. Just what you wanted to hear so soon after tax season, right?

It’s hard to argue with the numbers that say that the tax gap is increasing, and that 80% of individual underreporting comes from understated income, rather than from overstated deductions. I can’t help wondering, however, wonder how much of the tax gap is attributable not to deliberate or willful noncompliance, but to noncompliance due to the ever-increasing complexity of the Internal Revenue Code. In other words, how much of what the IRS call underreporting is really due to taxpayers and tax preparers simply being unable to achieve 100% accuracy on the tax returns they file?

GOOD NEWS ON THE FEDERAL TAX FRONT -
CONGRESS IS CONSIDERING NEW TAX-PREFERRED SAVINGS VEHICLES

On March 8, the Savings Account Vehicle Enhancement, or "SAVE," initiative was introduced in the House of Representatives. SAVE proposes new types of accounts that are designed to encourage savings, simplify the tax rules for tax-preferred savings, and provide a better, more responsive, simpler system for Americans to accumulate personal savings for retirement. The initiative would create the following new types of accounts:

Lifetime Savings Accounts (LSAs), which could be used for any type of savings, including education, a new home, healthcare needs, or even seed money to start a small business. An LSA would allow any individual to contribute $5,000 a year (indexed for inflation) and make penalty free withdrawals at any time and for any purpose. Contributions would not be deductible, but earnings and distributions would be tax-free.

Retirement Savings Accounts (RSAs) would allow individuals to contribute up to $5,000 per year (indexed for inflation) in savings for retirement regardless of their income. RSAs would replace traditional IRAs, nondeductible IRAs and Roth IRAs. Contributions would not be deductible, but earnings would accumulate tax free and distributions after age 58 (or death or disability) would be tax free.

Employer Retirement Savings Accounts (ERSAs), which would consolidate 401(k), thrift, 403(b), and governmental 457 plans as well as SARSEPs and SIMPLE IRAs into a single account, Employer Retirement Savings Accounts (ERSAs), which could be sponsored by any employer.

Simple is good. Simple and tax-preferred is better.