Strictly speaking, the Tax Gap exists where a taxpayer pays less tax than what their obligation should be. The IRS periodically measures this gap and publishes their findings.
The last time such a measurement was done was 2008-2010. The estimated Tax Gap in those years was $406 billion, with voluntary compliance down to 81.3 percent. Why?
One of the main reasons for this gap, or so the Service will say, is tax professionals. This assessment has forced experts to do careful due diligence when preparing a tax return or giving advice. Today, professionals must use the determination of “more likely than not” in the preparation of a return, which can make the process both painstaking and tedious.
Let’s say you have a client who is showing $30,000 in income. They’re married and have a couple of kids. The income in itself is not a cause of alarm.
However, suppose there is a difference in income from the previous year to the current one of approximately 30 percent or more. You, as the tax professional, need to find out why. Further, let’s say the same client had a mortgage interest statement showing they paid $19,000 in interest and $4,000 in property taxes. You should ask what they lived on that year.
Usually, there is a good answer, but sometimes, there isn’t.
During tax season, I had a client who had been with me at least 15 years. He had moved out of state, got married and had a child. In 2017, he stated his total income was only $13,000, which was a sharp decrease from prior years.
While doing his return, I asked him about this change in income. The client stated he lived on savings. I filed the paperwork and didn’t think much more about it.
Later, he decided he wanted to buy a house. The underwriter for the mortgage asks the same question I did regarding his income. Lo and behold, it turned out he failed to tell me his wife was the recipient of $85,000 that she received on an installment sale. I amended the return and went on with my life.
I should mention this client owns a fiscal year C-Corporation. While I was doing his corporate tax return, I noticed hundreds of thousands of dollars being transferred into the business account via wire. With no other explanation, I counted the transfers as income. Doing so produced a rather substantial profit and a subsequently high income tax.
When presented with the tax return to sign, the client balked at the amount of taxes he owed. I explained there were several wire transfers that we counted as income. Again, he gave the same answer: These were from his savings account.
Upon hearing this same explanation, I made an appointment with the client to explain my concerns.
During the conversation, I asked him how all the money could come from savings. My client said he had made a lot of money in the past, saved it, invested it in gold and was now selling it. Going back to his personal return, you could see that for several years he had reported capital gains on these sales of gold. So it was “more likely than not” that what he was telling me was true. I proceeded to get the explanation in writing and changed the tax return.
There are many contributors to the Tax Gap. To say that there is one specific reason is to simplify the situation. While it’s true we as tax professionals are responsible for looking into discrepancies in our clients’ returns, it should be noted the US Tax System relies on “voluntary” compliance. This means we choose to file our tax returns, and clearly, 18.7 percent of the population is electing not to.
This is where enforcement comes in, but with the dwindling budget of the IRS, this is at record lows. The system seems to cyclical. We have increased enforcement for a few years, followed by a lull. So it’s not just us: There is a combination of issues as to why the Tax Gap exists.
About Craig W. Smalley, EA
Craig W. Smalley, MST, EA, has been in practice since 1994. He has been admitted to practice before the IRS as an enrolled agent and has a master's in taxation. He is well-versed in US tax law and US Tax Court cases. He specializes in taxation, entity structuring and restructuring, corporations, partnerships, and individual taxation, as well as representation before the IRS regarding negotiations, audits, and appeals. In his many years of practice, he has been exposed to a variety of businesses and has an excellent knowledge of most industries. He is the CEO and co-founder of CWSEAPA PLLC and Tax Crisis Center LLC; both business have locations in Florida, Delaware, and Nevada. Craig is the current Google small business accounting advisor for the Google Small Business Community. He is a contributor to AccountingWEB and Accounting Today, and has had 12 books published on various topics in taxation. His articles have also been featured in the Chicago Tribune, New York Times, Yahoo Finance, Nasdaq, and several other newspapers, periodicals, and magazines. He has been interviewed and been a featured guest on many radio shows and podcasts. Finally, he is the co-host of Tax Avoidance is Legal, which is a nationally broadcast weekly Internet radio show.