National Taxpayer Advocate

186 Pages·2008·2.2 MB·English

e 2007 Annual Report to Congress
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Preface . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . v b
1 . A Comprehensive Strategy for Addressing the Cash Economy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
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2 . Study of the Role of Preparers in Relation to Taxpayer Compliance
with Internal Revenue Laws . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44

3 . Effect of Tax Increase and Prevention Reconciliation Act of 2005 o
on IRS Offer in Compromise Program . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 76
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4 . IRS Earned Income Credit Audits - A Challenge to Taxpayers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94
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5 . Simulating EITC Filing Behaviors: Validating Agent Based Simulation
for IRS Analyses: The 2004 Hartford Case Study . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 118
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6 . Normative and Cognitive Aspects of Tax Compliance: Literature Review and
Recommendations for the IRS Regarding Individual Taxpayers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 138
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Preface: Introductory Comments of the National Taxpayer Advocate
Preface I
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Over the years, I have stressed the importance of research to achieving effective tax t
administration . Accordingly, the Office of the Taxpayer Advocate has committed significant r
resources to studying issues that impact taxpayer compliance . Volume 2 of the 2007 National o
Taxpayer Advocate Annual Report to Congress reports on six of these studies .
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In selecting research initiatives, the National Taxpayer Advocate and the Taxpayer Advocate
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Service (TAS) Office of Research seek answers to questions or empirical confirmation of
assumptions that have significant import to tax administration . Moreover, because the National c
Taxpayer Advocate and the IRS may have different research priorities or different approaches
to the same problem, we do not duplicate research the IRS is already conducting . No TAS t
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research project, however, could be accomplished without the assistance of the IRS National o
Office and Operating Division Research staffs . I am extremely grateful for their insights,
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support, and cooperation .
This year, our research studies fall into two categories: first, a comprehensive strategy to
address cash economy noncompliance; and second, an attempt to better understand what
drives taxpayer compliance . In the first instance, I must admit some frustration with the
perceived wisdom that it is almost impossible (and certainly too costly) to positively impact
the cash economy tax gap .1 This study is our response to that assumption . In it we set forth
specific measures that we believe should be implemented immediately or warrant further study,
all of which are promising in their ability to significantly improve tax compliance in the cash
economy . We submit them to engender discussion and, most importantly, action .
The studies in the second category are quite diverse but have one thing in common – they
all attempt to shed light on why taxpayers comply with the tax laws and what helps them
comply . From our study of Earned Income Tax Credit (EITC) audit barriers and the impact of
representation on the outcome of EITC exams, to a computer simulation of EITC filing behavior
in the Hartford, Connecticut certification initiative, to our study of the impact of recently
enacted Offer in Compromise payment rules on the ability of taxpayers to file successful offers
– each of these studies looks at the burdens, barriers, and influences on taxpayers in filing,
payment or compliance initiatives, and seeks to identify practices that would mitigate if not
eliminate the burdens and barriers .
TAS commissioned two other studies in this second category from two highly respected
academics – Professors Leslie Book and Marjorie Kornhauser . These studies include surveys
of existing research and scholarship and provide insightful observations on two important
1 Although there is no universally agreed-upon definition of “cash economy,” we use the term to mean taxable income from legal activities that is not re-
ported to the IRS by third parties. This definition can include businesses dealing strictly in cash as well as others that handle a portion of their transactions
in cash or receive other payments not subject to information reporting. For example, a retailer who receives most of his revenue through debit and credit
cards can be considered part of the cash economy because these forms of payment are not subject to information reporting.
Taxpayer Advocate Service — 2007 Annual Report to Congress — Volume Two v
Table of
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Preface: Introductory Comments of the National Taxpayer Advocate
issues: the role of tax preparers and practitioners in tax compliance, and what factors motivate
taxpayers to comply with the tax laws .
I believe all of these studies will serve as a baseline for future research, both within and
outside of the IRS . They certainly inspire one to question and explore, even as we go about our
day-to-day tasks in tax administration . For without that inquisitive spirit, and the willingness
to follow where it leads, tax administration will lag behind the world in which it operates . If
anything, what this volume demonstrates is how much you can learn if only you ask .
Nina E . Olson
National Taxpayer Advocate
31 December 2007
vi Preface — Introductory Comments of the National Taxpayer Advocate
Table of
2007 Annual Report to CongCronetenstss
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2007
Annual Report to Congress
Cash Economy Preparers and EITC Audit EITC Certification Table of Table of
TIPRA and OIC Tax Morale
Strategy Compliance Challenges Simulation Contents Contents
A Comprehensive Strategy for Addressing the Cash Economy
A Comprehensive Strategy for Addressing the Cash Economy
Table of Contents
Executive Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
Composition of the Tax Gap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
What is the Cash Economy? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Why Focus on the Cash Economy? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Cash Economy Businesses Account for Largest Category of Misreporting . . . . . . . . . . . . . 11
Cash Economy Expected to Grow . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
IRS Has Fewer Tools for Addressing the Cash Economy . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
Challenges in Addressing the Tax Gap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
Create a Cash Economy Program Office . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
Improving Income Reporting Compliance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
Making Reporting Compliance Easier . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
Improve Outreach Efforts to Small Business Owners . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
Simplify Guidance on Tax Rules that Confuse Taxpayers . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
Improving the Visibility of Business Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
Create an Income Database . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
Require Reporting on Credit Card Payments to Merchants . . . . . . . . . . . . . . . . . . . . . . . . . 15
Require Banks to Report Existence of All Individual and Merchant Bank Accounts . . . . 16
Require 1099 Reporting for Small Corporations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
Reverse Matching against State and Local Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
Add Line on Schedules C for Form 1099 Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
Develop Ratios of Cash to Credit Card Receipts by Industry . . . . . . . . . . . . . . . . . . . . . . . . 19
2 Section One — A Comprehensive Strategy for Addressing the Cash Economy
Table of Table of EITC Certification EITC Audit Preparers and Cash Economy
Tax Morale TIPRA and OIC
Contents Contents Simulation Challenges Compliance Strategy
A Comprehensive Strategy for Addressing the Cash Economy
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Capture Information from Forms 8300 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
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Improving the Productivity of Audits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
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Initiate Single Issue Gross Receipts Audits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

Simplify the Tax Code . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
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Conducting Research on the Direct and Indirect Effects of Audits . . . . . . . . . . . . . . . . . . . 22
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Increasing the Focus on Preparers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
Conducting Research on Attitudes toward Tax Compliance . . . . . . . . . . . . . . . . . . . . . . . . . 24 o
Improving Payment Compliance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
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Making Payment Compliance Easier . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
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Encourage More Frequent Estimated Payments through EFTPS . . . . . . . . . . . . . . . . . . . . . 25
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Send Reminder Notices to Taxpayers for Estimated Payments . . . . . . . . . . . . . . . . . . . . . . 26
Allow Voluntary Withholding Agreements between
Independent Contractors and Service Recipients . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26 y
Using Collection Alternatives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
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Improving Filing Compliance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
Making Filing Compliance Easier . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28 t
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Educate Taxpayers about Filing Requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
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Additional Research on Nonfilers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
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Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
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Appendix A – Tax Gap Map . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
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Appendix B – Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
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Taxpayer Advocate Service — 2007 Annual Report to Congress — Volume Two 3
Cash Economy Preparers and EITC Audit EITC Certification Table of Table of
TIPRA and OIC Tax Morale
Strategy Compliance Challenges Simulation Contents Contents
A Comprehensive Strategy for Addressing the Cash Economy
Executive Summary
The IRS estimates that the gross tax gap – the difference between what taxpayers owe
and what they pay voluntarily and timely – amounted to $345 billion in tax year 2001 .1
Underreported income from the “cash economy” – income from legal activities that is not
subject to information reporting or withholding – is probably the single largest component
of the tax gap, likely accounting for over $100 billion per year .2
The National Taxpayer Advocate believes the cash economy deserves special attention be-
cause of its size and the likelihood that it will become an even larger problem in the future .3
This paper presents a strategy for addressing the cash economy through administrative
changes within the IRS and legislative changes to the tax law . The goal is to find solutions
for improving voluntary compliance by making it easier for cash economy taxpayers to
understand and meet their tax obligations, and to improve the tools available to the IRS for
enforcing the tax laws when necessary .
The proposed strategy is a comprehensive approach that addresses numerous interrelated
issues that impact taxpayers operating in the cash economy . It includes recommendations
in the following areas:
„„ Overall Recommendation – Establishing a Cash Economy Program Office;
„„ Making Compliance Easier;
„„ Improving Income Visibility and the Productivity of Audits;
„„ Increasing the Focus on Preparers; and
„„ Conducting Research on Attitudes toward Tax Compliance .
A summary of the principal recommendations follows .
Overall Recommendation
The IRS should establish a Cash Economy Program Office . This office would have respon-
sibility for implementing an overall strategy for addressing the cash economy, coordinating
the use of tools for identifying the underreporting of income and nonfilers, and promoting
a research agenda that addresses the unique issues associated with the cash economy .
1 IRS, National Research Program, tax year 2001. The net tax gap for TY 2001 is estimated at $290 billion, which accounts for another $55 billion of tax
revenue as the result of taxpayers paying late or from IRS enforcement actions.
2 See IRS News Release, IRS Updates Tax Gap Estimates, IR-2006-28 (Feb. 14, 2006) (accompanying charts). Underreporting makes up about 83 percent
of the tax gap ($285 billion of the $345 billion gap). Underreporting of business income by individuals – from sole proprietors, rents and royalties, and
passthrough entities – accounted for about $109 billion. Id. Associated underreporting of self employment taxes by unincorporated businesses accounts
for another $39 billion. Id.
3 The IRS projects that the number of individual small business returns will grow by over 13 million by fiscal year 2014. In contrast, individual returns, with
their high degree of information reporting, are expected to decrease during the same period. IRS Document 6292, Fiscal Year Return Projections for the
United States: 2007-2014 (June 2007).
4 Section One — A Comprehensive Strategy for Addressing the Cash Economy