Mind the Gap

Last week, the IRS announced that the “tax gap”—the difference between the amount of taxes Americans legally owed and the amount they actually paid—grew to $688 billion for 2021. That’s a lot more than a few pizza shop owners skimming out of the cash drawer. With Uncle Sam routinely running trillion-dollar deficits, closing that gap is a top priority at 1111 Constitution Avenue. The 2022 Inflation Reduction Act authorized the IRS to spend an extra $80 billion over the next 10 years. Only time will tell if the extra money helps—or even gets spent— in a government that can’t seem to get its act together.

The tax gap comes from three separate places. “Underreporting” is when taxpayers fail to accurately report their liability. “Underpayment” is when taxpayers simply fail to pay the amount of tax they report. And “non-filing,” as you’ve already cleverly guessed, is when taxpayers burrow into a hole and hope the IRS just doesn’t find them. Underreporting accounts for 80% of the gap—this comes mostly in taxes owed on income not subject to withholding or reporting requirements, such as rental real estate or business income.

The news on the collection front isn’t all bad. The IRS also announced last week that they had succeeded in collecting $122 million in back taxes by clamping down on a group of 1,600 taxpayers who earned $1 million per year or more and who also owed $250,000 or more in tax. In one case, they squeezed $15 million out of someone way out on the shameless spectrum who tried to deduct personal expenses, including a 51,000-square-foot mansion with an indoor basketball court, luxury cars, artwork, country club membership, and homes for his children.

Here’s the problem with all of those efforts. $122 million of the lower deficit is great, especially when the taxpayer isn’t disputing the amount owed. But there simply aren’t enough million-dollar earners blowing off their back taxes to close a $688 billion gap. Accomplishing that goal is going to take cracking on large public companies that don’t pay their proper amount. The Service is also focusing new attention on large partnerships, including hedge funds and large law firms. And they’ll be increasing audits for taxpayers earning $400,000 or more. (Social media scuttlebutt that the $80 million in funding will mean 87,000 new gun-toting IRS agents is greatly exaggerated—but that’s a topic for a different story.)

There’s another factor worth considering here, too. It’s the “reverse tax gap” that occurs when taxpayers pay too much because they aren’t aware of all the various deductions, credits, loopholes, and strategies they can use to pay less. Tax planners like us routinely find business owner clients paying tens of thousands or even hundreds of thousands more than they legally owe. It’s far worse when they go to sell those businesses at the end of a successful career and pay millions in tax that we could have helped them defer or eliminate. We‘d sure like to see an official IRS estimate for that figure!

Simplifying the tax system would help close both gaps. Unfortunately, right now, our government can’t manage a vote to declare that ice cream tastes good. The odds of “fixing” the code, or even giving the IRS the funding it needs to enforce the one we already have, seem as likely as finding intelligent life in space.

None of this means the IRS is going to come looking for you. Just play by the rules, and you’ll be fine. And count on us to help you navigate those rules as favorably as possible!