Unreported income from the cash economy and late-year Tax Code changes are the focus of the first of this year's two reports to Congress by National Taxpayer Advocate Nina E. Olson.In her report, Olson proposed a comprehensive strategy to address tax noncompliance in the cash economy, which accounts for the largest portion of the tax gap. The report identifies the lack of progress in addressing cash economy noncompliance as a most serious problem.

"It's particularly disturbing that, for the third year running, the IRS declines to create a Cash Economy Program Office to coordinate its various initiatives," Olson wrote. "Ad hoc measures will not get the job done."

The emphasis in the 900-plus-page report on collecting tax on unreported income is well-placed, according to David A. Lifson, co-managing partner of New York-based Hays & Co. LLP, president of the New York State Society of CPAs and a member of the IRS Advisory Council.

"The report shows that households that pay their taxes have to pay an average of about $2,680 per year to pick up the tab for those that do not," he said. "So anybody who wants to make the collection system more efficient is an advocate for taxpayers."

The significance of the cash economy is not surprising, according to Olson, "since research shows that taxpayers report well over 90 percent of the types of income that are reported to the IRS by third parties, but less than 50 percent of the types of income that are not."

Since a relatively small number of taxpayers account for most of the problem, Olson suggested, a goal of significantly raising compliance in the cash economy from below 50 percent might be reasonable.

To do this, she proposed 15 steps that would ease the tax gap attributable to the cash economy, including: the creation of an income database to help identify underreporting and improve audit efficiency; greater matching of state and local receipts-related data with income reported on federal income tax returns; a revision of Form 1040 Schedule C to break out income not reported on information returns; a revision of business income tax return forms to highlight information reporting requirements; the creation of a preparer database that tracks errors on client returns to use both for targeted outreach and possible audit selection; a specialized audit program to detect the omission of gross receipts; and the revision of collection policies to offer a reasonable payment alternative to all taxpayers who cannot fully pay what they owe.

Adding a line to Schedule C so that taxpayers separately report the amount of income reported on Forms 1099 and other income not reported on Forms 1099 could improve both voluntary compliance and audit selection and efficiency, the report proposed.

This proposal to break out income not reported on information returns is a good idea, according to New York-based CPA and tax attorney Alan Strauss. "It will cause people to think twice about what they put down for other sources of income," he said.

Olson suggested that the IRS create a preparer database to track errors on client returns that could be used for targeted outreach and, if outreach fails, for audit selection. "At least for those preparers who sign a sufficient number of returns, the database would allow the IRS to identify those who make frequent errors or may be encouraging taxpayers to underreport income," she said. "The IRS should generate a compliance 'score' for each preparer and send one or more notices to those preparers who make the most frequent errors, identifying the types of errors they are making and offering additional education. In cases where the notices fail to prompt the preparer to prepare returns with fewer errors, the IRS should also study whether it is feasible to select returns for audit based, in part, on the preparer's score."

Olson believes that if taxpayers think they may have a greater chance of being audited if they use a sloppy or unethical preparer, they will seek those who have a reputation for being meticulous and ethical: "This might help reduce the pressure on preparers and other advisors to recommend return positions for which there may be little, if any, legal support."

The IRS indicated that it's considering such a move, and has a number of initiatives underway regarding return preparer strategies. "We expect the strategy and supporting action plan to be released in March 2008," the IRS said.

Such a project would be using data that the IRS already has in a different format, according to Strauss. "It's no more onerous or overreaching than what already exists," he said.

COLLECT WHAT YOU CAN

Olson's report urged the IRS to revise its collection policies to offer a reasonable payment alternative to all taxpayers who cannot fully pay what they owe.

"Many taxpayers and IRS employees no longer view the IRS's Offer in Compromise Program as a viable collection alternative," she stated. "Moreover, the IRS needs to look for opportunities to use its authority to enter into installment agreements with taxpayers, especially those who do not qualify for 'streamlined' installment agreements under current rules (e.g., because the delinquency has been allowed to age and exceeds $25,000 or cannot be paid within five years)."

Olson noted that the IRS collects virtually nothing on accounts that remain unpaid after three years. "When the IRS fails to present taxpayers who cannot fully pay their taxes with a reasonable plan to resolve the outstanding liabilities, some may be so frustrated that they drop out of the tax system," she said.

However, the IRS disagreed with the proposal, stating that it believes current policies and procedures provide sufficient alternatives for taxpayers who cannot immediately pay the amount due in full.

Although all of the proposals would help, there is a certain level of noncompliance that will always go unnoticed, according to Roger Harris, president of Padgett Business Services and former chairman of the IRS Advisory Council. "In some cases, the cost to catch someone is not worth the effort. You're not going to issue 1099s to the babysitter or the neighbor's son who cuts the grass," he said.

"We're talking about the large transactions. All of these proposals would have some impact, but they're on the edges, rather than at the heart and soul of noncompliance," he said. "For example, the report suggests more education. We're not failing to report income because we don't understand, so education wouldn't help unless you educate people that they'll get caught and, 'Here's what will happen if you get caught.'"

"It comes down to how much burden we're willing to accept to close the gap," said Harris. "There's a hesitation to take meaningful steps because the burden it would create would be unacceptable."

Since small businesses are at the heart of the tax gap, Harris would propose that they be required to maintain a separate bank account for the business. "Deposits into the account would be furnished on an annual basis to the IRS. How hard is it to say, 'Here's your total for the year, and by the way we're sending this to the IRS?'... It will take something like that to get to the core. You can't audit your way out of the problem."

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