IRS Sounds the Alarm: The Growing Tax Gap and Its Implications!

The Internal Revenue Service has released updated tax gap projections for tax years 2020 and 2021. Their current data reflects a significant increase from previous tax gaps. The agency estimates a tax gap of $192 billion from tax years 2014-2016 and $138 billion from 2017-2019, with an estimate of $688 billion for the 2021 tax year. This is notably the first time that tax gap projections have been updated and provided for a single year.

IRS Commissioner Danny Werfel believes this significantly larger projected tax gap “underscores the importance of increased IRS compliance efforts on key areas” and remarked that funding from the Inflation Reduction Act will assist the agency in “adding focus and resources to areas of compliance concern,” which primarily include high income individuals, partnerships, and businesses.

What is a Tax Gap?

A tax gap is the difference between the estimated tax liability in a specific period of time and the amount of taxes that are actually paid on time. Generally, a tax gap is caused by three factors:

• Non-filing, which is taxes not paid on time by individuals and businesses who did not file on time
• Underreporting of taxes, which is understated income or tax obligation on tax returns that were filed on time
• Underpayment of taxes, which is taxes that were reported on time, but paid late or not paid at all

It’s important to note that the IRS acknowledges that tax gap projections do not account for all noncompliance and that projections are primarily based on data from previous audits, then extrapolated to the current tax year(s). In addition, the estimated tax liability for tax years 2014-2016 and 2021 include an increase of approximately 38%, which is similar to the increase in gross and net tax gaps. This means that some of the projected tax liability increase is due to economic growth.

How Does the IRS Calculate the Tax Gap?

Unfortunately, no single approach can accurately estimate the tax gap as it is subject to error. The IRS works with statisticians and other data collectors to collect, calculate, and interpret the data as accurately as possible. Current compliance behavior and past investigation into noncompliance is used to project future data.

The tax gap is simply an estimate and does not represent the full extent of taxpayer non-compliance because projections cannot completely represent all areas of noncompliance. For example, it is impossible to fully determine offshore financial activity and accounts, all digital assets and cryptocurrency, corporate income tax complications, income from illegal activities, and money laundering.

The IRS also faces the challenge of a lack of method to calculate pandemic tax credits. Finally, the agency needs additional time to develop the necessary expertise to work with noncompliance related to digital assets and other emerging areas.

How Will the IRS Respond to the Increased Projected Tax Gap?

The IRS intends to use some of their newly acquired resources from the Inflation Reduction Act to take steps to assist with voluntary tax compliance. This includes improving taxpayer service, rolling out new technology, the use of AI and other digital tools, taxpayer service programs in rural areas, and more.

IRS research and other studies have shown that third party reporting of income has a significant impact on voluntary compliance, and that compliance increases even further when income payments are subject to tax withholding. The agency views voluntary compliance as crucial and calculates that even a 1% increase in voluntary compliance would increase revenue by $46 billion. The agency is also using a significant percentage of their newly acquired funding to expand their criminal investigative branch to help uncover areas of tax noncompliance.

Facing IRS Audits & Seeking Legal Advice?

If you’ve received a notice from the IRS and aren’t sure what to do next, reach out to Silver Law, PLC. As Arizona’s leading tax attorney firm, we can provide trustworthy legal guidance, representation, and assistance for any tax controversy you are facing. Whether you need audit representation, are seeking innocent spouse relief, need advice regarding cryptocurrency or an offshore account, or have been notified of pending criminal tax action, we our Phoenix tax lawyers can help. Contact us today to schedule your completely free, confidential consultation.

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