THE TAX GAP

by Andrew D. Schwartz, CPA

In recent years, the IRS has become very concerned with the "Tax Gap", which is the difference between the total taxes that should have been remitted to the US government and the actual amount of tax revenues the IRS collected in a timely manner.  For 2006, the Tax Gap is estimated to be $450 billion.

According to the IRS, "The voluntary compliance rate — the percentage of total tax revenues paid on a timely basis — for tax year 2006 is estimated to be 83.1 percent. The voluntary compliance rate for 2006 is statistically unchanged from the most recent prior estimate of 83.7 percent calculated for tax year 2001."  What this means is that a whopping 17% of all federal taxes are initially going uncollected.

According to IRS' Tax Gap Map, the IRS estimates that the Tax Gap is comprised of these three segments:

• Underreporting of taxes - $376 billion
• Underpayment of taxes - $46 billion
• Non-filing of returns - $28 billion

The IRS believes that through "enforced and other late payments of tax", $65 billion out of the $450 billion tax gap will eventually be collected.  Even so, that still leaves a Net Tax Gap of $385 billion, or 14.5% of the total potential federal tax liability of $2.66 trillion.

Trust But Verify

The IRS has acknowledged that the Service can't "audit its way out of the tax gap."  Even so, audits remain an important compliance tool.

To make the most of their available resources, the IRS has taken steps to streamline the audit process while trying to better select which returns to audit.  Although a CPA representing a client is thrilled when an audit ends as a "no change", the IRS prefers that those tax returns never even get selected in the first place.

For anyone who fears being audited, you'll be happy to learn that one of the IRS's long-term goals is to move away from traditional audits to more of a "trust but verify" environment.  The Service has observed that the tax gap is greatly reduced in areas where there is third party verification, such as W-2s to report wages, 1098's to report mortgage interest, or Social Security numbers for dependents. 

In the past, however, a big challenge for the government is to find a source of third party verification that covers small businesses and self-employed individuals.  Well, effective for 2012, the IRS has introduced a new form called the Form 1099-K to provide income verification for this group of taxpayers.

According to the instructions to this form, "You have received this form because you have accepted merchant cards for payments, or because you
received payments through a third party network that (1) exceeded $20,000 in gross total reportable payment transactions and (2) the total number of those transactions exceeded 200 for the calendar year." 

With fewer people purchasing goods and services with cash, and a higher percent of all transactions being completed with debit or credit cards, the IRS will use this third party verification of merchant card payments as a tool to get a better sense of the revenue that many small businesses receive each year.  Take a look at Line 1a of the Revised Schedule C, Profit or Loss From Business, and you'll see that you'll be required to separately report all of the income reflected on the Form 1099-K's starting in2012.

Audit Stats

Currently, the IRS is auditing the following groups of taxpayers each year:

More Audits and Better Audits

Until the tax gap is brought under control, expect the IRS to rely on audits as a deterrent against non-compliance with the current tax laws. It will be interesting to see what happens with the Tax Gap once merchant card activity reported on 1099-K's is implemented starting in 2012.

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IN THE NEWS

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A PROFESSIONAL CRITIQUE OF MITT ROMNEY'S 2011 & 2010 TAX RETURNS

by Andrew D. Schwartz, CPA

Last month, Presidential Candidate Mitt Romney released his 2011 and 2010 tax returns to the public.  You can download a complete copy of these federal tax returns at:

• 2011 Federal Tax Return

• 2010 Federal Tax Return

Here is what I observed upon reviewing his returns:

• Mitt Romney reported gross income of just about $21 million for each of these two years.  A little more than 50% of this income was from long-term capital gains and qualified dividends, which are taxed at the maximum rate of 15% for the regular tax calculation.  

• With respect to his self-employment income, Mitt Romney did not appear to be very concerned about minimizing his tax burden.  Take a look at the Schedule C each year, and while he did not claim any expenses against his Author/Speaking Fees income of $110,500 in 2011, he did claim his agent commission of $39,756 and advertising expenses of $9,000, for a total of $48,756, against his gross self-employment income of $528,871in 2010. Apparently, he decided not to claim any other expenses, including the home office or automobile mileage, that many self-employed individuals claim on their Schedule C each year. Mitt Romney also did not contribute to a retirement plan either year based on his net self-employment income, which would have reduced his taxable income.

• If you look at line 45 of his tax return for both year, you'll see that he paid a ton of Alternative Minimum Taxes each year.  Based on these returns, his AMT was $224,425 in 2011 and $232,989 in 2010.  While most taxpayers with income greater than $1 million pay no AMT, people with substantial long-term capital gains and qualified dividends end up paying this tax due to how this tax calculation works.

• The total 2011 tax liability reflected on this tax return is $3,226,623 - or just over 15% of his gross income of $20,908,880.  This might seem quite low, but he claimed a substantial deduction of $4,020,572 for donations to charities.  Without his charitable donations, his total federal tax liability would have been approximately $4.6 million, or 22% of his gross income. 

• The total 2010 tax liability reflected on this tax return is $3,009,766 - or just under 14% of his gross income of $21,646,507.  This might also seem very low, but he claimed substantial donations to charities of $2,983,974.  He also saved taxes by taking a $129,697 credit for Foreign Taxes paid during the year.  Without these two tax breaks, his total federal tax liability would have been approximately $4.2 million, or 19.5% of his gross income.

• The Romneys claimed itemized deductions of $5,688,179 on their 2011 Schedule A and $4,519,140 on their 2010 Schedule A.  For 2011, their itemized deductions include: $4,020,572 of charitable donations, $46,033 in investment interest expense, $226,356 in real estate taxes, and $1,323,094 in state income taxes.  They also claimed $490,000 in Miscellaneous Itemized Deductions that were passed through to him by one of his investment trusts or partnerships, of which only $71,978 was deductible since Miscellaneous Itemized Deductions are only allowable to the extent they exceed 2% of your income. 

• Finally (and surprisingly), Mitt Romney had a sizeable capital loss carryover reported on 2010 Schedule D.  Take a look at line 14 of that year's Schedule D and you'll see that he went into 2010 with a capital loss carryover of $4,844,089.  His returns don't indicate when or how those losses arose.

Extremely Complicated Return

These tax returns are anything but straightforward.  In my office, we don't prepare any returns nearly as involved as Mitt Romney's 2011 and 2010 returns.  I can only imagine how many hours the staff of PriceWaterhouseCoopers spent on preparing and reviewing these tax returns.

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2011 & 2012 TAX FACTS

• For 2011, the standard deduction for a single individual is $5,800 and for a married couple is $11,600. A person will benefit by itemizing once allowable deductions exceed the applicable standard deduction. Itemized deductions include state and local income taxes (or sales taxes), real estate taxes, mortgage interest, charitable contributions, and unreimbursed employee business expenses.
• For 2011, the personal exemption is $3,700. Individuals will claim a personal deduction for themselves, their spouse, and their dependents. 
  
• The maximum earnings subject to social security taxes is $110,100 for 2012, up from $106,800 in 2011.
  
• The standard mileage rate is $.555 per business mile as of July 1, 2011, up from $.51 per mile for the first six months of 2011.
  
• The maximum annual contribution into a 401(k) plan or a 403(b) plan is $17,000 in 2012, up from $16,500 in 2011.  And if you'll be 50 or older by December 31st, you can contribute an extra $5,500 into your 401(k) or 403(b) account that year.
• The maximum annual contribution to your IRA is $5,000 for 2011 and 2012.  And if you turn 50 by December 31st, you can contribute an extra $1,000 that year.  You have until April 15, 2012 to make your 2011 IRA contributions. 

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