Tax Underreporting, High-Income Earners’ Non-Compliance Among Major

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The IRS is reportedly finding it difficult to plug the tax gap due to ‘sophisticated tax evasion schemes.’

Tackling the underreporting of incomes and ensuring tax compliance by wealthy individuals and corporations are two of the “major management challenges” the IRS is facing in fiscal year 2025, according to the Treasury Inspector General for Tax Administration (TIGTA).

A key responsibility of the IRS is to ensure that taxpayers comply with the Internal Revenue Code since small declines in compliance can “cost the country billions of dollars in lost revenue,” the watchdog said in an Oct. 15 report. Out of the $696 billion tax gap—when paid taxes are less than what’s owed—in tax year 2022, underreporting alone accounted for $539 billion, TIGTA said.

The increasing complexity of tax administration and “sophisticated tax evasion schemes” are hindering the IRS’s ability to close the tax gap, the report stated. To deal with the issue, the IRS expanded enforcement on taxpayers with “complex tax filings and high-dollar noncompliance.”

The agency aims to focus increasingly on taxpayers with complex returns whose audit rates are relatively low. This includes big corporations, large partnerships, and high-income, high-wealth individuals.

TIGTA noted that the IRS has had some success in its tax compliance measures. An initiative launched in late 2023 to collect unpaid taxes from 1,600 taxpayers who owed more than $250,000 recovered $1.1 billion by September this year.

In addition, the agency is using data analytics to identify large corporations that should be subjected to audits. It has already begun 60 audits on America’s biggest corporate taxpayers.

A critical issue that TIGTA is focusing on when it comes to the IRS’s increased compliance efforts is whether the tax agency is going after Americans making less than $400,000.

Back in 2022, the Treasury secretary asked the IRS not to use additional resources it gained via the Inflation Reduction Act to increase audit rates on small businesses or households earning below $400,000 a year relative to recent years.

Subsequently, the IRS commissioner said the agency aimed to modify its audit selection process for the earned income tax credit that is intended for lower-income taxpayers.

TIGTA said it will review the IRS’s efforts to ensure “they are fair and equitable and to assess compliance with the Secretary of Treasury’s directive.”

Tax Gap, Underreporting of Taxes

The TIGTA report followed the IRS’s release of the tax gap data for tax year 2022 last week. The IRS noted that the gap grew by more than $200 billion from tax years 2014 through 2016.

However, the agency did not attribute this increase to large-scale tax evasion but cited economic growth as the key reason.

The voluntary compliance rate among taxpayers remained steady at 85 percent during this period. The 2022 tax gap jump “ultimately reflects growth in the economy and changes in the sources of income—not a change in taxpayer behavior involving filing or paying their taxes,” the agency said.

A May 6 report from the U.S. Government Accountability Office (GAO) pointed out that the gross tax gap estimates have almost doubled between tax year 2001 and 2021, jumping from $345 billion to $688 billion. During this period, the gross tax gap has fluctuated between 2.6 percent and 3.5 percent of the GDP.

The single largest contributor to the tax gap estimates was sole proprietor income data. GAO’s review found that an estimated 21.5 million taxpayers reported some kind of sole proprietor income between 2014 and 2015.

Out of this, 28 percent was estimated to have reported the income correctly, and roughly 65 percent underreported by an average of $13,500.

While there has been interest in understanding how the tax gap is distributed in terms of taxpayer income, “identifying noncompliance by income is challenging because, by definition, noncompliant taxpayers do not accurately report their income,” GAO noted.

“Thus, IRS does not know a taxpayer’s true income without first conducting an audit,” it said.

As to the IRS’s position on increasing audits for Americans earning $400,000 or less annually, the agency admitted in May that a lack of funds could end up increasing scrutiny on low-income filers.

“Since lower-income taxpayers are more likely to have simple tax returns, this lack of funding will likely translate into a higher share of audits falling on low- and middle-income taxpayers, while examination coverage rates for high-income and large corporate taxpayers will severely decline,” the agency said in a report.