Taxpayer Advocate’s Annual Report to Congress highlights compliance problems & suggests improvements
The National Taxpayer Advocate has released its 2007 Annual Report to Congress. It’s a voluminous study of the most serious problems facing taxpayers and IRS, along with suggested improvements. These problems include late-year Code changes by Congress, nonreporting of income in the cash economy, and lack of clear IRS guidance to taxpayers on the tax consequence of cancellation of debt.
Impact of late-year Code changes on taxpayers and IRS. The Report excoriates Congress for making retroactive changes at the last minute in December of 2006 (extender legislation) and 2007 (AMT patch). IRS finalizes Form 1040 and its accompanying instructions in early November, and tax software companies finalize their shrink-wrapped software packages around the same time. In 2006, Congress reauthorized deductions for state and local sales taxes, educator expenses, and post-secondary tuition and fees in December, and taxpayers made an estimated 1.4 million fewer claims for these benefits in 2006 than in 2005. The only discernible difference between the two years was that the benefits for 2006 were not included in the Form 1040 package or shrink-wrapped software. Thus, it appears that numerous taxpayers did not claim tax deductions to which they were entitled simply because they did not know about them (they didn’t obtain updated forms and instructions, or didn’t download software patches).
Late legislative changes also force IRS to divert its resources to implement the changes, delay the start of the filing season, result in delayed refunds to taxpayers, make it more difficult to engage in legitimate tax planning, and may subject taxpayers to unanticipated penalties for failure to pay sufficient estimated tax, the Report said.
The Report suggested that IRS identify and estimate the filing-season impact of significant tax legislation–particularly provisions extending existing benefits–and transmit its findings to the tax-writing committees at several points during the year, perhaps on June 30, September 30, and monthly thereafter.
Income from the cash economy. Taxable income from legal activities that is not subject to information reporting or withholding is the type of income most likely to go unreported. Unreported income from the cash economy is probably the single largest component of the tax gap, according to the Report, likely accounting for over $100 billion per year. To improve noncompliance in the cash economy, the Report suggests that IRS:
o establish a Cash Economy Program Office to coordinate its efforts to improve compliance in this area;
o conduct research to identify tax rules that often confuse taxpayers, and provide simplifying guidance;
o combine all of the gross receipts information that it receives from third parties into a single database and then use that database to detect potential underreporting of income as well as nonfilers;
o obtain more state and local receipts-related data, match it against income reported on federal income tax returns, and use it to improve audit efficiency;
o revise Form 1040, Schedule C to break out income not reported on information returns.
The Report urges Congress to enact legislation that:
o increases use of IRS’s electronic payment system for estimated tax payments;
o authorizes voluntary withholding agreements;
o eliminates the corporate exception to information reporting for small corporations if IRS’s National Research Program shows significant noncompliance;
o accelerates the taxpayer identification number validation process;
o provide for withholding on payments to noncompliant contractors;
o requires information reporting by financial institutions on credit and other payment card receipts; and
o requires financial institutions to report all accounts to the IRS by eliminating the $10 minimum on interest reporting.
Improved taxpayer guidance on cancellation of debt. The Report found that many taxpayers may be paying taxes they don’t owe because IRS instructions do not adequately explain exceptions to “cancellation of indebtedness” income. Although Congress passed legislation granting temporary relief relating to mortgages, taxpayers received about two million Forms 1099-C reporting canceled debts last year, many relating to defaults on automobiles and credit card bills. The Report points out that there are several exceptions to the general rule that these amounts are taxable. If the taxpayer is insolvent (i.e., the taxpayer’s liabilities exceed the taxpayer’s assets), the canceled debt is excludable from gross income up to the amount of insolvency. If the debt is nonrecourse (i.e., the lender’s only remedy in case of default is to repossess the property to which it relates), the canceled debt is not income. Additionally, lenders may not correctly value property, leading to erroneous reporting of income.
The Report found that IRS’s instructions do not explain the exceptions clearly. As a consequence, many taxpayers who receive Forms 1099-C reporting canceled debts may include the amounts in income because they lack knowledge of the exceptions. The Report recommended that IRS improve its instructions and develop a publication devoted to canceled-debt issues.
If you’re having a tax problem, you will be better off if you hire a licensed tax professional to represent you before the IRS.