The government is reportedly losing billions of dollars in unpaid income taxes each year. According to a growing chorus of tax experts, the government's tax collector, the Internal Revenue Service, doesn't really know how much, and it can't figure a way to find out without riling Congress and the taxpayers.
Reluctant to return to the intrusive Taxpayer Compliance Measurement Program so thoroughly denounced by both Congress and taxpayers, the IRS is caught between the proverbial rock and a hard place.
The IRS' strategic business plan declares that the tax system "depends on each person who is voluntarily meeting his or her obligations having confidence that his or her neighbor or competitor is also complying."
Unfortunately, the last time the IRS ventured even a guess at the size of the tax gap was in 1998, when the agency told Congress that $195 billion in individual and corporate income taxes was not collected in fiscal 1997.
Even worse, that number, according to IRS officials, is simply an update of estimates made in the early 1980s and assumes that the rate of tax compliance has not changed in the past two decades.
In the past, the IRS estimated the tax gap every few years using a system of random audits of income tax returns with an examination of the finances of a sample of non-filers. Experts both within and outside the IRS agree that that method is the most accurate way to measure the tax gap.
David Mader, the IRS' assistant deputy commissioner, says that income tax withholding and IRS document-matching programs ensure "a relatively high level of filing, reporting and paying compliance" among wage earners.
What the agency is trying to do now, he says, is to figure out how to better use data collected from tax returns each year to improve compliance among other groups of taxpayers. The current focus is on abusive tax shelters and trusts, and the earned income tax credit.
"We need to know where groups of taxpayers are having difficulty in complying with the tax law," Mr. Mader says. "That would allow us to more effectively deploy resources to help them understand."
In the words of some tax experts: The IRS is now "warm and fuzzy," and it has no idea of how much money it should be collecting.
IRS nudges firms on short years
* The IRS recently provided guidance to partnerships regarding the need for them to file a final, short-year partnership tax return following a partnership termination. A partnership terminates for tax purposes if there is an exchange of 50% or more of the total interest in partnership capital and profits within any 12 months.
The taxable year of the partnership ends when the partnership is dissolved. A partnership that terminates under Section 708, "Partnership Continuations," of the tax rules is required to file a short-year final return.
Cite: Notice 2001-5, IRB 2001-3
No interest? Drop it
* The IRS has withdrawn the stock transfer rules it proposed in January. They would have provided a modified version of an election contained in Section 367, "Other Foreign Transfers." That election was not adopted when the final Section 367 regulations were issued.
The dropped rule would have allowed certain taxpayers to recognize the gain, but not the loss, realized in certain Section 367 exchanges, rather than including the "all earnings and profits" amount in income.
The IRS and the Department of the Treasury originally issued the proposed rules to provide taxpayers with an opportunity to comment on the decision not to include the taxable-exchange election in the final regulations.
Though withdrawn, the taxable-exchange election, as proposed, did apply to transactions between Feb. 23, 2000, and Feb. 24, 2001.
Although a public hearing was scheduled for last April 20, and written comments were solicited, no one requested to speak, and no comments were submitted.
Cite: Announcement 2001-27, I.R.B. 2001-11
When is a return not a return?
* In a recent field service advisory, the IRS concluded that blank forms 1065, for partnerships, with attached balance sheets filed by several partnerships in bankruptcy, were not valid.
Apparently, a tax shelter acquired a series of partnerships that were already in involuntary bankruptcy. A trustee was appointed, and the bankruptcy court collapsed all partnerships into one entity. The partnerships were either already under examination by the IRS or part of cases docketed before the U.S. Tax Court.
The partnerships had filed blank forms 1065 and attached balance sheets. For the combined partnership created by the bankruptcy court, the trustee filed a Form 1065 that was also blank, except for the name and address of the entity and a statement that the trustee lacked the information from which a return could be prepared.
The IRS pointed out that a tax form, which does not contain any information relating to the taxpayer's income and from which the tax cannot be computed, is not a valid tax return.
Cite: FSA 200108004
New rules issued on euro conversion
* Three years ago, the IRS requested comments relating to the tax issues for U.S. taxpayers conducting business in a currency that is converting to the European Union's currency, the euro. As a result of numerous comments received, the IRS issued regulations that became effective Jan. 31 for all tax years ending after July 29, 1998.
The final rules apply to the tax treatment by U.S. taxpayers investing in or doing business in the currencies of certain European countries that replace their national currencies with the euro.
Cite: T.D. 8927, I.R.B. 2001-11
A taxpayer wins on flow-through
* A U.S. district court recently ruled in favor of an individual who grouped his activities in two successive companies to show that his share of flow-through operating losses from his limited-liability company was an ordinary loss.
Stephen Gregg successively created two limited-liability managed-care companies, Ethix and Cadaja. The two companies provided consulting services to the health-care industry, with Ethix focusing on traditional medical care and Cadaja on alternative health care.
The IRS audited Stephen and Kristina Gregg's 1994 tax return and disallowed a flow-through ordinary loss from Cadaja, calling it a passive loss that can be offset only by passive income.
The Greggs paid the deficiency and filed for a refund, which the IRS denied. The Greggs argued that Mr. Gregg should be treated as a general partner.
The IRS argued that because Cadaja extended limited liability to all members, Mr. Gregg's interest in Cadaja was as a limited partner.
The district court rejected the government's argument. The court held that a dependency existed between the two companies as Mr. Gregg intended the expertise and reputation he gained in the medical community through Ethix to be transferred to Cadaja.
The court stated that Mr. Gregg met the requirements that he participate in Cadaja beyond 500 hours, which entitled him to take a flow-through loss from Cadaja as an ordinary loss. The IRS was instructed to refund the overpayment and withdraw its penalties.
Cite: Stephen A. Gregg, et ux., v. United States, No. CV 99-845 AA
