Tax Gap and 1099s

While there weren’t a lot of tax changes that affected individual tax returns for 2011, many taxpayers saw changes on the forms they prepare to report their income. Schedules C, D, E and F were revised to report income that will be coming from the new 1099Ks. Because of confusion about what should be reported on the 1099Ks and how that information is to be calculated, the IRS didn’t require 1099K info to be reported on 2011 returns. Congress also repealed the extensive 1099MISC reporting that businesses and rentals were supposed to begin issuing. Now the American Institute of CPSs (AICPA) is asking the IRS to delay matching basis information on 2011 1099Bs against the amount reported on taxpayer’s tax returns. The AICPA is citing confusion by brokers and taxpayers on basis calculation and requesting better standardization of formatting. The new rules for 1099B reporting and the creation of the 1099K as well as the general tightening of the reporting requirements for any Form 1099 were made to reduce the Tax Gap.

The Tax Gap is the difference between the tax that taxpayers should pay and what they really pay on time. It includes both individual and business returns and the gross tax gap estimated to be about $450 billion dollars for 2006. (Calculating the Tax Gap requires extensive audits and information from other sources and isn’t done every year.) Of the gross tax gap, $65 billion will get paid leaving a net tax gap of $385 billion.

While there are a variety of factors contributing to it, the IRS breaks the Tax Gap into three broad issues. The first issue is tax money not received because the taxpayer didn’t file their return. For 2006, the IRS estimated that $28 billion in tax money was lost because taxpayers and estates didn’t file (and pay) their tax return. The second issue is underpayment of tax. These are returns that have been filed but the balance due wasn’t paid on time. This Gap for individuals was about $36 billion in 2006. The major factor contributing to the Tax Gap is underreporting of income on filed returns. This is estimated to be about $376 billion for 2006.

Who’s responsible for the Tax Gap? The IRS has discovered that it’s the individual taxpayer. Of the total Tax Gap, 66% is because of individual tax returns. That percentage rises to 80% when underreporting is separated out from non-filing and not paying. While there are shortfalls in employment, corporate and excise taxes, the big problem is caused on individual returns. Underreported income includes business income reported on the Schedules C, E and F, non-business income from wages and investments, and offsets to income and tax through deductions and credits.

Currently, the IRS matches the information from tax returns to what has been reported by information returns like W-2s and 1099s. Where they can do that, underreporting income is easier to catch and prevent. A taxpayer may “forget” to report wages from one of their W-2s but she’ll get a letter in a year to 18 months wanting any extra tax caused by the missing income. And I bet she won’t “forget” again.

That is why the changes to the 2011 forms. Congress has created new income reporting laws. The IRS can use these 1099a to match to tax return info and hopefully, reduce the tax gap. Unfortunately, these programs have been delayed (or a delay in matching is requested) for now. The IRS has also increased the penalties for late and non-filing of required 1099s. While the more expanded 1099 reporting requirements for businesses have been repealed, I expect to see cleaned up versions in the future. With luck, better income matching will mean more taxes paid and less chance for tax increases to offset the Gap.

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