'Cheating' by Ordinary Taxpayers:
Does the Underreporting of Income Contribute
to the 'Tax Gap'?
Allen J. Rubenfield and Ganesh M. Pandit
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
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.”
of the Tax Gap
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:
Taxes evaded through nonfiling of returns: $30 billion.
Unreported or underreported FICA and unemployment taxes:
Unreported or underreported estate and excise taxes: $4
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).
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
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.”
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.
1: Small Insurance Damage Claims
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
Does Ms. X have reportable income?
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).
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].
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.
2: Survey Payments
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.
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
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
Do any of the above survey responders have reportable income
from participating in the noted activity?
All compensation for personal services, no matter the actual
form of payment, must be included in gross income [IRC section
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
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.
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.
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.
Does Dr. A have reportable income from the sale of the review
Under the current tax law, the recipient of a gift, upon
its sale, has taxable income equal to the cash received.
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)].
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.
4: Barter Exchange/ Services for Services
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.
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.
Is this exchange of goods and/or services for goods and/or
services reportable income to either or both parties?
The fair market value of the goods or services exchanged
must be included in the income of both parties [IRC section
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).
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
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.
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.
5: ‘Charitable’ Giving
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
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.
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)].
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.
Are taxpayers taking advantage of charitable giving?
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
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.
Innocent ‘Cheating’ Be Stopped?
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.
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.
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.
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.