Closing the gap: Why the IRS wants to practice random acts of audit

According to IRS estimates, there is a $345 billion gross "tax gap" for 2001. The tax gap is the difference between taxes the IRS thinks should have been paid and taxes that actually were paid. Not surprisingly, "the tax gap is, on and off, seen as a revenue source," says Charles Christian, professor of accountancy at the W. P. Carey School of Business.

If everyone paid up the taxes they owe, the United States could slash its national budget deficit and start paying down that pesky $9 trillion gross national debt now carried by the nation. At least, that's what some policy wonks in Washington say. As of August 6, the Congressional Budget Office reports a national budget deficit of $158 billion for the first 10 months of fiscal year 2007.

Meanwhile, the Internal Revenue Service estimates a gross "tax gap" of $345 billion from 2001, the last year for which figures are available. The tax gap is the difference between the amount of tax money taxpayers should have paid and what they actually did pay on a timely basis. After IRS brings in the $55 billion it expects to collect through enforcement measures, the net tax gap still tops $290 billion.

Not surprisingly, "the tax gap is, on and off, seen as a revenue source," says Charles Christian, professor of accountancy at the W. P. Carey School of Business and a member of the IRS Advisory Council. "The current gap is more than double the annual deficit," he adds.

"So, some people are saying, 'Oh, if we could collect just half of that money, we could balance the federal budget.'" (Christian points out that his comments do not represent the IRS Advisory Council.) Such thinking is behind renewed interest in the tax gap and a refurbished method of trying to get clear understanding of it.

The IRS is resurrecting the random audits it last used in 2001 to gauge tax-code compliance. Beginning this October, some 13,000 individuals will be randomly selected for audits of their 2006 tax returns. A similar number of people will be chosen to undergo the random audits on returns from 2007 and 2008.

Chance encounters

Random audits are not new for the IRS. Beginning in 1964, the agency has conducted tax-return reviews periodically — usually every three years — through the Taxpayer Compliance Measurement Program (TCMP). The IRS retired the TCMP after its 1988 study, but then created a successor project called the National Research Program in 2000.

Through that initiative, some 46,000 people won — or perhaps you could say lost — the no-prize lottery that earned 41,000 of them detailed, face-to-face examinations of their tax returns and supporting documentation. Such random audits are performed mostly on individual tax returns.

The IRS completes such a substantial number of audits on large corporations that agency officials simply use math computations to compensate for the lack of random sampling when estimating the corporate tax gap. Currently, an estimated 16 percent of the nation's tax liability falls into the gap, which is composed of three large divisions: non-filing, under-reporting and under-paying of taxes owed.

Loss leaders

"There are many misconceptions surrounding the tax gap," Christian says. The IRS Advisory Council, of which he is a member, is a 23-person entity formed in 1953 to provide citizen input on IRS policies and procedures. He's chair of that organization's Tax Gap Analysis Group, a team focused squarely on tax-gap issues. Christian notes that many people think corporate tax cheats are the biggest part of gap problem. That's not the case.

Only $32.3 billion of the gap — less than 10 percent – stems from corporate sources. Non-filers — people who file late or not at all — make up $27 billion of the $345-billion gap, according to what the IRS calls "reasonable estimates." For many of the non-filers, some third party has reported income that should be accounted for in a tax return.

That is, employers report wages using a W-2 form, corporations report the 1099 income earned by independent contractors, banks and investment houses also use 1099 to report non-wage income, and so on. If such forms are filed for a taxpayer who doesn't file a tax return, the income those forms represent becomes part of the tax gap.

The IRS also studies census data that indicate "how many taxpayers in the population are of income-earning age," Christian explains. "That gives them an estimate of the number of taxpayers who would be likely to file a tax return, and then they compare that to the number of people who actually do pay." Some taxpayers come clean in their income-tax reporting.

They file on time and accurately report income. They simply don't send the money. That group provides the IRS with the underpayment figures in the tax gap, an amount that equaled $33.5 billion in 2001. Most of it — $23.4 billion — should have come in from individuals. The biggest contributor to the gap is under-reporting, and Christian says it is due to many causes, including overstating deductions or credits and understating income.

Underreporting accounts for 83 percent of the tax gap, with $197 billion — nearly 70 percent of underreported income — accruing to individuals, according to IRS estimates. More than half of that amount — some $109 billion — is attributed to business income. "Self-employed individuals who underreported their income make up the largest single component" of underreporting, Christian notes.

What's the DIF?

Knowing the extent of the tax gap is just one small reason for reviving those random audits via the National Research Program. The real value behind such inspections lies in the insights they provide into who should be picked for "operational" audits. Those are the reviews that crop up when something doesn't quite add up in the IRS's view.

"Operational audits may be initiated for a variety of reasons," Christian explains, and not all require face-to-face meetings. For instance, sometimes automated programs at an IRS service center detect discrepancies between information in a return and that on a W-2 or 1099. That might generate a letter from the IRS, asking the taxpayer to supply additional information to reconcile the inconsistency.

Another way individuals get tapped for operational audits is via a statistical scoring method that was created using information gleaned in random audits. Called the "discriminate index function (DIF)" score, this computation rates the potential for change in an audited tax return. "If a return has a high DIF score, it would be a strong candidate for audit," Christian says.

Given the characteristics of returns with high DIF scores, he says, there is a high probability that abnormalities and non-compliance will be found. Because the IRS has used findings from random audits to fine-tune the DIF-score algorithm, Christian maintains that random audits ultimately lower the number of returns audited unnecessarily.

In IRS terms, random audits reduce the "no-change" rate on returns that have triggered operational examinations. Random audits also may help the IRS pinpoint areas where taxpayers have trouble understanding and complying with tax law. That, in turn, allows the agency to revamp taxpayer service, redesign forms, rewrite instructions and take other clarifying measures.

These benefits have not prevented criticism of random-audit programs, however. Some might say the historic, line-by-line audits of the past amounted to a financial strip search, and Christian reports that there have been concerns the random audits "impose an undue hardship on the individuals who were selected."

Still, he believes the random audits are of value for keeping IRS audit-selection models current. "The burden on individual tax payers must be compared to the benefit that these audits produce in terms of improved audit-selection formulas," he says. "Over time, tax laws and behavioral patterns change, so the IRS needs to regularly update its audit-selection procedures."

Bottom Line:

• According to IRS estimates, there is a $345 billion gross "tax gap" for 2001. The tax gap is the difference between taxes the IRS thinks should have been paid and taxes that actually were paid.
• To better understand the tax gap and non-compliance with tax codes, the IRS is resurrecting random audits of tax returns.
• Some 13,000 taxpayers will be chosen for random audits of 2006 returns.
• The IRS will continue random audits for tax years 2007 and 2008.