Approximately $7.6 billion of potentially collectible taxes is lost annually due to withholding noncompliance, according to a report from the Treasury Department's inspector general.

The report credits the Internal Revenue Service's withholding compliance program with improving compliance by taxpayers and employers, but said that more effort is needed to ensure that employers comply with the withholding requirements and to penalize taxpayers who make false statements on their W-4 withholding forms and tax returns.

The Treasury Inspector General for Tax Administration found that enforcement actions often were not taken against employers who did not comply with "lock-in letters" sent to them after they did not withhold enough taxes in tax year 2003. TIGTA estimated that 4,100 taxpayers were still not withholding enough taxes, and noncompliant employers were liable for $34.5 million in underwithheld taxes.

Taxpayers are generally not penalized when they make false statements on the Form W-4, costing the IRS million of dollars. "If the IRS consistently assessed penalties on all underwithheld taxpayers for whom lock-in letters were issued, penalties potentially totaling approximately $127 million could have been assessed against these taxpayers," said the report.

TIGTA recommended that the IRS develop a process to identify employers who do not adequately withhold taxes after receiving a lock-in letter, work to develop criteria for referring employers who don't comply, develop better training for IRS employees, and form a team to develop criteria to expand use of the W-4 civil penalty. In response, IRS officials agreed and plan to take corrective action.

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