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The famous tax gap:

The Tax Gap is the difference between
taxes owed and taxes actually collected. The
IRS estimates the Tax Gap in 2001 was $345
billion. With roughly 71% of this “gap” attributed
to individual non-compliance and errors,
Congress is putting pressure on the IRS to find
ways to bring more individual taxpayers into
compliance and collect over $245 billion in
legally owed taxes, thus, increasing revenues
without raising taxes.

Congress demands answers
In April 2007, U.S. Treasury Secretary
Henry Paulson testified before Congress that
reducing the Tax Gap may not be possible
without “draconian and painful requirements
on all taxpayers.” Senators did not receive this
news well, with Senator Max Baucas expressing
his frustration that the IRS did not have, in
his opinion, a real plan to close the Tax Gap.
Baucas requested the Treasury revise its current
plan to include benchmarks, timetables
and goals by mid-July 2007.

In a July letter to Senator Baucas,
Paulson indicated the Treasury will have
such a plan to present in “the next few
weeks.” Senator Bacucas indicated he was
fine with the delay, saying, “I’d rather the
Treasury Department take the time necessary
to get it right than to provide the
committee with an incomplete plan.”
Responsibility for the gap

The IRS estimates the majority of noncompliant
returns belong to self-employed
individuals who do not report their businesses’
entire income. One IRS official has
estimated that cash-based businesses report
as little as 19% of their actual income. As a
result, the IRS has submitted a strategy to
Congress, focusing on small businesses and
individual taxpayers. Underreporting of business
income cost the Treasury $109 billion
in income tax in 2001. By comparison, IRS
figures show it lost just $14 billion to individuals
inflating their deductions.

IRS offers possible solutions
One interesting suggestion by the IRS is to
require credit card companies to report payments
to any sole proprietor of more than
$600 in a year, similar to the 1099 reporting
rules. Proprietors would be required to provide
their tax identification numbers to the
credit card companies or face the prospect of
being subject to backup withholding.

The IRS has also acknowledged that the
complexity of our tax code is the single biggest
factor affecting taxpayer compliance. One of
their recommendations does include simplifying
the tax code, but enforcement appears to be
the plan of attack in the mean time.

The IRS also has suggested that brokerages
and other third parties boost reporting on
individuals’ investments, and they would like to
make repeat offenders who willfully fail to file
their returns eligible for a felony charge rather
than a misdemeanor.

We have certainly not seen the end of this
debate, and as tax professionals, we should
make our clients aware of potential changes
coming in the near future. l