The IRS faces a major problem: Nonfilers

The Internal Revenue Service is well-known (some may say "infamous") for auditing tax returns for accuracy and pursuing tax debtors for payments. However, there is a third compliance area that has been deprioritized in recent years: filing compliance. 

Taxpayers who exit the tax system by not filing a required return have emerged as a growing and under-the-radar problem for the IRS. A Feb. 29, 2024 IRS nonfiler enforcement announcement comes not a moment too soon as the service tries to reel back in the growing number of taxpayers who are not filing a required return.

For the past few decades, tax gap studies have been measuring the amount of revenue lost each year due to nonfiling. In the most recent study, the IRS estimated that the nonfiling tax gap almost doubled in five years: from $39 billion in 2016 to $77 billion in 2021. 

While this increase is dramatic, possibly even more alarming may be the extent of the nonfiling problem that is unknown to the IRS. For instance, the agency's nonfiling tax gap measurements do not include an estimate of corporate (Form 1120 series) non-filing. 

The decline of nonfiler enforcement

To the extent that the IRS pursues nonfiling at scale, it does so primarily through two programs: 

• Delinquent return notices; and, 
• The Substitute for Return program. 

The SFR program is the IRS's ultimate mass enforcement tool. The program works as its name suggests: The IRS assesses its own calculation of tax, penalties and interest that would be owed on a return when the taxpayer refuses to file. This calculation makes assumptions (for instance, the agency does not provide potential deductions, credits or business expenses in the SFR) that often create rather startling, not to mention inaccurate, balances due. 

The IRS typically follows interim steps — notices and investigations — before issuing an SFR. In the past, many delinquent return notices and investigations did not escalate to a final SFR when the taxpayer did not respond to the notice and file a required return. In the end, enforcement fell short as the IRS does not penalize the taxpayer with an additional tax assessment for failing to file the return. 

Al Drago/Bloomberg

In the Feb. 29, 2024, initiative announcement, IRS Commissioner Danny Werfel recognized the agency's past nonfiler enforcement presence. He confirmed that the nonfiler enforcement program has "run sporadically since 2016" due to lack of resources. However, he also added that the added funding from the Inflation Reduction Act allows the IRS to do more in this program. 

Werfel's statement is backed up by IRS enforcement data. Since late 2016, nonfiler investigations have been sparse. The agency briefly enforced nonfiling in 2019 and 2020 but quickly shut it down during the pandemic.

Nonfiler enforcement resumes

The initial targets for the IRS's restarted nonfiler enforcement program are approximately 125,000 individuals in tax years 2017-2021 who received more than $400,000 in income. While the IRS needs to start somewhere, this initiative represents only a small part of the overall nonfiler population. 

Past studies showed there were 50.7 million taxpayers in 2015-2019 who were required to file an individual tax return, but did not. The nonfiling trend continued past 2019. In 2022, the IRS identified 11.3 million known individual nonfilers. To put the nonfiling in the context of overall returns, missing Forms 1040 represent about 7% of the total tax returns the IRS should have received in 2022.

This announcement marks a necessary and welcome first step in restarting nonfiling enforcement. While the IRS over four years ago started an active high-income nonfiler program focused on individual nonfilers who earned more than $100,000, it primarily accomplished the initiative by using local IRS collection enforcement personnel. Using local collection resources did not allow the IRS to reach many taxpayers. Local revenue officers (field collection personnel) resources are scarce and are usually prioritized for the most egregious tax debt cases — not nonfiler issues. Recently, IRS officials stated that its local field collection resources can only enforce about 100,000 taxpayers a year. Considering the millions of nonfilers, local enforcement could not put a dent in the large population of nonfilers.

The IRS uses its campus locations to provide high-volume nonfiling compliance enforcement. These campuses have the capacity to send millions of notices each year to taxpayers through automated notice programs. Nevertheless, for almost the past decade, the IRS sent very few nonfiler notices from its campuses. Campus notice volume reached its lowest point in 2023, when the IRS did not send any initial campus notices (i.e., Notice CP59) to individual taxpayers who did not file a required return. 

Individual taxpayers are not the only significant nonfiler problem. In the past, the IRS focused primarily on individual nonfiling taxpayers, even though the number of known business unfiled taxpayers was also growing. In 2022, the IRS identified 87.6 million unfiled business returns (corporate, partnership, employment, excise tax, etc.), up from 66.5 million in 2021. For the potentially millions of unfiled business returns, the IRS enforcement presence has been scarce — and leaning toward nonexistent. The IRS in 2021 sent 65,900 notices to business nonfilers and in 2022 the agency sent even fewer — only 9,900 to business nonfilers in that year. 

Other alarming trends and tax policy implications

Nonfiling may be heavily driven by taxpayers who find they do not receive refunds (i.e., they owe a balance due with their tax returns). And the IRS may be inadvertently reinforcing this behavior. Each year, during tax season, it frequently urges taxpayers to file, and file early, to receive their refunds. However, this refund incentive, paired with the agency's recent lax nonfiler enforcement, may be promoting more nonfiling. An equal "make sure you file if you owe" message (paired with a reminder of the steep penalties for nonfiling) for the growing number of balance-due taxpayers may be warranted to push balance-due taxpayers to file. 

Data shows that using refunds as a value proposition to incentivize people to file a tax return may be leaving out an increasingly larger number of taxpayers. Since 2018, the number of balance-due filers has increased at an alarming rate: in fact, from 2018 to 2022, balance due filing volume has increased by a startling 32%.

When taking into consideration the increase in balance-due filers, the decline in total returns filed for the 2022 tax year may support the conclusion that taxpayers stopped filing to avoid paying a balance due. The number of filed tax returns for tax year 2022 dropped 2.3% compared to tax year 2021. The IRS received almost 3.8 million fewer returns for tax year 2022 (162 million) than for tax year 2021 (165.8 million). This should have surprised the IRS, which projected, in fall 2022, that it would receive approximately 166 million returns. 

An increase in the number of extension filers may also lend some insight to nonfiling behavior. While individual tax returns are generally due on April 15, taxpayers may request an automatic six-month extension for filing (not for paying) their tax returns. The number of extension filers increased by 28% from 2021 to 2022 and 82% from 2020 to 2022. In 2022, individuals filed 19.4 million extensions — up from 15.1 million in 2021 and 10.6 million in 2020. 

Many tax professionals have suggested that more individuals are filing an extension to push their balance-due tax bill to October. This behavior may also lead to nonfiling, as many extension taxpayers facing a balance due elect not to file. A 2016 report by the Treasury Inspector General for Tax Administration showed that 1.7 million taxpayers out of the 12.4 million extension filers never filed returns after filing an extension for their 2013 tax return. It seems reasonable to question whether the growth in extensions, in conjunction with increasing balance-due filers, will result in more nonfilers.

In addition to the nonfiling trend, the increase in balance-due filers should be another concern for the IRS. Withholding complexity on Form W-4 and estimated tax payment compliance for the growing number of gig economy workers are just two examples of challenges the IRS faces to reduce the number who have a balance due.

Facing the problem

Data supports the conclusion that nonfilers are a large and growing problem. The IRS has heard criticism that it lacks a comprehensive nonfiler plan. The TIGTA states that the IRS does have a strategy, but no single business unit owns it. As a result, it appears chasing nonfilers has not been a priority for the IRS.

A consistent nonfiling compliance strategy is now an urgent matter for the IRS, as the number of delinquent nonfilers appears to be growing. The restart of the agency's campus nonfiler compliance programs is a solid beginning. The 2024 initial nonfiler targets will be 125,000 taxpayers with incomes greater than $400,000. That likely will reach about 2% of the known nonfiler population. 

While the restart may be the beginning of a larger strategy, the IRS needs to move with vigor to broaden its reach, to both individuals and businesses, to address the growing nonfiling tax gap and better understand the behavior driving nonfiling. A steady, significantly scaled cadence of notifications to known nonfilers, backed by enforcement as necessary, needs to be the annual standard operating procedure for the IRS. The 165 million-plus taxpayers who voluntarily file their returns every year expect nothing less.