INSIGHT: Tax Gap for Non-filers—Looking Through the Lens of Covid-19

In the wake of Covid-19, April Tax Day was justifiably extended to July 15 this year, creating $300 billion worth of liquidity for taxpayers. With tax return filing and payment deadlines around the corner, it is a good time to revisit the topic of the tax gap, or the amount of tax liability that is not paid on time. This article reviews two recent Treasury Inspector General for Tax Administration (TIGTA) reports and Internal Revenue Service (IRS) announcements regarding several groups of taxpayers who neither filed their returns nor made timely payments.

Tax Gap Statistics

The IRS periodically publishes tax gap estimates. Several key statistics stand out from its most recent report: the gross tax gap, or the difference between tax owed and actually paid on time, was $441 billion each year between 2011 and 2013. Put differently, out of the $2,683 billion that the IRS should have collected if everyone paid on time, $1 out of $6 was not collected when it was due. About $60 billion each year between 2011 and 2013 was eventually paid voluntarily or through IRS enforcement activities, narrowing the tax gap to $381 billion per year. (This amount is referred to as the “net” tax gap). However, this still means that for every $7 of tax due, $1 is not paid, even after IRS audit and collection efforts.

The gross tax gap includes three major groups of offenders: non-filers who are responsible for $39 billion (or 9%) of the tax gap; under-reporters who file their tax returns on time but collectively understate their true tax liability by $352 billion (80% of the tax gap); and finally, under-payers who file their returns but fail to pay in full. The last group is responsible for $50 billion (11%) of the gross tax gap.

Most researchers either address all three groups together or focus on the under-reporters, as this group accounts for the lion’s share of the tax gap. However, several strategic moves and studies are underway to put the non-filer group under the spotlight. Although this group represents the smallest dollar amount owed among the three groups, the IRS indicates that their violations significantly undermine tax administration: non-filers not only fail to pay taxes, but they also fail to file their tax returns. Some researchers suggest that this group could be the low-hanging fruit for IRS collection efforts, given the agency’s budget and resource shortages.

Recent IRS Announcements

In February, prior to the pandemic, the IRS indicated that it would focus more on taxpayers who have not filed tax returns. One mechanism the agency claims to heavily rely on is the Automated Substitute for Return (ASFR) Program, under which the IRS prepares a return for taxpayers who fail to do so themselves. The IRS suspended the program between mid-2015 and May 2019 due to budget constraints, and research shows that before its suspension, the downsized ASFR program was not as effective as when it was fully staffed.

However, just as there is no free lunch, there are no free tax returns. Although the IRS is authorized to prepare substitute returns based on information the agency receives from other sources, including employers, banks, and other third parties, some information may still be missing. In these cases, the IRS can maximize taxpayer liabilities by making assumptions about the individual’s filing status (i.e., single or married filing separately), or by using the standard deduction instead of itemized deductions. The result could be tax liabilities that are higher than if the information had been properly identified.

After being notified of the substitute return results, taxpayers still have a chance to propose different tax positions. However, the substitute returns give the IRS a starting point to propose an assessment and bring taxpayers to compliance.

In March, at the outset of the pandemic, the IRS released its People First Initiative, which temporarily offered taxpayers a reprieve from certain IRS actions; for instance, the IRS delayed collection and enforcement activities as well as most new audits until July 15. Whether the IRS will knock on taxpayers’ doors and resume these collection and enforcement activities shortly after July 15 is uncertain; however, the agency believes this window provides a good chance for delinquent taxpayers, including for non-filers, to come forward and bring themselves to compliance.

Focus on High Income Non-filers

Echoing the IRS’s recent announcement about focusing on non-filers, the TIGTA issued a report in May that zeroed in on high-income non-filers whose earnings exceeded $100,000 per year. The report shows that a small number of high-income non-filers are the largest contributors to the tax gap created by non-filers.

The report estimates that between 2014 and 2016, 879,415 high-income non-filers owed close to $46 billion in past due taxes. The distribution of tax owed is highly skewed: the top 0.6% of the non-filers in terms of past due taxes (about 5,000 non-filers) account for a third of tax owed (about $16 billion), with each non-filer owing at least $500,000 in unpaid taxes. The top 100 non-filers have an estimated tax liability of close to $10 billion. Many of these cases have not been identified or worked on by the IRS.

Besides these alarming statistics, the report reveals several troubling phenomena. For instance, the number of non-filers increased during TIGTA’s review period. There were about 7 million non-filers in 2010, and this number increased to more than 10 million in 2016. In comparison, the number of IRS agents in collection functions has decreased from over 11,000 in 2013 to approximately 9,000 in 2018, a 20% reduction.

One could argue that fewer IRS enforcement agents have led to an increase in non-filers, or that non-filers have simply become more aggressive over time because more money is at stake. Regardless of the reason, the TIGTA indicates that pursuing non-filers is one of IRS’s most cost-effective enforcement strategies because the process only requires the issuance of an automated delinquency notice as a starting point. Preliminary evidence indicates that some prodding from the IRS appears to be an effective collection mechanism: an IRS survey shows that for a sample of taxpayers, almost 90% of non-filers filed in the following tax year after either receiving the delinquency notice, entering the collection or examination process, or being contacted by the ASFR program.

Over the years, the TIGTA has repeatedly urged the IRS to enhance its method of pursuing non-filers, especially those with high incomes. The TIGTA believes that because this group is generally sophisticated and has significant financial resources, their intentional non-filing practices constitute a higher risk than other non-filers, and are “a brazen form of non-compliance.” In response, the IRS has strategically improved its identification of non-filers by, for instance, performing more analytical research and data testing. However, the TIGTA states there is still a lack of oversight and consistency across various functions.

A point of disagreement between the TIGTA and the IRS is whether the non-filer enforcement strategy should focus on reducing the number of non-filers or maximizing the tax dollars collected. According to the study, the current IRS policy requires ASFR agents to work on single year cases without looking into other possible non-filing years, potentially missing out on opportunities that may be uncovered in more comprehensive reviews. The TIGTA believes a change of policy that allows a multi-year review could maximize the dollars collected. However, the IRS states that instead of investigating one taxpayer’s case for multiple years, the single year treatment allows its ASFR program agents to work on more taxpayer cases. This approach may not increase tax collection—in fact, the IRS concluded in a study that tax collection totals are lower—but it reduces the number of non-filer inventories. One possible reason for this is that more than 1 million non-filers are actually owed tax refunds, potentially from withholding, estimated tax payments, or credits.

Pursuing high income non-filers is definitely challenging through the double whammy of taxpayers’ level of sophistication and the IRS’s shortage of resources. On the one hand, higher income taxpayers generally are involved in more complicated tax arrangements and receive income from more opaque sources—such as partnerships, capital gains, rents, and royalties—with inadequate information reporting. This means the IRS has a limited view of this income and parsing the layers usually requires substantial training.

On the other hand, it is no secret that the IRS has long been underfunded and operates under dated IT systems, but is tasked with an enormous amount of work. The agency played integral roles in implementing the Affordable Care Act, the Foreign Account Tax Compliance Act, and the Tax Reforms and Jobs Act. As the coronavirus pandemic spread, the IRS was charged with distributing over $250 billion worth of Economic Impact Payments within a short period of time. A former National Taxpayer Advocate believes it will take the IRS over a year to clear the backlog of work generated during the pandemic.

Focus on Non-filers Who are Paid Tax Return Preparers

A separate TIGTA report in June 2020 explores another phenomenon: a fair number of tax return preparers who helped clients prepare tax returns did not file their own returns.

The good news is these unscrupulous preparers are mostly limited to unenrolled return preparers and not tax professionals including attorneys, certified public accountants, and enrolled agents. Unlike tax professionals who need to meet state licensing requirements or satisfy certain qualification standards, unenrolled return preparers face no qualification and training requirements. Prior to 2014, the IRS was able to conduct comprehensive oversight and review preparer tax compliance when processing Preparer Taxpayer Identification Number (PTIN) applications and renewals. However, a court ruled in 2014 that tax return preparation does not constitute practicing before the IRS. As a result, the IRS has no authority to regulate these unenrolled preparers and cannot refuse to issue PTINs to them even if they are not in tax compliance. The bad news, perhaps unsurprisingly, is that there is plenty of evidence that the unregulated preparers are prone to misconduct and are more likely to prey upon innocent taxpayers or deliberately understate their clients’ tax liabilities.

Although the IRS cannot regulate unenrolled preparers, the PTIN renewal process includes a question regarding whether the preparer is current with his/her federal individual and business taxes, including corporate and employment tax obligations. Based on applicants’ answers to this question, the TIGTA found that 10,495 unenrolled tax return preparers self-identified as being tax noncompliant in 2016, and they collectively prepared over 2 million returns but failed to file their own.

The number of returns prepared is not evenly distributed across these preparers: the top 100 non-filing preparers each prepared between 1,000 and 6,000 tax returns for their clients in 2016, and each received about $189,000 to $1 million in fees. Because these preparers did not file their own tax returns, there is a high chance that they failed to report the significant income they earned for preparing a large number of returns. The report also points out that many rogue preparers are non-filers for multiple years: 54% of the 10,495 self-identified non-filers in 2016 did not file their own returns in 2015, and 34% did not file for four consecutive years. The TIGTA estimates that if the IRS works on two-thirds of these non-filer preparer cases, a potential $45.6 million in taxes could be collected.

Although the number of cases or potential revenue recovery is modest in filling the tax gap, the TIGTA finds the non-filer preparer situation concerning. Unlike general taxpayers who may inadvertently make tax reporting mistakes, these are people with tax knowledge who deliberately represent themselves as tax experts. They have the ability, and possibly the intent, to evade taxes, which can significantly compromise the tax compliance mechanism. In worse cases, they may be inexperienced and operate in the return preparation business with limited tax knowledge.

One potential challenge is that some unreported income may be hard to detect due to the lack of information reporting requirements. Under current rules, a taxpayer is only required to issue a Form 1099 if he/she paid over $600 in a certain tax year to a non-employee who provided services related to a trade or business. Payments made for personal purposes are not subject to this requirement. As such, as long as taxpayers pay the preparers less than $600, or the payments are not associated with a trade of business, it is hard for the IRS to detect this income. As a result, total unpaid taxes could be much higher than estimated.

Conclusion

The next stimulus package is currently being discussed, with many tax instruments on the table and potential costs in the trillions. Given that Congress’s four stimulus packages already carry a price tag of $3 trillion, many observers see both higher taxes and lower government spending on the horizon. Now is a timely moment to address elements of the tax gap as a way to improve government finances. Although it is not possible to completely close the tax gap, improving tax compliance will have meaningful implications for the federal budget.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Joyce Beebe is a research fellow at the Center for Public Finance at Rice University’s Baker Institute for Public Policy.