One of the debates over President Biden’s American Jobs Plan (AJP) and American Families Plan (AFP) is how to pay for them. While raising taxes is one option, an alternative is to collect more of the taxes that are already owed. The Biden Administration is calling for an additional $80 billion in IRS funding to pursue this alternative, which amounts to a 10% per year increase to the current IRS budget. Financial institutions would also be required to report more information that would help identify sources of taxable income. Before exploring what these initiatives mean for you, their underpinnings will first be analyzed.
The Tax Gap
The difference between what is owed and what is collected is called the “tax gap.” Current estimates on the size of the tax gap range from $584 billion to, in the words of IRS commissioner Chuck Rettig, an amount that may “approach, and possibly exceed $1 trillion” annually. Recent decreases in IRS funding have exacerbated the tax gap, where the percentage of IRS audits on individuals with annual income over $1 million decreased from 8.36% in 2010 to 3.23% in 2018. The aim of increased IRS funding is to close this tax gap, where it is estimated that for every $1 spent on IRS enforcement, the IRS collects at least $4 in revenues and possibly as much as $6 in revenues. This additional funding would go to, among other things, additional revenue officers and examiners to find and collect these unpaid tax dollars. Although additional IRS funding by itself cannot recover the entire tax gap, estimates indicate that additional IRS enforcement paired with increased information reporting from financial institutions could bring in $700 billion over 10 years, and $1.6 trillion over the following decade.
Because efforts to close the tax gap are not actually tax increases, they may be a more appealing option to offset additional spending proposals. But it may not be that simple.
Financing the AJP and AFP by Closing the Tax Gap
Under the Senate’s budget reconciliation rules – the arcane procedural rules that allow laws to pass with a simple majority – a bill cannot increase the deficit outside of a budget window which is generally 10 years. This is important because the large spending plans in the AJP and the AFP must be fully offset by revenue raising measures in order for the AJP and AFP to be eligible for the budget reconciliation process. However, current scorekeeping guidelines prohibit the consideration of revenue increases obtained from additional IRS enforcement, so any of the tax gap closed for this reason will not count as an offset against the cost of the AJP or AFP. On the other hand, it is possible that revenue increases obtained from new reporting requirements may not be subject to this scoring prohibition, so calls to increase information reporting by financial institutions may become more prevalent.
Regardless of the means utilized to close the tax gap, the objective is to collect more of the tax liabilities owed by taxpayers. So what does all this mean for you?
While the tax gap is attributed in part to non-filers as well as reported but unpaid tax liabilities, most of the tax gap (around 80%) is on account of under-reporting income or over-claiming deductions. The primary target of measures to close the tax gap will be individuals with the highest incomes; audit rates would not rise relative to recent years for those earning less than $400,000 in actual income. This isn’t to say that high-income individuals are universally bad actors when it comes to taxes. Rather, a level of complexity in the tax planning structures used by these individuals and businesses make it difficult for the IRS to verify that all income is being reported and taxed correctly. So what exactly will the IRS be looking for and how might they go about finding it?
As we have seen with offshore assets and conservation easements, one of the tools of the IRS is more disclosure. The information reporting portion of the plan to close the tax gap is to build on the current Form 1099-INT framework from financial institutions to identify unreported income. Domestic and foreign financial institutions, third-party payment settlement organizations, crypto asset exchanges and custodians, and other related businesses would be required to report gross inflows and outflows for all business and personal accounts starting in calendar year 2023. Information part of these inflows and outflows would include loans, investment, and payments by merchant acquiring banks and third-party settlement organizations. A de minimis gross flow threshold would be established, and taxpayers would not have an additional reconciliation requirement. The Treasury department estimates that this alone could raise $460 billion over 10 years.
Other Focus Areas
In addition to auditing more individual tax returns and utilizing more information reporting, the IRS would also increase enforcement for pass-through entities such as partnerships and S corporations. Common tax planning structures involve tiered organizational structures that present a level of complexity that the IRS cannot untangle with its current resources. The IRS focus on pass-through entities would identify both income and employment taxes that are imposed on pass-through owners. For example, S corporation owners incur employment taxes based upon the compensation they receive for services performed. This compensation is supposed to be “reasonable,” but for the IRS an examination of what is reasonable is a fact intensive inquiry. Without an examination, the subjective “reasonable” standard may skew against government interests.
The IRS has already started to increase enforcement on pass-through entities with the recent addition of information reporting requirements for partner tax capital. Subsequent considerations for additional information reporting might also center on tracing income from its source through tiered organizational structures to its ultimate recipient, to ensure that it is ultimately reported correctly. Some estimates indicate that unreported pass-through income and unpaid pass-through employment taxes could be nearly half of the tax gap, which may be one of the reasons for additional information reporting and additional IRS enforcement for pass-through entities.
Because the tax gap is attributed to high-income individuals and pass-through entities, additional IRS focus would likely target these areas. In turn, the additional IRS funding and new information reporting requirements from financial institutions would mean more audits and examinations for these taxpayers. Furthermore, the new information reporting requirements would substantially expand the scope of recipients subject to reporting, to include both business and individual recipients (businesses often are exempt under current rules).
For more information regarding the proposed increases to IRS enforcement and information reporting, please contact us.
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