Tuesday, June 27, 2006

Business Income and the Tax Gap

The Internal Revenue Service recently completed a National Research Program (NRP) reporting compliance study of individual taxpayers for tax year 2001. The study involved random selection of about 46,000 returns for review. The examinations generally concluded in the fall of 2004.

IRS designed the NRP to measure reporting compliance and determine the tax gap. The tax gap is the difference between the amount of tax that taxpayers should pay for a given year and the amount that is paid voluntarily and timely. The tax gap represents, in dollar terms, the annual amount of noncompliance with the tax laws.

The largest component of the tax gap comes from unreported and underreported income. Non-filing and underpayment of tax comprise the rest of the tax gap. NRP data suggest that well over half ($109 billion) of the individual underreporting gap came from understated net business income — underreported receipts and overstated expenses.

While the NRP data tell IRS quite a bit about the tax gap there is one critical unknown piece. The data do not reveal how much of the gap is attributable to willful non-compliance or carelessness and how much is the result of a lack of understanding by the taxpayer of his or her full tax obligation.

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