Despite a four-year crackdown, billions of dollars go unreported to the Internal Revenue Service each year because Americans are still hiding funds in Swiss bank accounts. A single Swiss bank, holding an estimated $10 billion or more for more than 22,000 US customers, has revealed the names of only 238 of them.
Outrageous? The Senate Finance Committee’s report recommended telling the Justice Department to crack down harder on the offending bank, Credit Suisse. Unfortunately, tax evasion via Switzerland is a small sliver of a much larger problem that’s known as the tax gap – the difference between what Americans owe in taxes each year and what they pay voluntarily on time.
Congress seems much less willing to address that problem. Potentially, it’s a huge source of revenue that requires no enabling legislation. The IRS estimated the gap to be $450 billion a year in 2006 (and it's probably much higher now). If the federal government could recoup a third of that 2006 amount, it would have cut the fiscal year 2013 deficit by 22 percent.
But Congress isn’t just disinterested in recouping that amount. It’s pulling the other direction, cutting back funding for IRS agents, who bring in unpaid taxes many times their salary. Why? The best way to answer that question is with another question. Who benefits from an inadequately funded IRS?
It's not America’s wage earners, whose income and FICA (Social Security and Medicare) taxes are collected through payroll. Those taxes plus the payroll taxes paid by their employers provided about 70 percent of the revenue collected by the IRS for 2012.
Collecting that money is easy. The IRS and state governments rely on businesses to withhold taxes from their workers' paychecks and to deposit their own payroll taxes in a timely fashion as well. Employers who fail to collect and hand over payroll taxes are obligated for those taxes plus penalties and interest. When that failure is willful, the responsible parties are personally liable for the amounts.
It’s not so easy to collect taxes owed on income that's not subject to withholding, especially if that income is also not reported on a W-2 or 1099 form. These are typically the taxes owed by independent contractors, whose income frequently goes unreported and by small business owners, who sometimes knowingly mischaracterize their company income on Schedule K-1, recording it as profit rather than salary to avoid payroll taxes. This mischaracterization, called the “S corporation loophole,” is estimated to result in a loss of $10 billion to $15 billion in taxes over the next 10 years.
Uncollected taxes are also owed by wealthy taxpayers who earn underreported investment income -through foreign entities and accounts in foreign financial institutions.
Cracking down on such recalcitrant taxpayers requires IRS enforcement. A recent successful example was the IRS’s original targeting of unreported foreign income of wealthy taxpayers in undisclosed bank accounts in Switzerland. This was followed up with a voluntary disclosure program resulting in the collection of untold billions of dollars in enforcement revenue – a few wealthy individuals even went to jail and more than 38,000 people came into US tax compliance.
But IRS enforcement activities are chronically undercut by cuts to the IRS budget. For fiscal years 2011 and 2012, Congress reduced IRS’s annual budget by almost $1 billion, an 8 percent decrease at a time when the total population of business and individual tax filers increased by 4 percent. The IRS budget was cut by another $600 million for 2013 as a result of sequestration and then Congress slashed it again by another $526 million with its omnibus appropriations bill resulting in still fewer IRS personnel. (In perhaps the most egregious underfunding example, Congress failed to fund the IRS’s capital improvement budget for 20 years forcing the IRS to do its job for decades using antiquated computers– a “punishment” that began after President Nixon lost an IRS audit resulting in a $215,000 tax bill.)
Between fiscal years 2010 and 2013, the number of full-time IRS personnel fell from 95,000 to 87,000, according to the National Taxpayer Advocate’s 2013 report to Congress, and the agency's training budget was slashed from $172 million to $22 million, an 87 percent decrease. The report points out such cuts are counterproductive since each dollar appropriated returns $255 in revenue.
Government shutdowns also hamper the IRS’s ability to collect enforcement revenue – to the tune of $1 billion per week during the recent 16-day shutdown. (The shutdown also caused $3.7 billion in interest on tax refunds that could not be issued in a timely fashion by the IRS.)
There are reasons politicians tolerate such a large tax gap. No one really likes taxes, so the IRS has no natural constituency. When it does crack down, as it did for a time during the 1990s, the howls of protest from wealthy and not-so-wealthy taxpayers alike motivate Congress to force the agency to back off.
But that leniency with tax scofflaws has its costs. The IRS collected substantially less through its enforcement efforts in fiscal 2012 – $50.2 billion – than in the previous two years, according to the Treasury Inspector General for Tax Administration. The 13 percent drop in enforcement revenues corresponds with the 14 percent drop in enforcement personnel in the same two years.
Eliminating the tax gap through increased IRS enforcement activities is probably not possible in today’s political climate. The smart business move for Uncle Sam today is to collect more tax revenue through withholding – and it’s a sure way to improve current cash flow.
Under a 2010 law known as “FATCA,” designed to ferret out THAT foreign financial income of US tax cheats, new withholding as well as reporting and intra-country exchange of information procedures are already scheduled to begin on July 1, 2014. (At its annual winter meeting, the Republican National Committee voted to call for a repeal of FATCA, the only tax law considered during this event.)
A side benefit of FATCA’s upcoming implementation is the awareness that businesses now have of their long-standing obligation to withhold and report on US income payments to foreign entities as well as to nonresident aliens (called “NRA withholding”) – a tax law dating to 1956 that has been complied with historically more as the exception than the rule.
Congress can do much to improve the government’s cash flow. Withholding on payments to US independent contractors (already required on income paid to nonresident alien contractors) would close the tax gap caused by these taxpayers. Tightening up the rules defining “employee” (already done by a number of states) would cause more workers to be reclassified as the employees that they really are, subjecting their income to payroll taxes and W-2 reporting – and closing the S Corporation loophole would stem significant loss of revenue.
And withholding on income paid to US government contractors would further reduce the tax gap – more than 60,000 contractors owed more than $7 billion in unpaid taxes in 2007. (The Senate already has a bill to ban tax scofflaw contractors from future government contracts.)
New withholding and reporting procedures and a tighter definition of employee combined with tax reforms that simplify both individual and small business taxes is the way to reduce the size of the IRS, not budget cuts that impinge on tax collection. Until these reforms can be enacted, Congress needs to fund the IRS so it can meet its dual responsibilities of serving the needs of US taxpayers and collecting the taxes already owed to Uncle Sam.
– Paula N. Singer is a tax attorney with Vacovec, Mayotte & Singer LLP and author of many articles in tax journals and 11 tax guidebooks published by Windstar Publishing (now Thomson Reuters). She owned small businesses with tax-related products and services for over 20 years.