Understanding the Tax Gap and what it Means to you

There’s a new buzz phrase in Congress that has legislators salivating at its revenue potential. What is it and what does it mean to the average citizen? It’s called the Tax Gap and because Congress is very interested in it so is the IRS. So just what is the Tax Gap and why is it so important to the very people that pass laws that have a tendency to separate us from our hard-earned money?

According to Congress the Tax Gap is an estimate of the difference between the taxes individual, corporate, employment, estate, and excise that the IRS believes should have been paid on time voluntarily, and what was actually paid for a specific year. In other words, the Tax Gap is the difference between the tax that taxpayers should pay and what they actually pay on a timely basis.

So what? Well, the Tax Gap in 2001 has been valued at 345 billion dollars. Yes – billions of dollars, and that’s just for 2001! Expectations are that the amount is significantly higher for subsequent years and because it’s such a large amount of money and Congress is convinced it should have been paid in the first place, legislators are eager to get their hands on it.

There are daily news reports of looming deficits due to all the economic strains on the economy, and the pending explosion of Medicare and Social Security benefit payments for aging boomers in the coming years. Given this, Congress and states are looking to raise funds wherever and however they can without raising the income tax rates of people whose votes they need to stay in office. The premise of the Tax Gap is that since it is money that should have been collected in the first place it does not amount to a tax increase and therefore is not a political issue.

So just who is contributing to the Tax Gap and are you one of them?

A 2004 study by the IRS National Research Program (NRP) for Congress identified three primary sources of the Tax Gap that include non-filing, underreporting and underpayment.

Non-filers are individuals or businesses where the IRS has information reported from other sources that indicate money has been paid to these groups but they have failed to file a tax return for whatever reason. It’s possible that a refund would have been calculated but without a tax return actually filed the IRS computers calculate the tax based on incomplete information in their systems. Moreover, if a taxpayer waits more than three years to file a tax return any credits that the taxpayer was entitled to will expire. The taxpayer is still obligated to file but without the benefit of the tax credits the taxpayer can easily transition from receiving a refund to owing money to the IRS.

Of the three Tax Gap sources listed above underreporting by individuals is the largest noncompliance component amounting to 197 billion dollars in 2001 alone and which is why Congress is so eager to close the gap. Underreporting includes understating income, improper deductions, overstated expenses, and erroneously claimed credits. Let’s look at the behavior associated with each of these and how the IRS detects them on each of our individual tax returns.

With regard to understating income, this typically happens when individuals pay someone in cash for a service or a product. For example, the person who provides home daycare might ask her clients to pay in cash and not provide her Social Security Number (SSN) so that the payer doesn’t report the transaction on the payer’s individual tax return in the form of the Child/Dependent Day Care Credit, which would then alert the IRS to the transaction. This credit is a very generous one so Congress and the IRS dangle it in front of taxpayers to discourage them from working with people or businesses that avoid paying taxes. The credit also rewards people who play by the rules.

Improper deductions include charitable deductions – cash and/or non-cash. Over the years the IRS has been tracking how much each of us claims for charitable contributions and analyzing that data by region and income brackets to gauge how realistic our “write-offs” are with respect to our individual tax profiles. Recent changes in the tax law will now require more proof that the amount we claim is legitimate.

An example of an overstated expense is the basis of a capital asset that an individual sells. Capital assets include stocks, a house, fine art, jewelry or anything that the taxpayer has purchased as an investment with the intent of selling at a profit. Over the years, Congress has relaxed the rules on taxing profits from the sell of a primary residence but there are very strict rules about which house is a primary residence when taxpayers own more than one home.

Stocks include those that are purchased outside of a sheltered account, such as retirement funds. Capital gains tax is typically applied when individuals purchase stock on their own, through a broker or as part of an employee purchase stock option where they work. When the taxpayer sells that stock they will either realize a gain, a loss, or break even – and it will either be short-term or long-term which impacts on the rate at which it is taxed. The taxpayer needs to know the date that the stock was purchased and sold, how long it was held and the basis of the stock. Short-term stock is held for one year or less and long-term stock is held for more than one year. The basis is the purchase/acquisition cost plus any allowed expenses such as broker’s fees. This basis is compared to what the stock sells for and the result is a gain, a loss or zero.

Until very recently the only information reported to the IRS was the sell price of the stock, the sale date and the number of shares sold. It was the taxpayer’s responsibility to supply the IRS with the cost basis and date acquired by filing a Schedule D with their tax return. The only way the IRS could verify this information was through an audit. The IRS is now requiring financial institutions that sell stock for individuals to include more information that helps the IRS determine the correct basis of the stock sold. This is called third-party verification because it involves someone other than the taxpayer. The IRS has the authority to fine the third party if due diligence is not exercised in reporting the information.

Erroneously claimed credits involve someone intentionally or “mistakenly” taking a credit on their tax return that they are not legally entitled to take. Credits have a significant impact on the amount of taxes owed or the amount of refund received. This is because credits are a dollar-for-dollar reduction of tax liability. These credits can be very generous depending on the individual’s tax profile.

An example of tax credit abuse is the Earned Income Credit (EIC). EIC requires a qualifying dependent and often taxpayers claim dependents they are not legally entitled to claim which incorrectly qualifies them for the credit. Because of the tendency for abuse, Congress and the IRS consider credits such as EIC as high-target audit areas.

So, the bottom line for taxpayers is to ensure that they only take those credits and deductions that they are legally entitled to and that they claim all taxable income received regardless of the source. After years of decline, the number of audits the IRS conducts of individual tax returns is increasing in response to mandates from Congress to close the Tax Gap for the past three and future years. The best defense taxpayers have against becoming part of the Tax Gap is to use reputable tax preparation software or a reliable tax preparation service.

For more information go to www.irs.gov and see the following publications and links;

– Use the term “tax gap” to search for the latest updates
– 17 – Your Federal Income Tax (For Individuals)
– 523 – Selling Your Home
– 525 – Taxable and Nontaxable Income
– 526 – Charitable Contributions
– 529 – Misceallaneous Deductions
– 551 – Basis of Assets
– 552 – Recordkeeping for Individuals