The Tax Gap and How It Impacts IRS Compliance Efforts

Periodically the IRS evaluates the level of voluntary compliance and non-compliance when it comes to taxpayers paying the taxes that they should pay. The purpose of the study is to give the IRS information on the scope of the problem by placing dollar amounts on the different areas of non-compliance. The difference between what the IRS believes taxpayers should be paying and what taxpayers are actually paying (either voluntarily or through the governments collection efforts) is known as the Tax Gap.  The IRS estimates that the current annual Tax Gap after all of their collection efforts is $409 billion. Basically, the IRS estimates that taxpayers only pay 83.7% of what should be remitted.

With the detailed information they collect, the IRS creates strategies to improve taxpayer compliance. In other words, the data shows the IRS (1) where taxpayers are underpaying their taxes and (2) where the IRS should concentrate its enforcement efforts.

The Tax Gap consists of three components:

  • Under reporting, which covers the understating of income or overstating of deductions by individuals and businesses.
  • Underpayment, which covers the failure to pay taxes that are reported as being due but never paid.
  • Non-Filing, which is failure to file required individual or business tax returns.

The largest area of the Tax Gap by a significant margin is the under reporting component; it comprises 85% of the total gap. By comparison, underpayment comprises 9% and non-filing comprises 7%.

Each of the three components of the Tax Gap have several sub-components. The sub-components of the Tax Gap which contribute the most to the under reporting of income are the areas where the IRS will most likely focus their collection and enforcement efforts. The sections that comprise more than 10% of the Tax Gap are:

  • Business income from Schedules C, E and F, and from Schedule K-1 that is under reported on individual returns. This sub-component makes up 27% of the total Tax Gap or $125 Billion annually.
  • Failing to pay Self-Employment taxes by improperly classifying income or not correctly reporting income that should be subject to SE tax. This sub-component makes up 14% of the total Tax Gap or $65 Billion annually.
  • Individuals under reporting non-business income. This sub-component makes up 14% of the total Tax Gap or $64 Billion annually.

At this summer’s Nationwide IRS Tax Forum, the Tax Gap and more specifically, the under reporting of business income was identified by IRS representatives and industry professionals as one of the top concerns for the IRS going forward. It was stated that increased actions will be taken by the IRS in upcoming tax seasons to help close the Tax Gap. The IRS and industry professionals offered numerous sessions addressing the shortcomings in tax returns that under report income and singled out the deficiencies on Schedule C and other pass-through businesses that may be subject to added scrutiny in the future.

Later this year, TaxSlayer Pro will be publishing a series of blog articles addressing returns that contain a Schedule C or other pass through business income that could be selected for further review by the IRS. These types of returns may contain indicators that the IRS is looking for to determine whether or not a taxpayer may be under reporting business income. The series will also offer guidance on how to support the amounts reported on these types of returns and how to prepare to respond to the IRS in the event of a possible inquiry.