ROBERT E. MCKENZIE, ESQ.

ARNSTEIN & LEHR LLP

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National Research Program (NRP)

By: Robert E. McKenzie

IRS Study Provides Tax Gap Estimate

3.100 In February, 2006, Internal Revenue Service officials announced that they have updated their
estimates of the Tax Year 2001 tax gap based on the National Research Program (NRP). The
updated estimate of the overall gross tax gap for Tax Year 2001 – the difference between what
taxpayers should have paid and what they actually paid on a timely basis – comes to $345 billion.
This figure falls at the high end of the range of $312 billion to $353 billion per year, an estimate
released in March, 2005.

Net Tax Gap Tops Quarter-Trillion Dollars

3.110 IRS enforcement activities, coupled with other late payments, recover about $55 billion of the
tax gap, leaving a net tax gap of $290 billion for Tax Year 2001.

“The vast majority of Americans pay their taxes accurately and are shortchanged by
those who don’t pay their fair share,” said IRS Commissioner Mark W. Everson. “The
magnitude of the tax gap highlights the critical role of enforcement in keeping our
system of tax administration healthy.”

The complexity of the tax law is also a significant factor in causing the tax gap, which can be
seriously addressed only in the context of fundamental tax reform and simplification. While no tax
system can ever achieve 100 percent compliance, the IRS is committed to taking all reasonable steps
to improve compliance through increased and better targeted enforcement and through increased
taxpayer service and outreach efforts.

Sources of Misreporting

3.120 Though the net misreporting percentage varies by category of income, the rates reflect
that compliance is highest where there is third-party reporting or withholding. Simply stated,
compliance is highest where there is third-party reporting.

For example, one percent of all wage, salary, and tip income is misreported,
contributing an estimated $10 billion to the tax gap. In contrast, nonfarm sole proprietor
income, which is reported on a Schedule C and is subject to little third-party reporting
or withholding, has a net misreporting percentage of 57 percent, contributing about $68
billion to the tax gap.

Understanding the Tax Gap

3.130 The Internal Revenue Service developed the concept of the tax gap as a way to gauge
taxpayers’ compliance with their federal tax obligations. The tax gap measures the extent to which
taxpayers do not file their tax returns and pay the correct tax on time.
Components of the Tax Gap

3.140 The tax gap can be divided into three components:

· nonfiling,

· underreporting and

· underpayment.

Nonfiling occurs when taxpayers who are required to file a return do not do so on time.
Underreporting of tax occurs when taxpayers either understate their income or overstate their
deductions, exemptions and credits on timely filed returns. Underpayment occurs when taxpayers file
their return but fail to remit the amount due by the payment due date.

Three Components

3.150 Of these three components, underreporting of income tax, employment taxes and other taxes
represents about 80 percent of the tax gap. The single largest sub-component of underreporting
involves individuals understating their incomes, taking improper deductions, overstating business
expenses and erroneously claiming credits. Individual underreporting represents about half of the
total tax gap. Individual income tax also accounts for about half of all tax liabilities.

Underreporting Is Largest Component

3.160 Underreporting noncompliance is the largest component of the tax gap. Preliminary estimates
show underreporting accounts for more than 80 percent of the total tax gap, with non-filing and
underpayment at about 10 percent each. Individual income tax is the single largest source of the
annual tax gap, accounting for about two-thirds of the total. For individual underreporting, more than
80 percent comes from understated income, not overstated deductions.
Noncompliance Rising

3.170 Overall, the noncompliance rate is from 15 percent to 16.6 percent of the true tax liability. The
old estimate, derived from compliance data for Tax Year 1988 and earlier, was 14.9 percent.

Areas Where Compliance Has Decreased

3.180 Among the areas where taxpayer compliance appears to have worsened are:

Reporting of net income from flow-through entities, such as partnerships and S corporations
Reporting of proprietor income and expenses, such as gross receipts, bad debts and vehicle
expenses
Reporting of various types of deductions

Areas With Improved Compliance

3.190 Among the areas where compliance seems to have improved is the reporting of farm income.
Overall, compliance is highest where there is third-party reporting and/or withholding.

For example, most wages, salaries and tip compensation are reported by employers to
the IRS through Form W-2. Preliminary findings from the NRP indicate that less than
1.5 percent of this type of income is misreported on individual returns. IRS researchers
anticipate identifying other specific areas of deterioration and improvement in the
coming months as they complete the detailed analysis of the study’s data.

Further Benefits of This Research

3.200 More than establishing the overall extent of individual underreporting, the NRP study also
offers IRS officials specific insight into the types of income reporting that have the greatest
compliance problems. For example, the NRP data will not only provide the misreporting rates
associated with individual lines of the tax return, but will also be the basis for updating the statistical
formulas that assist IRS employees in selecting returns for audit.

New DIF Formulas

3.210 The IRS has done a preliminary update of its DIF formulas for 2006 and when fully updated
formulas become available for use, IRS employees will be better positioned to select returns for
examination that have the greatest likelihood of underreporting. Using such an approach better
ensures that IRS audits are focused on the returns most in need of examination. This not only
improves IRS efficiency, but it also assures taxpayers that others are paying their fair share. It also
lessens the likelihood that those with accurate tax returns will receive the same degree of scrutiny.
Businesses More Likely to Not Comply.

3.220 Most of the understated income comes from business activities, not wages or investment
income. Compliance rates are highest where there is third-party reporting or withholding. Preliminary
findings show less than 1.5 percent of wages and salaries are misreported.

NRP Subchapter S Corporation Study Overview

3.230 During 2007 the IRS continues its NRP of S corporations. The study has the following
elements:

Random Sample consists of approximately 5,000 returns from Small Business/Self-Employed

(SB/SE) and Large & Mid-Size Business (LMSB) taxpayers covering two tax years, TY2003 and
TY2004.
The study follows the standard NRP methodology:
 – IRS is preparing “case built” files for key cases.

– IRS is classifying returns to identify specific issues that must be examined.

– Examiners have the ability to expand scope of the audit, if warranted.

The examination phase of the study will encompass approximately 36 months, beginning
October 2005.

Each tax year will have an examination cycle of approximately 24 months.

The TY 2003 portion of the sample (1,200 returns) is complete, and these cases are now in the
hands of Revenue Agents.
NRP is selecting the TY 2004 (3,800 returns) portion of the sample.

Expect results by December 2008

New Individual NRP Study

3.235 In June, 2007 the IRS announced that it will initiate a new individual NRP study in October,
2007. The program details are:

IR-2007-113, June 6, 2007

New (NRP) study for individual taxpayers that will provide updated and more accurate audit
selection tools and support efforts to reduce the nation’s tax gap.

NRP study will be the first of an ongoing series of annual individual studies using an innovative
multi-year rolling methodology. The study will start in October 2007 and examine about 13,000
randomly selected tax year 2006 individual returns. Similar sample sizes will be used in
subsequent tax years.
2001 Federal Tax Gap
Fiscal Year 2006

October 1, 2006 - December 31, 2006 Totals

Investigations Initiated 955
Prosecution Recommendations 678
Information/Indictments 526
Total Convictions 546
Total Sentenced 504
Percent to Prison 82.5%
Average Months to Serve 38

07/15/2009 05:46:13 PM