TAX UNDERREPORTING IS AN EPIDEMIC

April 2006

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As you pay your taxes this coming week, you would probably want to know that others are paying their fair share. Sorry. Here are some events that were reported this last week:

First, an NBC News intern, who is also a part-time waitress, went to the two largest tax return preparers in the United States wearing hidden camera and sound recording apparatus.

At H&R Block, two tax preparers told the intern that she did not have to report any of her tips that tax law clearly says she has to report. One preparer said “There’s no paper trail on it. You’re not making a lot of money. It’s not like the IRS is going to track you down.” A second preparer provided the same advice, explaining “There’s no paper trail on it.”

At #2 Jackson Hewitt, it was worse. The tax preparer said, “That’s not taxed. It’s one of those perks for ... you know”. Later, the same preparer encouraged further falsehood by claiming a dependant child that did not exist: “We can make up a kid and put it in there, just to show you, if you want to do that.”

These items are not perks. They are illegal.

Second, in an undercover audit conducted by the Government Accountability Office (GAO), tax return preparers from the large chain tax companies were asked for assistance for two modest hypothetical families – one for a single mother and another for a plumber. In only around ten percent of the returns that resulted was the tax correct. Incorrect refunds on some returns delivered as much as $2,000 extra to some, but took more than $1,500 from others. Here is a sampling of the mistakes:

Side income was NOT reported properly in over half of the returns. Like the NBC reporter described above, tax preparers often incorrectly advised that it was up to them to report side income because the IRS would not know about it otherwise.

On approximately half of the returns prepared for the hypothetical single mother, the preparers took deductions and credits for two children, even though the undercover auditor clearly said that only one of the children lived with her.

In none of the returns for the single mother did the preparers use child-care expenses to claim the child- and dependent-care credit.

Numerous errors were made in calculating education credits for college expenses paid by the hypothetical plumber for his child.

Quite appropriately, lawmakers from the Senate Finance Committee said the study demonstrated the need for tax preparers to have to meet minimum training and competency requirements.

Third, and perhaps most annoying, another GAO report of the IRS’s activities encouraged additional resources for reducing the “tax gap”, meaning the amount of income that evades reporting and taxes due to dishonesty. Although it is difficult to measure the amount of income underreporting, the IRS estimates that the annual tax gap is a staggering $345 billion. Of this, around $55 billion is recovered through IRS enforcement activities, leaving around $290 billion annual uncollected taxes. The GAO indicated that reductions in this massive amount would require:

Simplifying the tax code to make it easier to understand the obligations that exist

Increasing withholding for income not currently subject to withholding

Improving information reporting, such as what exists for Form 1099 – this might include increasing the penalties for those that do not file these informational returns

Increasing technology improvements at the IRS

Continuing to increase the number of tax returns filed electronically

We hope you don’t blame us for being the reporter for such dismal news.

Fulcrum Inquiry is a forensic accounting firm that performs fraud audits, litigation claims consulting and business valuations.