Tax 'Cheating' by Ordinary Taxpayers:
Does the Underreporting of Income Contribute to the 'Tax Gap'?

By Allen J. Rubenfield and Ganesh M. Pandit

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MARCH 2007 - The 16th Amendment to the U.S. Constitution gave Congress the right to levy and collect income taxes. For federal income tax purposes, the Internal Revenue Code defines “gross income” as all income from whatever source derived, except items specifically excluded by the Code (IRC section 61).

The extent to which taxpayers underreport their gross income represents taxes that go unpaid every year. The IRS and the Economic Policy Institute estimate the amount of taxes owed but not paid at $353 billion, equal to about 15% of the total taxes owed. These taxes not paid through our “voluntary and timely” system of taxation are often known as the “tax gap.”

Components of the Tax Gap

In 2001, the IRS identified the following as the primary components of the tax gap:

  • Underreported business income: $155 billion. This represents taxes owed by small businesses and self-employed individuals.
  • Underreported nonbusiness income: $57 billion.
  • Underpayment of taxes: $32 billion. This represents the amount of taxes actually reported but not paid.
  • Underreported corporate income: $30 billion.
  • Overstated adjustments, deductions, exemptions, and credits: $30 billion.
  • Taxes evaded through nonfiling of returns: $30 billion.
  • Unreported or underreported FICA and unemployment taxes: $15 billion.
  • Unreported or underreported estate and excise taxes: $4 billion.

The IRS acknowledges that the amount of revenues lost as a result of complex transactions by corporations and wealthy individuals internationally is unclear; it admits that the sum may be far greater than the IRS estimates. The Tax Justice Network (www.taxjustice.net) estimates the extent of taxable wealth outside the reach of U.S. taxing authorities at over $11 trillion (Economic Policy Institute, 2005).

National Taxpayer Advocate Nina E. Olson, in her 2006 annual report to Congress, called the federal tax gap one of the serious problems facing U.S. taxpayers. Much has been written on why the tax gap exists, as well as who cheats, why they do it, and how. In recent years, the Taxpayer Advocate’s annual report to Congress has highlighted the significance of the tax gap. It is not uncommon to hear the average taxpayer’s mantra that the corporations and wealthy do not pay taxes, or, at the very least, do not pay their fair share. There is no doubt that a variety of people do not pay their taxes for a variety of reasons (“2004 Taxpayer Attitude Survey,” MSN Money, December 13, 2005). The most common reason noted is the complexity of the tax code and tax laws. Other reasons include the new and greater regulatory burdens placed upon the IRS at a time when its funding for tax enforcement is severely lagging behind economic growth (Economic Policy Institute, 2005).

It would be impossible to illuminate all of the reasons behind the many forms of tax evasion that constitute the tax gap. The authors have chosen instead to look at just a sample of common situations in which ordinary taxpayers would find themselves, either knowingly or unknowingly, involved in underreporting or unreporting of tax liabilities. This might involve a tax preparer, tax preparation software, or self-preparation. In these scenarios, taxpayers regularly pay the taxes they believe to be owed, and when asked if they ever cheated on their taxes, would generally answer “no.”

In this article, the authors ask: If ordinary taxpayers do “cheat” on their tax returns, how do they do it? When looking at that question, one may be tempted to ask another: “Are these taxpayers evading taxation knowingly, or unknowingly?” It is likely that many taxpayers are doing it unknowingly, primarily because the tax laws are complex and go unread by ordinary taxpayers. In the absence of a survey with honest respondents, however, it would be nearly impossible to ascertain the taxpayers’ intention. To illustrate the issues involved, the authors looked at five common situations that generate revenues which typically go unreported, and then reviewed the IRC and Treasury Regulations for the relevant tax treatment.

Situation 1: Small Insurance Damage Claims

Background. Ms. X is on her way to work in a major metropolitan city. She is driving her 2002 Volvo, which is in excellent condition except for a few dings and scratches. Behind her is Mr. Executive, discussing the day’s upcoming events on his cell phone. Ms. X is stopped for a red light when the distracted Mr. Executive fails to stop soon enough and runs into the back of the Volvo. No one is hurt, and damage to the cars is minimal. There is no argument as to who is at fault. The adjuster for Mr. Executive’s insurer reviews the damages, writes up an estimate, and in a week Ms. X receives a check for $497.17. After looking over the damage to the car and discussing the situation with her boyfriend, Ms. X cashes the check and does not fix the damage to her car.

Question: Does Ms. X have reportable income?

Answer: Ordinarily, a taxpayer must report a gain if she receives a reimbursement for damaged property in the form of unlike property or cash. If the taxpayer wishes to postpone any gain, she must use the money to restore the property to its predamaged condition (IRC section 1033).

Casualty and loss from theft of personal property are reported on IRS Form 4684. On the same form, a taxpayer must also report any gain resulting from such situations. If the amount received from an insurance reimbursement is greater than the cost or other basis of the property damaged or destroyed, a gain may result (IRS Instructions, Form 4684, p. 1). The recognition of the gain may be postponed for up to two years if the replacement property will be purchased in an equivalent or greater amount [IRC section 1033(a)(2)(B)(i); IRS Instructions, Form 4684, p. 1].

In the above example, Ms. X has decided to keep the insurance reimbursement and not fix or replace the damaged property. This would result in taxable income. She can, however, postpone the gain by deciding to replace the property later; if Ms. X does not, within the two-year period, fix or replace the damaged property, she will have to report the income.

Situation 2: Survey Payments

Background. Mrs. Consumer receives a phone call from Huge Consumer Product Company. The company representative asks her if she would be willing to answer a few questions and fill out a product survey that will be sent to her in the mail. He also informs her that if she participates in the survey, she would receive coupons for up to $100 of the company’s products. Mrs. Consumer agrees to participate, receives the coupons, and uses them to purchase $100 of the company’s products.

Mr. Couch Potato receives a phone call from Media Research Company during his favorite television show. The company asks him to participate in a survey on television viewing habits. If he agrees to spend 15 minutes answering the survey, the company will send him a check for $50. Mr. Potato agrees to participate.
A university professor, Dr. A, receives an e-mail from Text Book Publishers, Inc., asking him to review a textbook and respond to a set of questions. For responding to the questionnaire, he will receive a $100 honorarium. Dr. A receives a few such e-mails per academic year. He decides to respond to this one.

Question: Do any of the above survey responders have reportable income from participating in the noted activity?

Answer: All compensation for personal services, no matter the actual form of payment, must be included in gross income [IRC section 61(a)].

If one accepts a prize or award for performance of a service, it must be included in one’s income. Furthermore, any prize or award received in goods or services must be reported at its fair market value (IRC section 74). Mrs. Consumer, Mr. Couch Potato, and Dr. A were all asked to perform services for which they would be paid. The fact that some were paid cash and others were rewarded in services makes no difference. It makes little difference that none of them will receive a Form 1099 showing the amount of the award.

The instructions for Form 1099 make it clear that it does not need to be filed for services, prizes, awards, or other income that does not exceed $600. Nevertheless, the taxpayers performed services and received income. The income is taxable, although most taxpayers are quite often unaware of this because they do not receive any type of notification. At the same time, it is likely that the company is deducting the related expense. Multiplying this amount by thousands of taxpayers who receive such awards or prizes each year yields a significant amount of uncollected tax.

Situation 3: Booksellers

Background. Returning to university professor Dr. A, consider another activity familiar to many faculty members. Many receive unsolicited review copies of textbooks that the publishers are trying to convince them to use. The bigger the school, the more review copies of textbooks are received; but even at smaller schools, a faculty member may receive a dozen or so books a year. Faculty members often have no control over the textbook chosen for their classes, bear no obligation to the publisher for the unsolicited copies, and have no need for all of the books sent.

Book-buyers frequent college campuses to buy these review copies from faculty members. Dr. A receives 10 review copies during the academic year; he wants none of them and they are cluttering up his office. He sells the textbooks to a book-buyer for $250 in cash.

Question: Does Dr. A have reportable income from the sale of the review copies?

Answer: Under the current tax law, the recipient of a gift, upon its sale, has taxable income equal to the cash received.

The IRS defines a gift as any transfer to an individual, either directly or indirectly, where full consideration (measured in money or money’s worth) is not received in return [Duberstein v. Commissioner, 363 US 278 (1960); IRS Publication 950, p. 2]. In Duberstein the taxpayer actually provided a service—the names of potential clients—in return for an automobile. Dr. A provided no service for the textbooks received; they were truly an unsolicited gift. The value of a gift is excludable from gross income, but any income generated from the gift, including profit upon its sale, is taxable [IRC section 102(a)].

In the scenario above, Dr. A received textbooks that were unsolicited, and this meets the definition of a gift. There is no consideration paid for them, so Dr. A has no cost basis in the books. The cash he receives for the books is pure profit. The textbook publishers are trying to sell textbooks, and sending review copies to faculty members is a cost of doing business. The publishers would have no reason to send out a Form 1099 showing the “possibility” of income to the recipient. It is obvious that there is a sale of merchandise from Dr. A to the book-buyer in return for cash payment. Because there are no related expenses, the entire amount received is taxable income. The $250 is the proper amount to report, not a fair market value. Income from the sale of unsolicited giveaway items often goes unreported, and no tax ever is collected on the money earned by the seller.

Situation 4: Barter Exchange/ Services for Services

Background. Many people will be familiar with the notion of “services in return for services.” Consider the case of Mr. CPA, the owner of a number of classic cars. The expense of maintaining them would be significant if it were not for Mr. Auto Mechanic. Mr. Auto Mechanic owns two automobile repair shops. The accounting costs for his businesses would be significant if it were not for Mr. CPA. After Mr. Auto Mechanic and Mr. CPA met several years ago, they agreed that Mr. Auto Mechanic would take care of Mr. CPA’s cars and Mr. CPA would take care of Mr. Auto Mechanic’s accounting work. The value of the services performed by each individual was never mentioned again, including on their tax returns.

Another just as familiar, but often unknowingly abused and unreported source of income, is goods in return for goods or services. Mr. and Mrs. Homeowner would like to do some remodeling and upgrading of their house, beginning with a deck. The Homeowners own several local appliance stores. One of their neighbors is a contractor who does home remodeling and says that he would gladly help them during his free time. Over the next few weekends, he builds a nice deck for their house. He does not charge them for his labor, as he says he enjoyed doing it. Nevertheless, the Homeowners present him with a home theater system, which he gladly accepts.

Question: Is this exchange of goods and/or services for goods and/or services reportable income to either or both parties?

Answer: The fair market value of the goods or services exchanged must be included in the income of both parties [IRC section 83(a)(i)].
Bartering occurs when goods or services are exchanged for other goods or services rather than money. Income from such goods and services is included in the taxable income of the parties in the year in which the goods are exchanged or services are performed [IRC section 83(a)]. This income is generally reported on Schedule C, Profit or Loss From Business, of Form 1040 (www.irs.gov/taxtopics).

When two or more individuals get together, they form a barter club or barter exchange. The popularity of the organizations has grown dramatically since the advent of the Internet. The members or clients of such exchanges are in contact with each other for the sole purpose of bartering goods and services. The IRS requires that barter exchanges file Form 1099-B, Proceeds from Broker and Barter Exchange Transactions, and report all exchange transactions. The statement will generally show the value of any cash, property, services, or credit exchanged during the taxable year (IRC section 6045, www.irs.gov/taxtopics).

Mr. Auto Mechanic and Mr. CPA are definitely exchanging services for services. Based on the IRS regulations, the fair market value of the exchange of accounting services for automobile repair services should be included in each taxpayer’s income. Furthermore, each is required to send the necessary end-of-the-year information to the other, documenting the exchange of services.

As for Mr. and Mrs. Homeowner and their neighbor, they try to get around the rule, whether or not they are aware of it, by exchanging gifts. As noted above, however, a gift is any transfer to an individual, either directly or indirectly, where full consideration is not received in return (IRC section 83). Furthermore, considering that there was an exchange of goods for services, the facts would seem to indicate that this was a barter exchange.

Situation 5: ‘Charitable’ Giving

Background. Generally, taxpayers can deduct the contribution of money or property made to a qualified organization. Qualified organizations are defined by IRC section 170, and for the most part are found listed in IRS Publication 78 (see www.irs.gov). Contributions may be made by cash, check, credit card, or payroll deduction.

Recordkeeping is the most important part of making charitable deductions. When contributions to a qualified organization exceed $250, the taxpayer must have a written acknowledgement from the recipient describing the amount and organization. When the contributions are less than $250, a canceled check, a legible statement of account, or a credit card receipt will suffice. There are many cash donations that taxpayers may claim to have made in small amounts to various charitable venues that will go unrecorded and unremembered until tax time. Taxpayers often try to make an educated guess as to the smaller cash donations for which they have no receipts, but the natural response is likely to overestimate, rather than underestimate, the total. This is yet another area where ordinary taxpayers probably unknowingly, but regularly, “cheat” on their taxes.

Noncash charitable contributions are generally made at the fair market value of the property at the time of the contribution. Fair market value is determined by the price at which the property would exchange hands between a willing buyer and a willing seller, both acting with similar knowledge of the relevant facts (IRC section 1001, Treasury Regulations section 1.1001-1). The IRS is very specific on how to determine fair market value. For old clothing, as an example, fair market value is what it would sell for at a used clothing store. Old furniture and household goods, often extremely worn and of little value, should be supported by documentation such as photographs, magazine and newspaper articles, or advertised prices [IRC section 170, IRC section 170(f)(8)].

Noncash contributions are handled in much the same way as cash contributions. Contributions under $250 must have a written acknowledgment from the organization showing the name of the organization, the date and location of the contribution, and a description of the property. Between values of $250 and $500, the acknowledgment must also be in writing and state whether goods or services were given in return for the contribution, along with a good-faith estimate of those goods or services. If the gift is over $500, a Form 8283 must be filed with additional information. For gifts valued at $5,000 or more, appraisals are required [Treasury Regulations section 1.701A-13(c)]. Because the IRS rarely calls for this documentation if the amounts are under $500, it is not unusual for taxpayers to estimate the fair market value of a donation at just under $500, thus avoiding the documentation requirement.

Question: Are taxpayers taking advantage of charitable giving?

Answer: Charitable donations should be provable and, if noncash, fairly estimated (IRC section 170 and IRS Publication 78).
To help taxpayers estimate the value of donated property, many charities provide information on how to establish fair market value. Charities such as Goodwill (www.goodwill.org/page/guest/about) tell contributors to contact a local Goodwill store for information, to compare donations with similar items in the stores, or to check IRS Publication 561. The Salvation Army has estimated values for donated goods under a “donate” link on its website (
www1.salvationarmy.org/ihq/www_sa.nsf). Many other websites just link the contributor to IRS Publication 561, Determining the Value of Donated Property.
In 2006, the IRS made an effort to eliminate some of the problems that accompany noncash donations of clothing and household goods. For contributions made after August 17, 2006, the deduction for clothing and household items will only be permitted if the donated property is in good used condition or better. The IRS can now deny a deduction for any donated property that does not meet these requirements. There is an exception for single items that have a value in excess of $500 and are accompanied by an appraisal [IRC section 170(f)(16)].

While this new effort does add an appraisal requirement similar to that which already exists for collectibles such as gems, art, paintings, jewelry, antiques, and other such nonhousehold goods, does it really clear up the related issues? Does it answer the question of what constitutes “good used condition” or better? If it doesn’t, who answers the question, and what records are necessary to prove the answer? If the IRS has effectively changed the rules, has it really changed the results?
Charitable donations remain one of the most confusing aspects of the tax code to the ordinary taxpayer. The problems in recordkeeping for cash and noncash donations, valuations of noncash donations, and apportioning responsibilities between the taxpayer and the recipient, often lead to charitable contributions being misstated on many tax returns.

Can Innocent ‘Cheating’ Be Stopped?

These hypothetical examples are just a few of the everyday situations that could lead an individual, knowingly or unknowingly, to take advantage of the tax system. The IRS estimates the tax gap at $353 billion, and it could be even higher in reality. The IRS looks for taxpayers who evade large amounts of tax; it can estimate those components of the tax gap more accurately. It is difficult and often expensive, however, to track down taxpayers who “cheat” on a smaller scale. The cost of looking for them may outweigh the benefits, especially when looked at individually. What makes it more difficult is that the individuals may not think they are doing anything wrong. If these are truly individually insignificant amounts, one has to wonder if they are even considered when the IRS calculates the tax gap. If not, then the question is how much larger would the tax gap be if the IRS did include these individually insignificant amounts.

Using noncash charitable donations as an example, the small amounts can add up quickly. Let us assume that a million taxpayers who made noncash donations overestimated their donations by just $300. Assume that these are the middle-class taxpayers in the 25% tax bracket. Individually, each taxpayer “saves” $75 on taxes. There is little on a practical level that the IRS can do to try to collect the $75 from each taxpayer. The cost of enforcement to the government would be considerable. However, if one multiplies this $75 loss of tax revenue by the one million people who hypothetically donated and claimed the deduction, you now have $75 million in uncollected, and perhaps uncollectible, taxes. These figures are only speculative, but they imply that the IRS could be looking at many more hundreds of millions, if not billions, of dollars of tax revenues that go uncollected.

One cannot continually argue that our complicated system of taxation is the sole reason for the extensive tax cheating, and that simplifying our tax system will solve the problem. Most individuals have never looked at and probably will never look at the tax code and regulations. Most taxpayers believe they are honest, and many of them indeed are. They do not believe that they are cheating when they fill out and sign their tax returns. Ultimately, the question becomes whether, short of a complete overhaul of the system of taxation, these types of “innocent” activities that result in lost tax revenues can ever be stopped.


Allen J. Rubenfield, JD, CPA, is an associate professor of accounting and taxation at the school of business administration, Clark Atlanta University, Atlanta, Ga. Ganesh M. Pandit, DBA, CPA, CMA, is an associate professor of accounting at the school of business, Adelphi University, Garden City, N.Y.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 



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