In last year’s Annual Report to Congress, Olson identified “underreported income (and related self-employment tax) from the so called “cash economy” [as] probably the single largest component of the “tax gap.” Returning to the problem of underreporting in 2006 the report says that Internal Revenue Service (IRS) data indicate that 99-percent of income earned by wage earners is reported on a tax return, yet only about 43-percent of income earned by self-employed persons is reported.

Basker Johnson, who is a practicing CPA in Sapulpa, Oklahoma, thinks the noncompliance figure, 80-percent of which comes from underreported income, is probably well understated. He sees two contributing factors – the highly visible cash economy and self employed individuals, who provide paraprofessional services like information technology, setting themselves up as corporations.

Since employers or clients are not required to issue 1099’s to corporations, the IRS has no way to document total income of individuals who have set themselves up this way. The IRS does a pretty good job of matching up 1099 Misc. with Schedule C, Johnson says, but should require that 1099s be issued to corporations. Kent L. West, whose CPA firm is in Mooreland, Oklahoma, agrees and says that he can’t understand why the IRS does not issue 1099s to corporations. West thinks that the use of 1099s should be expanded -- to report payment for services, material and labor.

For many small businesses, the incentives to pay wages in cash– avoiding paying payroll taxes and workers comp insurance -- are very powerful, Johnson says. He cites a client, a contractor who had consistently issued W-2s to all of his workers who was also consistently underbid by other contractors who paid in cash.

The IRS estimates that excessive deductions represent only 20 percent of the gap. Nevertheless, some deductions for home office are a problem, Johnson says, because they may not be business-related.

Fred Imel, whose practice is in Yukon, Oklahoma, points out that in the larger society there is an assumption that everyone will be paying his or her fair share, but he did not assign the blame exclusively to individuals who are engaged in the cash economy.

Accountants are not employees of the government, Imel says, but as citizens they share the feelings of the public the tax system should apply to everyone. They also have an important role to play. “If a client breaks the law, and some will tell their accountants because they want someone to share the guilt,’ he says, “the accountant has the obligation to change the client’s tax position or fire the client.”

“There is also a certain element of culture behind the cash economy that is hard to combat,” Imel says. “If your Daddy and Granddaddy transacted some of their business in cash, it doesn’t seem so bad.”

West points out that it can get pretty expensive when a business owner is caught in an IRS audit because he deducted employee wages as a business expense, but did not issue W-2s and pay employment taxes, and the IRS reclassifies the deduction as wages. “He has to pay Social Security and Medicare taxes at both ends, state taxes, insurance, penalties and interest.” West says that some business owners pay cash wages to help workers avoid garnishments.

IRS enforcement efforts directed at individuals who are engaged in the cash economy have been limited, the Taxpayer Advocate report says, “because at a practical level, the IRS lacks the resources to close the tax gap through audits alone. The examination rate is currently less than one percent, and the majority of examinations are limited-scope examinations conducted by mail.” The Report suggests that enforcement actions be “targeted to combat clear abuses and send a message to all taxpayers that noncompliance has consequences.”

Baxter Jonhson blames Congress, “because it has not funded the IRS enforcement efforts. It needs to drastically increase funding for auditors and training. The IRS needs to drastically increase the number of audits it performs to possibly as many as six-percent of returns filed.”

Auditor training also needs to be enhanced, Johnson says. “The IRS should increase the number of audits at least 2-3 percent possibly even to six-percent of returns filed, and put better trained auditors in the field who are more motivated.”

Computer audits are useful, but to make a dent in the impact of the cash economy, Johnson says, the auditors should be in the field “looking at bank statements and lifestyle.”

Fred Imel's experience with the IRS in recent audits has been that they are much more professional and fair than they used to be. “They have high-level analytical thinking tools, come well-prepared and conclude their business quickly,” he says. “Enforcement will be weakened, though,” he adds, based on a conversation with an IRS official, “because so many senior agents are retiring and the IRS cannot hire enough people to replace them.” Imel also says that the IRS lacks training capacity.

Johnson questions the IRS commitment to providing taxpayer assistance, at least when it comes to connecting with a live person on the phone. “The word 'service' should be taken out of the name of the IRS. A caller needs to go through several menus to talk to a person on the phone and then need to tell his story over and over again to agents before he can resolve a simple issue. It raises the problem for accountants, too, of whether they can bill for the time spent on the phone.”

Olson arrived at the “surtax” figure by dividing the estimated $290 billion net tax gap by the roughly 130 million individual income tax returns filed, the Taxpayer Advocate Report says.

Amy Lowenstein , 23 January 2007 @ 22:11 PM  Corp Audits Woefully Short Another big reason for the tax gap is that corporate audits are cut short (New York Times article 1/12/07, "Agents Say Fast Audits Hurt I.R.S.") by managers who want to get bonuses for closing cases quickly. Good auditors have to leave a lot of tax money on the table and settle for very little, to close the cases early. Perhaps a change in the things for which managers are rewarded, would help make it possible for large companies which should be paying a lot more tax, to pay the right tax, rather than be able to stall an audit and get away with paying pennies on the dollar. Sincerely, Amy L., CPA Sole Practitioner Yardley PA

GREGORY J FOLK, CPA , 23 January 2007 @ 19:07 PM  the tax gap is JUST THE REASON INCOME TAX IS NOT SUCH A HOT IDEA. Well, here we are again wasting precious resources chasing the non-compliant cash economy. The story starts with cash economy and switches to more audits. The people in the cash economy probably don't file returns and why would they seeing those that file get audited? Steve Forbes ran for president(spending 400 million of his own money) on a flat tax, and others are promoting a national retail sales tax, concurrently with the abolishment of payroll taxes and income taxes individual and corporate. California workmen's comp is a license to steal. Did you ever wonder why? How many of billions is already spent by taxpayers trying to comply with the tax law, and you have this tax gap of $290 billion? How many billions of dollars is the IRS Budget? Add them together,comparing this sum, to the tax gap figure. Come on you cost versus benefits types, where are you? All sources of cash regardless of where they come from are spent, less whatever is kept out of the stream of spending as savings. So instead of punishing people who at least try to file, by auditing them, and knowing what the cash only people are doing(non-compliance), just change to picking up your tax flow off of what everyone spends, it is a lot less of an compliance and enforcement problem. Witness the states using sales taxes they pick up the underground and above ground spending nicking them with sales tax for their purchases. In sum, income tax law has within its mode of operation, called inherent structural problems, its very own seeds of failure. More and More laws and money spent to seek a shrinking pool of "tax gap", money. The tax gap is the very (strongest) reason to dump income taxes, and pick the citizens pockets for taxes as they purchase goods. Yours respectfully, Gregory J. Folk, CPA Colorado