TAX 'Cheating' by Ordinary Taxpayers

CPA Journal, The, Mar 2007 by Rubenfield, Allen J, Pandit, Ganesh M

Does the Underreporting of Income Contribute to the 'Tax Gap'?

The 16th Amendment to the U.S. Constitution gave Congress the right to levy and collect income taxes. For federal income tax purposes, the Internal Revenue Code defines "gross income" as all income from whatever source derived, except items specifically excluded by the Code (ERC section 61).

The extent to which taxpayers underreport their gross income represents taxes that go unpaid every year. The IRS and the Economic Policy Institute estimate the amount of taxes owed but not paid at $353 billion, equal to about 15% of the total taxes owed. These taxes not paid through our "voluntary and timely" system of taxation are often known as the "tax gap."

Components of the Tax Gap

In 2001, the IRS identified the following as the primary components of the tax gap:

* Underreported business income: $155 billion. This represents taxes owed by small businesses and self-employed individuals.

* Underreported nonbusiness income: $57 billion.

* Underpayment of taxes: $32 billion. This represents the amount of taxes actually reported but not paid.

* Underreported corporate income: $30 billion.

* Overstated adjustments, deductions, exemptions, and credits: $30 billion.

* Taxes evaded through nonfiling of returns: $30 billion.

* Unreported or Underreported FICA and unemployment taxes: $15 billion.

* Unreported or Underreported estate and excise taxes: $4 billion.

The IRS acknowledges that the amount of revenues lost as a result of complex transactions by corporations and wealthy individuals internationally is unclear; it admits that the sum may be far greater than the IRS estimates. The Tax Justice Network (www.taxjustice.net) estimates the extent of taxable wealth outside the reach of U.S. taxing authorities at over $11 trillion (Economic Policy Institute, 2005).

National Taxpayer Advocate Nina E. Olson. in her 2006 annual report to Congress, called the federal tax gap one of the serious problems facing U.S. taxpayers. Much has been written on why the tax gap exists, as well as who cheats, why they do it, and how. In recent years, the Taxpayer Advocate's annual report to Congress has highlighted the significance of the tax gap. It is not uncommon to hear the average taxpayer's mantra that the corporations and wealthy do not pay taxes, or, at the very least, do not pay their fair share. There is no doubt that a variety of people do not pay their taxes for a variety of reasons ("2004 Taxpayer Attitude Survey," MSN Money, December 13, 2005). The most common reason noted is the complexity of the tax code and tax laws. Other reasons include the new and greater regulatory burdens placed upon the IRS at a time when its funding for tax enforcement is severely lagging behind economic growth (Economic Policy Institute, 2005).

It would be impossible to illuminate all of the reasons behind the many forms of tax evasion that constitute the tax gap. The authors have chosen instead to look at just a sample of common situations in which ordinary taxpayers would find themselves, either knowingly or unknowingly, involved in underreporting or unreporting of tax liabilities. This might involve a tax preparer, tax preparation software, or self-preparation. In these scenarios, taxpayers regularly pay the taxes they believe to be owed, and when asked if they ever cheated on their taxes, would generally answer "no."

In this article, the authors ask: If ordinary taxpayers do "cheat" on their tax returns, how do they do it? When looking at that question, one may be tempted to ask another: "Are these taxpayers evading taxation knowingly, or unknowingly?' It is likely that many taxpayers are doing it unknowingly, primarily because the tax laws are complex and go unread by ordinary taxpayers. In the absence of a survey with honest respondents, however, it would be nearly impossible to ascertain the taxpayers' intention. To illustrate the issues involved, the authors looked at five common situations that generate revenues which typically go unreported, and then reviewed the IRC and Treasury Regulations for the relevant tax treatment

Situation 1: Small Insurance Damage Claims

Background. Ms. X is on her way to work in a major metropolitan city. She is driving her 2002 Volvo, which is in excellent condition except for a few dings and scratches. Behind her is Mr. Executive, discussing the day's upcoming events on his cell phone. Ms. X is stopped for a red light when the distracted Mr. Executive fails to stop soon enough and runs into the back of the Volvo. No one is hurt, and damage to the cars is minimal. There is no argument as to who is at fault. The adjuster for Mr. Executive's insurer reviews the damages, writes up an estimate, and in a week Ms. X receives a check for $497.17. After looking over the damage to the car and discussing the situation with her boyfriend, Ms. X cashes the check and does not fix the damage to her car.

Question: Does Ms. X have reportable income?

Answer: Ordinarily, a taxpayer must report a gain if she receives a reimbursement for damaged property in the form of unlike property or cash. If the taxpayer wishes to postpone any gain, she must use the money to restore the property to its predamaged condition (IRC section 1033).