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Reducing the FederalTax Gap

A Report on Improving VoluntaryCompliance

Internal Revenue Service

U.S. Department of the Treasury

August 2, 2007


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Reducing the FederalTax Gap

A Report on ImprovingVoluntary Compliance

EXECUTIVESUMMARY1UNDERSTANDINGTHETAXGAP6VOLUNTARYCOMPLIANCE17COMPONENTS19

SUMMARY57APPENDIXInitiativeTimeframes58GLOSSARY 97


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INTRODUCTIONInFiscalYear(FY)2006,federalreceiptstotaledover$2.4trillion.Morethan95percentofthenetreceiptswerecollectedbytheInternalRevenueService(IRS)throughitsadministrationoftheincome,employment,transfer,andexcisetaxprovisionsoftheInternalRevenueCode.Virtuallyallofthesereceiptswerecollectedthroughataxsystemunderwhichtaxpayersvoluntarilyreportandpaytheirtaxeswithnodirectenforcementandminimalinteractionwiththegovernment.TheoverallcompliancerateachievedundertheUnitedStatesrevenuesystemisquitehigh.Forthe2001taxyear,theIRSestimatesthat,afterfactoringinlatepaymentsandrecoveriesfromIRSenforcementactivities,over86percentoftaxliabilitieswerecollected.Nevertheless,anunacceptablylargeamountofthetaxthatshouldbepaideveryyearisnot,suchthatcomplianttaxpayersbearadisproportionateshareoftherevenueburden,andgivingrisetothetaxgap.Thegrosstaxgapwasestimatedtobe$345billionin2001.Afterenforcementeffortsandlatepayments,thisamountwasreducedtoanettaxgapofapproximately$290billion.TheTreasuryDepartmentandIRSarecommittedtoimprovingcurrentcompliancelevelsandcontinuingtoaddressallformsofnoncompliance.TheIRSOversightBoardhasadoptedan86percentvoluntarycompliancegoalby2009andSenateFinanceCommitteeChairmanMaxBaucushasaskedfora90percentvoluntarycompliancegoalby2017.ThisreportsetsforthstepsthatwillbetakentoimprovecomplianceandenhancetheIRSabilitytomeasurecompliance.Onceimplemented,thesestepswillimprovetheIRSabilitytogaugeprogressinachievingspecificlong-termcomplianceobjectives.ThisreportoutlinestepsthattheIRSwilltaketoincreasevoluntarycomplianceandreducethe

taxgap.ItbuildsontheComprehensiveStrategyforReducingtheTaxGap(theTreasuryStrategy)thatwasreleasedinSeptember2006bytheTreasuryDepartmentsOfficeofTaxPolicyandprovidesmoredetailforthatstrategy.TheIRSregularlyaddressescomplianceimprovementmeasuresinitsplanningandbudgetingprocesses.TheAdministrationsannualbudgetrequestidentifiestheresourcestheIRSwillneedtomeetspecificperformancegoalstoachieveitsstrategicpriorities.Thisdocumentcombinesandaddressescurrenttaxgapefforts.Inaddition,theIRShaslongbeenconductingresearchincomplianceandthetaxgap,andresultingdataisincorporatedthroughoutthisdocument.Thestepsoutlinedinthisreportare,inmanyrespects,onlyinitialstepstowardimproving

compliance.Asdescribedbelow,oneoftheprimarychallengesthattheIRSfacesinimprovingcomplianceistogetabetterunderstandingofthecurrentsourcesofnoncompliancebyimprovingresearchinthisarea.Untilthatunderstandingisclarified,effortstoimprovecompliancemaybemisdirectedandprogressmaynotbemeasurable.TheIRShastakensignificantstepsinthisdirection,mostimportantlythroughtheNationalResearchProgram(NRP),whichisthesourceofupdatedestimatesofcomplianceamongindividualtaxpayersfor2001.TheIRSiscommittedtofurtheringitsworkinthisareathroughupdatedindividualtaxpayerNRPexaminationsandacurrentstudyfocusingoncomplianceamongSubchapterScorporations(Scorporations).

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Inimplementingthestepssetforthinthisdocument,itisimportanttohaverealisticexpectationsandperspectives.Basedonthelimitedinformationavailable,complianceratesappeartohaveremainedrelativelystableataround85percentfordecades.Tomakeameaningfulimprovementinthisnumberwithoutafundamentalchangeintherelationshipbetweentaxpayersandthegovernmentwillrequirealong-term,focusedeffort.Implementationofthe

stepsoutlinedinthisdocumentandintheAdministrationsFiscalYear(FY)2008BudgetrequestfortheIRSwillbesubjecttotheuncertaintiesassociatedwiththeannualbudgetprocess.Moreover,itmustberecognizedthatthecausesofnoncompliancearenumerousandthatonlyaportionofthetaxgapresultsfromintentionalavoidanceorevasionofthelaw.Anequallyorperhapsmoreimportantpartoftheproblemliesinthegrowingcomplexityofthetaxlaws,whichwillcontinuetofrustrateeffortstoimprovecompliance.TheAdministrationiscommittedtoworkingwithCongressandotherstakeholderstoreducethetaxgap.TheAdministrationsFY2008Budgetrequestincludes$11.1billionfortheIRS,a4.7percentincreaseoverthebudgetenactedforFY2007.Atotalof$410millionisfornewenforcementinitiativesaspartofastrategytoimprovecomplianceby:

Increasingfront-lineenforcementresources; Increasingvoluntarycompliancethroughimprovedtaxpayerserviceoptionsand

enhancedresearch; Investingintechnologytoreverseinfrastructuredeterioration,accelerate

modernization,andimprovetheproductivityofexistingresources;and

Implementinglegislativeandregulatorychanges.

Since2001(thetaxyearstudiedbytheNRP),IRStaxcollectionshaveincreasedsignificantly,auditrateshaveimprovedacrossalltaxpayersegments,andmeasurementsoftaxpayerservice

haverisentohistoriclevels.Whilespecificdataisnotavailable,thereiseveryreasontobelievethattheseimprovementshavecontributedtoageneralshiftawayfromaggressivetaxplanningandanimprovementincompliancelevelsoverthepastsixyears.IncallingforasignificantincreaseinIRSfunding,theAdministrationsbudgetrecognizes,however,thatmuchworkremainstobedone.Basedonhistoricexperience,theIRSestimatesthattheoverallreturnonnewinvestmentsincomplianceaverages4:1,withanadditionalindirectimpactresultingfromtheimprovedoverallcompliancethatcomesfrommoretargetedandeffectiveenforcementofthetaxlaw.However,directspendingoncomplianceimprovementsdoesnotlenditselftotraditionalrevenue-estimatinganalysis,giventhedifficultyinquantifyingtheeffectthatsuchimprovementshaveontaxpayerbehavior.ThisreportprovidesdetailonhowtheadditionalfundsrequestedintheAdministrationsFY2008BudgetwillbuildonimprovementstheIRShasmadeinrecentyearstotaxpayerservice,modernization,andenforcement,allofwhicharecriticalelementsinthelong-termstrategytoimprovecompliance.Inparticular,thisreportdescribessixseparateinitiativesintheFY2008Budgetrequestthatareaimedatimprovingenforcement.Thereportalsodetailshowadditionalfundsrequestedwillbetargetedtoimprovingtaxpayerservice,includingimplementationoftherecommendationsmadeintherecentlyreleasedTaxpayerAssistanceBlueprint(TAB).Inaddition,thereportoutlineshowadditionalfundswillaccelerateimplementationofIRSmodernizationprograms,topermitbetterdocumentmatching,fasterandmoreaccurateprocessingofreturns,andmoretimelyaccesstotaxpayeraccountinformation.Adetailed

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timelineforimplementingthesevariousprogramsisincludedasanAppendixtothisreport.TheTreasuryDepartmentandIRSwillcontinuetoevaluateresourcedemandsforimprovingtaxpayercompliance.Inaddition,futurebudgetrequestswillidentifywaystoutilizeresourcesefficientlyandeffectivelytotargetenforcementeffortstoareaswheretheywillhavethegreatestdirectandindirectimpactoncompliance.Thestepsforimprovingcompliancethataredetailed

inthisreportwillcontinuetoevolveovertimeasourunderstandingoftheproblemimprovesandaschangesintheeconomyandchangesinthetaxlawpresentnewcompliancechallenges.The Treasury Departments Comprehensive Strategy for Reducing the Tax GapFourkeyprinciplesguidedthedevelopmentoftheTreasuryStrategyandcontinuetoguideIRSeffortstoimprovecompliance:

First,bothunintentionaltaxpayererrorsandintentionaltaxpayerevasionshouldbeaddressed.

Second,sourcesofnoncomplianceshouldbetargetedwithspecificity.

Third,enforcementactivitiesshouldbecombinedwithacommitmenttotaxpayer

service.

Fourth,policypositionsandcomplianceproposalsshouldbesensitivetotaxpayerrightsandmaintainanappropriatebalancebetweenenforcementactivityandimpositionoftaxpayerburden.

Theseprinciplespointtotheneedforacomprehensive,integrated,multi-yearstrategytoreducethetaxgap.Guidedbythesekeyprinciples,theTreasuryStrategyoutlinessevencomponentswhichformthebasisforthedetailedcomplianceimprovementeffortssetforthinthisdocument:

1.Reduce Opportunities for Evasion.TheAdministrationsFY2008Budgetrequestcontains16legislativeproposalstoreduceevasionopportunitiesandimprovetheefficiencyoftheIRS.Threeoftheseproposalswererecentlyenactedinmodifiedform.The16provisionswouldresultinanestimated$29.5billionofadditionalrevenuesoverthenexttenyears.TheTreasuryDepartmentandtheIRSalsocontinuetousetheregulatoryguidanceprocesstoaddressbothproceduralandsubstantiveissuestoimprovecomplianceandreducethetaxgap.2.Make a Multi-Year Commitment to Research.ResearchisessentialtoidentifysourcesofnoncompliancesothatIRSresourcescanbetargetedproperly.RegularlyupdatingcomplianceresearchensuresthattheIRSisawareofvulnerabilitiesastheyemerge.Newresearchisneededontherelationshipbetweentaxpayerburdenandcomplianceandontheimpactofcustomerserviceonvoluntarycompliance.Researchalsoisessentialtoestablishaccurate

benchmarksandmetricstoassesstheeffectivenessofIRSefforts,includingtheeffectivenessoftheTreasuryStrategy.3.Continue Improvements in Information Technology.Continuedimprovementstotechnology,includingcontinueddevelopmentofandadditionstoModernizede-File,willprovidetheIRSwithbettertoolstoimprovecompliancethroughearlydetection,bettercaseselection,andbettercasemanagement.

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4. Improve Compliance Activities.IRSactionshaveproducedasteadyclimbinenforcementrevenuessince2001,andanincreaseinboththenumberofexaminationsandthecoveragerateinvirtuallyeverymajorcategory.Byfurtherimprovingexamination,collection,anddocumentmatchingactivities,theIRSwillbebetterabletoprevent,detect,andremedynoncompliance.TheseactivitieswillincreasecompliancenotonlyamongthosedirectlycontactedbytheIRS,butalsoamongthosewhowillbedeterredfromnoncompliantbehavioras

aconsequenceofamorevisibleIRSenforcementpresence.AidedbyresultsfromtherecentNRPstudyofindividualtaxpayers,theIRScontinuestoreengineerexaminationandcollectionproceduresandinvestintechnology,resultinginefficiencygainsandbettertargetingofexaminationefforts.Theseefficiencygainstranslateintoexpandedexaminationcoverage,higheraudityields,andreducedburdenoncomplianttaxpayers.5.Enhance Taxpayer Service.Serviceisespeciallyimportanttohelptaxpayersavoidunintentionalerrors.Giventheincreasingcomplexityofthetaxcode,providingtaxpayerswithassistanceandclearandaccurateinformationbeforetheyfiletheirtaxreturnsreducesunnecessarypost-filingcontacts,allowingtheIRStofocusenforcementresourcesontaxpayerswhointentionallyevadetheirtaxobligations.TheIRSalsoisworkingtoprovideservicemoreefficientlyandeffectivelythroughnewandexistingtools,suchastheIRSwebsite.The

TaxpayerAssistanceBlueprint(TAB),whichwascompletedinApril2007,outlinesafive-yearstrategicplanfortaxpayerservice.TheTABincludesaprocessforassessingtheneedsandpreferencesoftaxpayersandpartnersandadecisionmodelforprioritizingserviceinitiativesandfunding.6.Reform and Simplify the Tax Law.Simplifyingthetaxlawwouldreduceunintentionalerrorscausedbyalackofunderstanding.SimplificationwouldalsoreducetheopportunitiesforintentionalevasionandmakeiteasierfortheIRStoadministerthetaxlaws.Forexample,theAdministrationsFY2008Budgetrequestincludesproposalstosimplifytaxcreditsforfamiliesandtaxtreatmentofsavingsbyconsolidatingexistingprogramsandclarifyingeligibilityrequirements.TheseinitiativeswillcontinuetobesupplementedbyIRSeffortstoreducetaxpayerburdenbysimplifyingformsandprocedures.7.Coordinate with Partners and Stakeholders.EnhancedcoordinationisneededbetweentheIRSandstateandforeigngovernmentstoshareinformationandcompliancestrategies.Expandedcoordinationalsoisneededwithpractitionerorganizations,includingbarandaccountingassociations,tomaintainandimprovemechanismstoensurethatadvisorsprovideappropriatetaxadvice.Throughcontactswithpractitionerorganizations,theTreasuryDepartmentandIRSlearnaboutrecentdevelopmentsintaxpracticeandheardirectlyfrompractitionersabouttaxpayerconcernsandpotentiallyabusivepractices.Similarly,contactswithtaxpayersandtheirrepresentatives,includingsmallbusinessrepresentativesandlow-incometaxpayeradvocates,providetheTreasuryDepartmentandtheIRSwithneededinsightonwaystoprotecttaxpayerrightsandminimizethepotentialburdensassociatedwithcompliancestrategies.The IRS Strategic Planning ProcessThemoredetailedstepsoutlinedforimprovingcomplianceare,inpart,contingentuponthebudgetprocessforFY2008andbeyond.Accordingly,adoptionoftheAdministrationsproposedFY2008BudgetfortheIRSalongwiththeenactmentofthelegislativerecommendationsincludedaspartofthatbudgetarecriticalcomponentsofthestrategytoreducethetaxgap.

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TheIRShasanextensiveannualstrategicplanningprocessthroughwhicheachofitsoperatingdivisionsdevelopandestimateresourcerequirementsneededtoachievefunctionalprioritiesandperformancetargetsbasedonbudgetallocations.Detailedactionplans,whicharepartoftheIRSstrategicplanningprocessandarecoordinatedwiththisreport,identifyspecificsub-goalsandmeasuresaswellasaccountableparties.ProgresstowardtheseplansismonitoredinternallyandreportedtotheTreasuryDepartmentandtheOfficeofManagementandBudget

(OMB)throughouttheyear.ReturntoTableofContents

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TheInternalRevenueCodeplacesthreeprimaryobligationsontaxpayers:(1)tofiletimelyreturns;(2)tomakeaccuratereportsonthosereturns;and(3)topaytherequiredtaxvoluntarilyandtimely.Taxpayersarecompliantwhentheymeettheseobligations.Noncomplianceandthetaxgapresultswhentaxpayersdonotmeettheseobligations.Thetaxgapisdefinedastheaggregateamountof true tax liabilityimposedbylawforagiventaxyearthatisnot paid voluntarily and timely.True tax liability foranygiventaxpayermeanstheamountoftaxthatwouldbedeterminedforthetaxyearinquestionifallrelevantaspectsofthetaxlawwerecorrectlyappliedtoalloftherelevantfactsofthattaxpayerssituation.Foravarietyofreasons,thisamountoftendiffersfromtheamountoftaxthatataxpayerreportsonareturn.Thetaxpayermightnotunderstandthelaw,mightmakeinadvertentmistakes,ormightmisreportintentionally.Tobepaid voluntarily,ataxliabilitymustbepaidwithoutdirectIRSintervention.Taxpayershavetheresponsibilitytodetermineandreporttheircorrecttaxliability,andtomakesurethatamountispaid(whetherthroughwithholding,estimatedtaxpayments,paymentswithafiledreturn,etc.).TheIRSfocusesitsenforcementwhereitisneededmost,buttheoverallrateoftaxcomplianceintheUnitedStatesisashighasitisbecausethevastmajorityoftaxpayersmeettheirobligationswithlittleornoinvolvementfromtheIRS.Tobe paid timely,ataxliabilitymustbepaidinfullonorbeforethedateonwhichallpaymentsforthegiventaxyearwerelegallydue.ItisimportanttoemphasizethatIRSestimatesofthetaxgapareassociatedwiththe legalsector oftheeconomyonly.Althoughtaxisdueonincomefromwhateversourcederived,legalorillegal,thetaxattributabletoincomeearnedfromillegalactivitiesisextremelydifficulttoestimate.Moreover,thegovernmentsinterestinpursuing thistypeofnoncomplianceis,ultimately,tostoptheillegalactivity,notmerelytotaxit. Althoughtheyarerelated,thetaxgapisnotsynonymouswiththe underground economy.Definitionsoftheundergroundeconomyvarywidely.However,mostpeoplecharacterizeitintermsofthevalueofgoodsandservicesthateludeofficialmeasurement.Furthermore,therearesomeitemsintheundergroundeconomythatarenotincludedinthetaxgap(suchastaxdueonillegal-sourceincome),andtherearecontributorstothetaxgapthatnoonewouldincludeintheundergroundeconomy(suchasthetaxassociatedwithoverstatedexemptions,adjustments,deductions,orcredits,orwithclaimingthewrongfilingstatus).Thegreatestareaofoverlapbetweenthesetwoconceptsissometimescalledthecasheconomy,inwhichincome(usuallyofabusinessnature)isreceivedincash,whichhelpstohideitfromtaxation.

Equallyimportant,thetaxgapdoesnotarisesolelyfromtaxevasionorcheating.Itincludesasignificantamountofnoncomplianceduetotaxlawcomplexitythatresultsinerrorsofignorance,confusion,andcarelessness.Thisdistinctionisimportanteventhough,atthispoint,theIRSdoesnothavesufficientdatatodistinguishclearlytheamountofnoncompliancethatarisesfromwillful,asopposedtounintentional,mistakes.Moreover,thelinebetweenintentionalandunintentionalmistakesisoftenagreyone,particularlyinareassuchasbasisreporting,whereataxpayermayknowthathisorherreportingisinaccuratebutdoesnothavereadyaccesstoaccurateinformation.Thisisanareawhereadditionalresearchisneededtoimproveunderstanding.

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MEASURING THE TAX GAPHistorically,estimatesoffederaltaxcompliancewerebasedonspecialstudies,includingtheTaxpayerComplianceMeasurementProgram(TCMP),whichcoveredincomeandself-employmenttaxesandgroupsoftaxpayers,andconsistedofline-by-lineauditsofrandomsamplesofreturns.ThesestudiesprovidedtheIRSwithinformationoncompliancetrendsand

allowedtheIRStoupdateauditselectionformulasregularly.However,thismethodofdatagatheringwasextremelyburdensomeonthetaxpayerswhosereturnswereselected.Asaresultofconcernsraisedbytaxpayers,Congress,andotherstakeholders,thelastTCMPauditsweredonein1988.TheIRSconductedseveralmuchnarrowercompliancestudiesbetween1988and2001,butnothingthatwouldprovideacomprehensiveperspectiveontheoveralltaxgap.Untilrecently,allofthesesubsequentestimatesofthetaxgaphavebeenroughprojectionsthatbasicallyassumenochangeincomplianceratesamongthemajortaxgapcomponentseventhoughthemagnitudeoftheseprojectionsreflectsgrowthintaxreceiptsinthesemajortaxgapcategories.TheNRP,whichtheIRShasusedtoestimatethemostrecenttaxgapupdates,aroseoutofa

desiretofindalessintrusivemeansofmeasuringtaxcompliance.TheIRSusedafocusedstatisticalselectionprocessthatresultedintheselectionofapproximately46,000individualincometaxreturnsforTaxYear(TY)2001somewhatfewerthanpreviouscompliancestudies,eventhoughthepopulationofindividualtaxreturnshadgrownovertime.Likethecompliancestudiesofthepast,theNRPwasdesignedtoallowtheIRStomeetcertainobjectivestoestimatetheoverallextentofreportingcomplianceamongindividualincometaxfilersandtoupdatetheaudit-selectionformulas.Italsointroducedseveralinnovationsdesignedtoreducetheburdenimposedontaxpayerswhosereturnswereselectedforthestudy.ThefirstNRPinnovationwastocompileacomprehensivesetofdatatosupplementwhatwasreportedontheselectedreturns.Thesourcesofthecasebuildingdataincludedthird-party

informationreturnsfrompayersofincome(e.g.,FormW-2andForm1099)andprior-yearreturnsfiledbytaxpayers.Also,forthefirsttime,theIRSaddeddataondependentsobtainedfromvariousgovernmentsources,aswellasdataobtainedfrompublicrecords(e.g.,currentandprioraddresses,realestateholdings,businessregistrations,andinvolvementwithcorporations).Together,thesedatareducedtheamountofinformationrequestedfromtaxpayers,withsomeoftheselectedtaxpayersnotrequiringanycontactfromtheIRS.Ineffect,thesedataallowedtheIRStofocusitseffortsonreturninformationthatcouldnototherwisebeverified.Thispioneeringapproachwassosuccessfulitisbeingexpandedinregularoperationalauditprograms.AsecondmajorNRPinnovationwastointroduceaclassificationprocess,wherebytherandomlyselectedreturnsandassociatedcase-buildingdatawerefirstreviewedbyexperiencedauditors(referredtoasclassifiers)whoidentifiednotonlywhichissuesneededtobeexamined,butalsothebestwaytohandleeachreturninthesample.Inthisway,eachreturnwaseither:(1)acceptedasfiled,withoutcontactingthetaxpayeratall(although,sometimes,minoradjustmentswerenotedforresearchpurposes);(2)selectedforcorrespondenceauditofuptothreefocusedissues;or(3)selectedforanin-personauditwheretherewerenumerousitemsthatneededtobeverified.Inaddition,theclassifiersidentifiedcomplianceissuesthattheauditorwasrequiredtoevaluate,althoughtheexaminershadtheabilitytoexpandtheaudittoinvestigateotherissuesaswarranted.

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OtherNRPinnovationsincludedstreamliningthecollectionofdata,providingauditorswithnewtoolstodetectnoncompliance,andinvolvingstakeholders(includingrepresentativesoftaxprofessionalassociations)inthedesignandimplementationofthestudy.Clearly,theNRPapproachwasmuchlessburdensomeontaxpayersthantheoldTCMPaudits,whichexaminedeverylineitemoneveryreturn.TAX GAP ESTIMATESAsnotedabove,forthe2001taxyear,theoverallgrosstaxgapwasestimatedtobeapproximately$345billion,correspondingtoanoncompliancerateof16.3percent.Afteraccountingforenforcementeffortsandlatepayments,theamountwasreducedto$290billion,correspondingtoanetnoncompliancerateof13.7percent.Noncompliancetakesthreeforms:

notfilingrequiredreturnsontime(nonfiling); notreportingonesfulltaxliabilityonatimelyfiledreturn(underreporting);and nottimelypayingthefullamountoftaxreportedonatimelyreturn(underpayment).

TheIRShasseparatetaxgapestimatesforeachofthesethreetypesofnoncompliance.Underreporting(intheformofunreportedreceiptsandoverstatedexpenses)constitutesover82percentofthegrosstaxgap,upslightlyfromearlierestimates.Underpaymentconstitutesnearly10percentandnonfilingalmost8percentofthegrosstaxgap.NonfilingThenonfilinggapisdefinedastheamountoftruetaxliabilitythatisnotpaidontimeby

taxpayerswhodonotfilearequiredreturnontime(oratall).Itisreducedbyamountspaidontime,suchasthroughwithholding,estimatedpayments,andothercredits.Thenonfilerpopulationdoesnotincludelegitimatenonfilers(i.e.,thosewhohavenoobligationtofile).UnderreportingTheunderreportinggapisdefinedastheamountoftaxliabilitynotvoluntarilyreportedbytaxpayerswhofilerequiredreturnsontime.Forincometaxes,theunderreportinggaparisesfromthreeerrors:underreportingtaxableincome,overstatingoffsetstoincomeortotax,andnetmatherrors.Taxableincomeincludessuchitemsaswagesandsalaries,rentsandroyalties,andnetbusinessincome.Offsetstoincomeincludeincomeexclusions,exemptions,statutoryadjustments,anddeductions.Offsetstotaxaretaxcredits.Netmatherrorsinvolve

arithmeticmistakesortranscriptionerrorsmadebytaxpayersthatarecorrectedatthetimethereturnisprocessed.Inadditiontodevelopinganestimateoftheaggregateunderreportinggap,itispossibletobreakaspectsofthisestimatedownintomeasuresoftheunderreportinggapattributabletospecificlineitemsonthetaxreturn.

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UnderpaymentTheunderpaymentgapistheportionofthetotaltaxliabilitythattaxpayersreportontheirtimelyfiledreturnsbutdonotpayontime.Thisarisesprimarilyfrominsufficientremittancesfromtaxpayersthemselves.However,italsoincludesemployerunder-depositsofwithheldincometax.Inthecaseofwithheldincometax,itistheresponsibilityoftheemployeestoreportthe

correspondingtaxliabilityontimelyfiledreturns,anditistheresponsibilityoftheiremployerstodepositthosewithholdingswiththegovernmentontime.THE TAX GAP MAPFigure1summarizesthekeycomponentsofthetaxgapandhowtheyrelatetooneanother.IthascometobeknownastheTaxGapMap.AstheTaxGapMapindicates,theIRSestimatesthat,for2001,approximately$55billionofthegrosstaxgapwilleventuallybepaidthroughenforcementorotherlatepayments,leavinganettaxgapofabout$290billion.Thisprojectionofwhatwilleventuallybepaidisbasedonfiscalyeartabulationsofpastenforcementrevenueandonpriorstudiesofamountsthatarepaidlatewithoutenforcementefforts.Obviously,thisprojectiondependsdirectlyonactionsthatboththeIRSandtaxpayerswilltakeinthefuture,andthepastisnotlikelytobeaperfectpredictorofthat.Moreover,theIRSdoesnothavegooddataontheamountsthatarepaidlatewithoutenforcementefforts.Consequently,thisestimateofenforcementrevenuesandotherlatepaymentsisnecessarilysubjecttosomeuncertainty.TheTaxGapMapdistinguishesbetweengoodandweakestimates.Forexample,thecorporationincometaxestimatesareacknowledgedasweakbecausecompliancebehaviormayhavechangedsincethemid-1980s,whichisthelasttimetheIRScollecteddataoncorporatecompliance.Moreover,theunderreportingtaxgapisestimatedasthedifferencebetweentruetaxliabilityandreportedamounts.Determiningtruetaxliabilityforlargemulti-nationalcorporationscanbedifficult,giventhecomplexityofthetaxlaw,economicactivitiesundertakenbythesetaxpayers,andthedifficultyofmakinganykindofstatisticallyvalid

assumptionsbasedonalimitedpopulationoftaxpayers.Weaknessesingeneralarisefromtwocauses:usingolddataandusingdataandmethodsthatdonotadequatelyreflectthefullextentofnoncompliance.Figure2organizestheseestimatesbytypeoftaxandbytypeofnoncompliance.Aswithtaxgapestimatesforpriortaxyears,theoveralltaxgapisdominatedbytheunderreportingofindividualincometax,whichresultsinpartfromthedominantrolethattheindividualincometaxplaysinoverallfederaltaxreceipts.Theindividualincometaxaccountedforabouthalfofalltaxreceiptsin2001.Individualincometaxunderreporting,however,wasapproximately$197billion,orabout57percentoftheoveralltaxgap.Whileacomparisonwith1988datawouldsuggestaslightdecreaseinindividual

incometaxreportingcompliance,itisimportanttorememberthatthedatatellnothingabouttheyearsjustbeforeorjustafterTY2001and,assuch,cannotshowwhethercompliancetrendstodayareimprovingorgettingworse.Moreover,manyaspectsofthedataandestimatingmethodologiesusednowarenotcomparabletoearlierstudies.Inaddition,broaderchangesintheeconomyoverthepast20yearshavemadecomparisonsbetweenthedatadifficult.

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Figure1

Figure 2

Tax Year 2001 Gross Tax Gap by Type of Tax and Type of Noncompliance (in $ billions)Type of Noncompliance TOTALType of Tax Nonfiling

GapUnderreporting

GapUnderpayment

Gap* AmountPercent

DistributionIndividualIncomeTax 25 197 23.4 245 71.1%

CorporationIncomeTax

# 30 2.3 32 9.3%

EmploymentTax # 54 5.0 59 17.0%

Estate&GiftTax 2 4 2.1 8 2.4%ExciseTax # # 0.5 1 0.1%

TOTALPercentDistribution

277.8%

28582.5%

33.39.7%

345

100.0%

* Sincetheunderpaymentgapfiguresaregenerallyactualamountsratherthanestimates,theyarepresentedheretotheclosest$0.1billion.

#Noestimatesareavailableforthesecomponents.

Amountsmaynotaddtototalsduetorounding.SeeFigure1regardingthereliabilityofestimates.

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Theestimateoftheself-employmenttaxunderreportinggapis$39billion,whichaccountsforabout11percentoftheoveralltaxgap.Self-employmenttaxisunderreportedprimarilybecauseself-employmentincomeisunderreportedforincometaxpurposes.Takingindividualincometaxandself-employmenttaxtogether,then,itcanbeseenthatindividualunderreportingcontributesapproximately68percentoftheoveralltaxgap.

Figure3presentsthesameinformation,brokenoutbytypeoftaxpayer(asdefinedbytheIRSoperatingdivisionsthatservethetaxpayer)ratherthanbytypeofnoncompliance.Thisindicatesthatmostoftheunderreportingofindividualincometaxisassociatedwithindividualswhohavebusinessincome.Theunderreportingofself-employmenttaxiscloselyassociatedwiththeunderreportingofbusinessincomebyindividuals;soleproprietorswhounderstatetheirbusinessincomeforincometaxpurposesarenotlikelytoreporttheunreportedincomeforemploymenttaxpurposeseither.

Figure3Tax Year 2001 Gross Tax Gap by Type of Tax and IRS Operating Division (in $ billions)

IRS Operating Division TOTALSmall Business / Self-EmployedType of Tax Wage &Invest-ment Indi-viduals Corpor-ations Total

Large &Mid-SizeBusinessTax-Exempt& GovtEntities

TaxGapNon-ComplianceRate

IndividualIncomeTax

50 195 N/A 195 N/A N/A 245 20.9%CorporationIncomeTax*

N/A N/A 6 6 25 1 32 18.5%EmploymentTax 0 40 7 47 8 4 59 8.1%Self-Employment

N/A 39 N/A 39 N/A N/A 39 51.9%FICAandFUTA

0 1 7 8 8 4 20 3.0%Estate&GiftTax

# 8 N/A 8 N/A N/A 8 22.9%ExciseTax

0 0 0 0 0 0 1 TOTAL GapPercentofTotal

5014.5%

24370.5%

144.0%

25774.5%

349.8%

41.2%

345100.0%

NoncomplianceRate

12.1% 27.1% 5.3% 22.3% 8.0% 3.4% 16.3%

* UnrelatedBusinessIncomeTaxisshownascorporationincometax.

Includesunderpaymentgaponly.

#Noestimateisavailableforthiscomponent.

Amountsmaynotaddtototalsduetorounding.Zerosindicateamountslessthan$0.5billion.SeeFigure1regardingreliabilityofestimates.

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Individualincometaxaccountsforover71percentoftheoveralltaxgapestimateof$345billion.Thisisdue,inpart,tothefactthatindividualincometaxisthelargestsinglesourceoffederalreceipts.Theindividualincometaxunderreportinggapcanbebrokenoutbythevariouslineitemsonatypicalreturnincomesources,offsetstoincome(i.e.,exemptions,adjustments,and

deductions),andoffsetstotax(i.e.,credits).Figure4providesupdatedestimatesofboththetaxgaparisingfrommisreportingoneachlineitemandthecorrespondingNetMisreportingPercentage(NMP).1Theseestimatesarebasedonthoroughauditsofarepresentativesampleofreturns,buttheyalsoaccountforunderreportingthatisnotdetectedinthoseaudits.Asinpreviouscompliancestudies,theNRPdatasuggestthatwelloverhalf($109billion)oftheindividualunderreportinggapcamefromunderstatednetbusinessincome(e.g.,unreportedreceiptsandoverstatedexpenses).Approximately28percent($56billion)camefromunderreportednon-businessincome,suchaswages,tips,interest,dividends,andcapitalgains.Theremaining$32billioncamefromoverstatedsubtractionsfromincome(i.e.,statutoryadjustments,deductions,andexemptions)andfromoverstatedtaxcredits.

AnobviousconclusionfromFigure4isthattheaccuracyofreportingthevariouslineitemsontheaverageincometaxreturnvarieswidely,dependingonthetypeofincomeoroffsetbeingreported.Figure5presentsthesamelineitemsgroupedbythedegreetowhichtheitemsarevisibletotheIRSthatis,theextenttowhichtheyaresubjecttoinformationreportingandwithholding.Theconclusionisstriking:reportingcomplianceisstrongestinthepresenceofsubstantialinformationreportingandwithholding.ThisisillustratedgraphicallyinFigure6.Althoughthecontributiontotheunderreportinggapdependsonthedollarsofincomeoroffsetatstake,theNMPisclearlyinverselyrelatedtothedegreeofvisibility.ItappearsthatcomplianceratesforsectionsoftheForm1040wherethemostnoncomplianceoccurshavenotchangeddramaticallysincethelastcompliancestudyforTY1988.Theamountsleastlikelytobemisreportedontaxreturnsaresubjecttoboththird-partyinformationreportingandwithholdingandare,therefore,themostvisible(e.g.,wagesandsalaries).Thenetmisreportingpercentageforwagesandsalariesisonly1.2percent.Amountssubjecttothird-partyinformationreporting,butnottowithholding(e.g.,interestanddividendincome),exhibitasomewhathighermisreportingpercentage.Forexample,thereisabouta4.5netmisreportingpercentagerateforitemssubjecttosubstantialinformationreporting,suchasinterest,dividends,pensions,andsocialsecuritybenefits.Amountssubjecttopartialreportingbythirdparties(e.g.,capitalgains)haveastillhighernetmisreportingpercentagerateof8.6percent.Asexpected,amountsnotsubjecttowithholdingorthird-partyinformationreporting(e.g.,soleproprietorincomeandtheotherincomelineonForm1040)aretheleastvisibleand,therefore,aremostlikelytobemisreported.Thenetmisreportingpercentageforthisgroupoflineitemsis53.9percent.

1Thenetamountofincomemisreporteddividedbythesumoftheabsolutevaluesoftheamountsthatshouldhavebeenreported.TheNMPmeasuresprovideinsightintotheextentofnoncomplianceforanygivenprovision.However,cautionshouldbeappliedwhencomparingNMPsacrosstaxprovisions.First,aprovisionmayhavealargeNMPbutcontributeonlyslightlytothetaxgap(e.g.,thetotaltruetaxliabilityforaparticularitemisrelativelysmall).Second,theNMPcontainsanadjustmentforincomeamountsthatwereunderreportedbutdoesnothaveacorrespondingadjustmentforoffsetamountsthatwerenotclaimed.

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Figure 4

Tax Year 2001 Individual Income Tax Underreporting Gap and Net MisreportingPercentage (NMP) Associated with Income and Offset Line ItemsType of Income or Offset UnderreportingGap ($B)

NetMisreportingPercentage

Total Underreporting Gap 197 18%Underreported Income 166 11%Non-Business Income 56 4%Wages,salaries,tips 10 1%Interestincome 2 4%Dividendincome 1 4%Stateincometaxrefunds 1 12%Alimonyincome * 7%Pensions&annuities 4 4%Unemploymentcompensation * 11%SocialSecuritybenefits 1 6%Capitalgains 11 12%Form4797income 3 64%Otherincome 23 64%

Business Income 109 43%Non-farmproprietorincome 68 57%Farmincome 6 72%Rents&royalties 13 51%Partnership,S-Corp,

Estate&Trust,etc.

22 18%

Overreported Offsets to Income 15 4%Adjustments -3 -21%SETaxdeduction -4 -51%Allotheradjustments 1 6%

Deductions 14 5%Exemptions 4 5%Credits 17 26%Net Math Errors (non-EITC) *

Theamountofincomeoroffsetmisreporteddividedbytheamountthatshouldhavebeenreported.TheNRPcontainsanadjustmentforincomeamountsthatwereunderreported,butdoesnothaveacorrespondingadjustmentforoffsetamountsthatwerenotclaimed.

*Lessthan$0.5billion.Taxpayersunderstatethisadjustmentbecausetheyunderstatetheirself-employmentincomeand,thereby,theirself-employmenttax.Therefore,thegapassociatedwiththisitemisnegative.

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Figure 5

Tax Year 2001 Individual Income Tax Underreporting Gap and Net MisreportingPercentage (NMP) Associated with Income and Offset Line Items, By VisibilityGroupsVisibility GroupTypeofIncomeorOffset

UnderreportingGap ($B)NetMisreportingPercentage

Total Underreporting Gap 197 18%Items Subject to SubstantialInformation Reporting and Withholding 10 1%Wages,salaries,tips 10 1%Items Subject to SubstantialInformation Reporting 9 5%Interestincome 2 4%

Dividendincome 1 4%Stateincometaxrefunds 1 12%Pensions&annuities 4 4%Unemploymentcompensation * 11%SocialSecuritybenefits 1 6%Items Subject to Some InformationReporting 51 9%Partnership,S-Corp,Estate&Trust,etc.

22 18%

Alimonyincome * 7%Capitalgains 11 12%

Deductions 14 5%Exemptions 4 5%Items Subject to Little or NoInformation Reporting 110 54%Non-farmproprietorincome 68 57%Farmincome 6 72%Rents&royalties 13 51%Form4797income 3 64%Otherincome 23 64%Totalstatutoryadjustments -3 -21%

Not Shown on Figure 6 17 26%Credits 17 26%

Theaggregateamountofincomeoroffsetmisreporteddividedbythesumoftheabsolutevaluesoftheamountthatshouldhavebeenreported.Theestimatesoftheamountsthatshouldhavebeenreportedaccountforunderreportedincomethatwasnotdetectedbytheaudits,butdonothaveacorrespondingadjustmentforunclaimedoffsets(e.g.,deductions,exemptions,statutoryadjustments,andcredits)thatwerenotdetected.

*Lessthan$0.5billion.

Sincecreditsareoffsetstotax,itisdifficulttocombinethemwithincomeandincomeoffsetitemswhencalculatingacombinedNMP.

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Figure 6

Tax Year 2001 Individual Income Tax Underreporting GapMisreporting of Income and Offsets by Visibility Categories

WithtransactionsthatarelessvisibletotheIRS,andwithverylowauditratesbyhistorical

standards,somesoleproprietorsmayhavebecomeemboldenedtocutcornersontheirtaxes.Othersmallbusinessownersmayfailtocomplyfullybecausetheyareoverwhelmedbythecostandcomplexityofmeetingtheirtaxobligationsandtheirbusinessrequirements.Whateverthereasons,thereisaseriousproblemwithunderreportingforthoseitemsnotsubjecttoinformationreporting.Theunderpaymentgapisthesimplestcomponentofthetaxgaptomeasuresince,forthemostpart,itisobservedinfull.Theunderpaymentgapisthedifferencebetweenthetaxthattaxpayersreportontheirtimelyfiledreturnsandtheamountthatisactuallypaidbythepaymentduedate.ThefirstamountistabulatedfromtheIndividualMasterFile.Withtheexceptionofemployerunder-depositofwithheldincometax,theamountpaidisalsotabulatedfromtheIndividualMasterFile.

Figure7summarizestheunderpaymentgapandratesforTY2001arrayedbytaxpayertype(ratherthantaxtypeasinFigure1).Almostallofwhatisvoluntarilyreportedisalsopaidontime,andmorethantwo-thirdsofthebalanceispaidwithintwoyears.Individualincometaxcontributesalmosttwo-thirdsofthetotalunderpaymentgap,andoverthree-quartersoftheindividualincometaxunderpaymentgapisassociatedwithtaxpayerswhohavebusinessincome.

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Sincesoleproprietorsreporttheirself-employmenttaxontheirindividualincometaxreturns(Form1040),theTY2001NRPstudyprovidednewcompliancedatawithwhichtoestimatethiscomponentofthetaxgap.Self-employmenttaxissometimesnotreportedcorrectly(oratall)inconnectionwithreportedself-employmentincomethatisreported.However,mostofthiscomponentofthetaxgapisassociatedwithunreportedself-employmentincome.TheNRPauditorsdetectedsomeofthisunreportedincome,butnotallofit.TheIRSestimateoftheself-

employmenttaxunderreportinggapaccountsforthisundetectedincome.Estimatesalsoaccountforthefactthatsomeofthisunreportedincomewouldnotbesubjecttofullself-employmenttax,giventheannualcaponSocialSecuritytaxes.Accountingforallofthesefactors,theupdatedestimateoftheself-employmenttaxgapforTY2001is$39billion.TheremainingtaxgapestimatesshownontheTaxGapMap(Figure1)arebasedondataolderthanTY2001.Inordertodevelopestimatesbasedonthelatestdata,butforacommontaxyear,theIRSprojectedthemostrecentpreviousestimatestoTY2001usingasimpleapproach.Lackinginformationtothecontrary,theIRSassumedthatthecompliancerateforeachmajorcomponentremainedconstant.Thetaxgapinagivencomponentwasprojectedtogrowatthesamerateastaxreceiptsinthatcomponent.TheIRSplanstoupdatetheseestimatesasnewercompliancedatabecomeavailable.

ThemainlessonfromtheTaxGapMapisthatnoncomplianceisworstwherethebarrierstovoluntarycomplianceortheopportunitiesfornoncompliancearegreatest.ThisisseenevenmorevividlyinFigure6,whichshowstheimportanceofthird-partyinformationreporting.

Figure7Tax Year 2001 Underpayment Gap By Type of Taxpayer

Net UnderpaymentGap ($ Billions) Cumulative PaymentCompliance RateType of TaxpayerGrossUnderpaymentGap

($ Billions)

VoluntaryPaymentComplianceRate

After1 Year

After2 Years

After1 Year

After2 YearsAll Taxes * 31.7 98.6%

Wage&Investment 4.3 98.9% 2.1 1.8 99.4% 99.6%SmallBusiness/Self-Employed

23.7 97.6% 7.3 6.5 99.2% 99.3%

Large&Mid-SizeBusiness

3.3 99.6% 2.0 2.0 99.7% 99.7%

TaxExempt/GovernmentEntities

0.4 99.87% 0.2 0.1 99.95% 99.97%

TheVoluntaryPaymentComplianceRateistheportionoftaxreportedontimelyfiledreturnsthatispaidontime. TheCumulativePaymentComplianceRateistheportionoftaxreportedontimelyfiledreturnsthatispaidasofacertaindate.

*The$31.7billiontotalforalltaxesexcludes$1.6billionofindividualincometaxeswithheldbyemployersbutneitherreportedontimelyfiledemploymenttaxreturnsnorpaidbyemployers.

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Awiderangeoffactorsinfluencevoluntarycompliance,althoughthereislittleempiricalconfirmationastothemostimportantofthesefactorsortheirmagnitudes.However,itisgenerallyagreedthatIRSactionsarenotthesoleorperhapseventheprimarydeterminantsofvoluntarycompliance.Inadditiontowhetherinformationreportingandwithholdingrequirementsexistasmentionedpreviously,otherimportantfactorsincludethefollowing:

Taxlawchanges,including:o openingorclosingopportunitiesfornoncomplianceo taxlawcomplexitymayconfusetaxpayersormakenoncompliancemore

difficulttoobserveo taxratesmayaffectincentivestoreportincome

Theeconomy,including:

o incomeandunemploymentlevelso themixofindustries

Demographics,including:

o theagingofthepopulationo changinghouseholdarrangementso growthinthenumberofnon-English-speakingtaxpayers

Socio-politicalfactors,including:

o swingsinpatrioticsentimentso taxpayerperceptionsofwhethertheyaregettingtheirmoneysworthfrom

theirtaxes

Additionally,therearebothdirectandindirecteffectsofenforcementactivities.Directeffectsrefertothecollectionofadditionalrevenuefromtaxpayerswhoaresubjecttoenforcementactions.Indirecteffectsrefertospillovereffectswhenenforcementactivityononesetoftaxpayershaspositiveeffectsonthecompliancebehavioroftherestofthetaxpayerpopulationinresponsetoheightenedenforcementactivity.MEASURING VOLUNTARY COMPLIANCEItisverydifficulttodeterminetheimpactthatanyIRSactivityhasonvoluntarycompliance.WhilethedirecteffectofIRSenforcementactivitiesisidentifiablethroughtheimpactoncollections,theIRScannoteasilyestimatetheindirecteffects.ThatispartlybecausetheIRS

cannotobservetaxpayerstruetaxliabilities(theymustbeestimated),andpartlybecausesomanyfactorsmayinfluencetheextenttowhichtheypaytheirtaxvoluntarilyandtimelyincludingmanyfactorsoutsideofIRScontrol.ThechallengeistoestimatetheimpactofeachIRSactivityonobservablebehaviorsreturnsfiled,taxreported,andtaxpaidcontrollingforotherinfluencesasmuchaspossible.OnlythenwilltheIRSknowthebestmixofactivitiesthatwillfosterthegreatestdegreeofvoluntarycompliance.

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Long-Term Goal for Voluntary ComplianceTheVoluntaryComplianceRate(VCR)istheamountoftaxforagiventaxyearthatispaidvoluntarilyandtimely,expressedasapercentageofthecorrespondingamountoftaxthattheIRSestimatesshouldhavebeenpaid.Itreflectstaxpayerscompliancewiththeirfiling,reporting,andpaymentobligations.ThelatestestimateofVCRis83.7percentforalltaxesand

alltaxpayersforTY2001.IntheAdministrationsbudgetrequestforFY2007,theIRSestablishedalong-termgoalofan85percentvoluntarycompliancebyTY2009.InFebruaryof2007,theIRSOversightBoard,aspartofestablishingastrategicdirectionfortheIRS,establishedalong-termgoalofan86percentvoluntarycomplianceratebyTY2009.SenatorBaucus,ChairmanoftheSenateFinanceCommittee,hasaskedfora90percentvoluntarycompliancegoalbyTY2017.AnincreaseintheVCRto86percentbyTY2009maynotseemlarge,buttheavailableevidencesuggeststhattheVCRhasnotchangeddramaticallyoverthelast20to30years.Forexample,basedonTCMPdatafromthe1960sthroughthe1980s,theIRSestimatesthattheVCRhasmovedwithinarangeoftwopercentagepointsandwasvirtuallythesameinTY2001

asithadbeeninTY1985.Muchoftheestimatedfluctuationduringthistimelikelywasduetotheinherentlyimprecisenatureoftheseestimates,theimpactoftheTaxReformActof1986,andthechangingrelativesizesofrevenuesfromdifferenttaxes.SincetheIRShasestimatedtheoverallVCRforjustafewselectedyearsinthatperiod,itispossiblethatcompliancemayhavefluctuatedintheinterveningyears.However,theevidencefromindividualincometaxunderreportingbyfarthelargestportionofthetaxgap,andthecomponentmostfrequentlymeasuredindicatesthattherewasnoconsistenttrendoverthistimeperiod.

TheIRSandthepublicmusthaverealisticexpectationsaboutthemagnitudeandtimingoftheimpactofanyreasonableactionstoreducethetaxgap,particularlyifitisnotaccompaniedbybroadersimplificationandreformofthetaxcode,orsignificantadvancesincompliancetechnology.Implementingeffortstoreducethetaxgapwilltaketime;changingtaxpayerbehaviorsignificantlywillalsotaketime.Accordingly,resultsfromtheseeffortswillberealizedincrementallyoveranumberofyears.Aspartoftheactionsoutlinedinthisreport,theIRSwill,forexample,acquireandanalyzenewdata,improvedocument-matchingprograms,refineexaminationselectioncriteria,purchaseandtestnewtechnology,andtrainemployeestohandlenewenforcementandcustomerserviceresponsibilities.

Moreover,whileitmaybepossibletotakeactionto reducethetaxgap,itisnotpossibletoimplementapolicythateliminatesthetaxgapwithoutanunacceptablechangeinthefundamentalnatureofthecurrenttaxcompliancesystem.TheIRSis,however,committedtoaddressingalllevelsofnoncompliance.Therefore,theeffortstoreducethetaxgapwillcontinuetobedevelopedandrefinedtoachievethehighestlevelofcompliancepossible.

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Withanestimatednettaxgapof$290billionforTY2001,nosingleapproachwillbesuccessfulatsubstantiallyreducingnoncompliance.Accordingly,theTreasuryStrategysetoutacomprehensive,integrated,multi-yearstrategythatmustbeimplementedwithinthecontextoftheannualbudgetprocess.ThisreportbuildsontheworkoftheTreasuryStrategytoprovideacomprehensiveframeworkthatwillbeinstitutionalizedbytheIRSaspartofsoundtaxadministration.Thisreportincludessevencomponents,detailedbelow: 1. Reduce Opportunities for Evasion (pages20-25)

2. Make a Multi-Year Commitment to Research (pages26-27)3. Continue Improvements in Information Technology (pages28-32)4. Improve Compliance Activities (pages33-41)5. Enhance Taxpayer Service (pages42-49)6. Reform and Simplify the Tax Law (page50-52)7. Coordinate with Partners and Stakeholders (page53-56)

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Component1Reduce Opportunities for Evasion

Legislative changes and published guidance will reduce opportunities for evasion.

Legislative Proposals

TheAdministrationsFY2007Budgetcontainedfivelegislativeproposalsthatwouldreduceevasionopportunitiesbyfocusingonemploymenttaxes,informationreporting,streamliningcollectionprocedures,andproblemreturnpreparers.TheAdministrationsFY2008Budgetexpandsonthosefiveandcontainsseveraladditionalproposalsthatwouldfurtherreduceopportunitiesforevasionwithoutundulyburdeninghonesttaxpayers.Collectively,theDepartmentofTreasuryestimatesthatthese16legislativeproposalswouldgenerate$29.5billionoverthenext10years.TheIRSisencouragedtoseethatthreeoftheproposalshavealreadybecomelaw(inmodifiedform)andthatCongressistakingactiononanumberofthe

remainingproposals.PublicLaw110-28,TitleVIII,theSmallBusinessandWorkOpportunityTaxActof2007,enactedproposalsonamendingthecollectiondueprocessproceduresforemploymenttaxliabilities,expandingpreparerpenalties,andcreatinganerroneousrefundclaimpenalty.Theseproposals,alongwithotherscontainedintheFY2008Budget,aredescribedbelowinmoredetail:ExpandingInformationReporting:Third-partyreportingiscriticalforensuringvoluntarycompliance.Withoutreliablethird-partydata,theIRScannoteasilydetecterrorsintheabsenceofexpensiveandintrusiveaudits.TheIRSreceivesover1.5billioninformationreturnsayear,reportingincomefromemployers,financialinstitutions,third-partypayers,and

stateandfederalgovernments.However,theIRSstilllacksreliableinformationoncertaintypesofincome,mostnotablyincomeearnedbysmallbusinessesandtheself-employed.InformationreportingproposalsintheAdministrationsFY2008Budgetwould:

Requireinformationreportingonpaymentstocorporations.Thisproposalwouldrequireabusinesstofileaninformationreturnforpaymentsaggregatingto$600ormoreinacalendaryeartoacorporation(exceptatax-exemptcorporation).Thisproposalisestimatedtogenerate$7.7billionoverthenexttenyears.

Requirebasisreportingonsecuritysales.Thisproposalwouldrequirecertainbrokersto

reportinformationregardingadjustedbasisinconnectionwiththesaleofcertainpubliclytradedsecurities.Brokerswouldalsoberequiredtoreportacquisitionordisposition

datestohelpdeterminegainorlossfortaxpayers.Thisproposalisestimatedtogenerate$6.7billionoverthenexttenyears.

Expandbrokerinformationreporting.Thisproposalwouldrequireabrokerwhoisan

auctioneeroroperatesaconsignmentbusiness(electronicorother)tofileaninformationreturnshowingcustomerinformationandgrossproceedsfromthesaleoftangiblepersonalproperty.Therequirementwouldapplyonlyforcustomerswith100ormoreseparatetransactionsgeneratingatleast$5,000ingrossproceedsinayear.Thisproposalisestimatedtogenerate$2.0billionoverthenexttenyears.

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Requireincreasedinformationreportingforcertaingovernmentpaymentsforproperty

andservices.ThisproposalwouldauthorizetheIRSandTreasuryDepartmenttoissue

regulationsrequiringinformationreportingonallnon-wagepaymentsbyfederal,stateandlocalgovernmentstoprocurepropertyandservices.Thisproposalisestimatedtogenerate$390millionoverthenexttenyears.

Increaseinformationreturnpenalties.Thisproposalwouldincreasethe$50and$100

penaltyamountsto$100and$250,respectively,andwouldincreasethe$250,000and$100,000penaltycapsto$1,500,000and$500,000,respectively.Thisproposalisestimatedtogenerate$546millionoverthenexttenyears.

ImprovingCompliancebyBusinesses:Moreefficientfilingmechanisms,clearerrulesonwhoisliableforemploymenttaxes,andstreamlinedcollectiondueprocesswillcontributeto

improvedbusinesstaxcompliance. Requiree-filingbycertainlargeorganizations.Thisproposalwouldrequireall

corporationsandpartnershipsrequiredtofileScheduleM-3tofiletheirincometaxreturnselectronically.InthecaseoflargetaxpayersnotrequiredtofileScheduleM-3,suchasexemptorganizations,theregulatoryauthoritytorequireelectronicfilingwouldbeexpandedbeyondthecurrent250-returnminimum.

Implementstandardsclarifyingwhenemployeeleasingcompaniescanbeheldliablefor

theirclients'federalemploymenttaxes.Thisproposalwouldsetstandardsforholdingemployeeleasingcompaniesjointlyandseverallyliablewiththeirclientsforfederalemploymenttaxes.Thisproposalwouldprovidestandardsforholdingemployeeleasingcompaniessolelyliableiftheymeetspecifiedrequirements.Thisproposalisestimatedtogenerate$57millionoverthenexttenyears.

Amendcollectiondueprocessproceduresforemploymenttaxliabilities.Legislationwas

signedMay25,2007,implementingamodifiedversionofthisproposal.Itexpandstheexceptiontotherequirementforpre-levyCollectionDueProcessproceedingstoincludecertainleviesissuedtocollectfederalemploymenttaxes.Thechangewillgenerateanestimated$364millionoverthenexttenyears.

RequireacertifiedTaxpayerIdentificationNumberfromcontractors.Thisproposal

requiresacontractorreceivingpaymentsof$600ormoreinacalendaryearfromaparticularbusinesstofurnishtothebusinessitscertifiedTaxpayerIdentificationNumber(TIN).ThisproposalwouldrequireabusinesstoverifytheTINwiththeIRS,whichwouldbeauthorizedtodisclosewhethertheTIN-namecombinationmatchesIRSrecords.IfacontractorfailstofurnishanaccuratecertifiedTIN,thebusinesswouldthenberequiredtowithholdaflatrate.Thisproposalisestimatedtoraise$749millionoverthenexttenyears.

Requireinformationreportingonmerchantpaymentcardreimbursements.Thisproposal

wouldprovidetheIRSwithauthoritytoputintoeffectregulationsrequiringmerchantacquiringbanks(organizationsthatprocesscardpaymentsformerchants)toreporttotheIRSannuallythegrossreimbursementpaymentsmadetomerchantsinacalendaryear.Thisproposalisestimatedtogenerate$10.7billionoverthenexttenyears.

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StrengtheningTaxAdministration: Taxadministrationwillbestrengthenedthroughdisclosurerevisionsandstrongerpenaltiesfornonfiling.

ExpandIRSaccesstoinformationintheNationalDirectoryofNewHires(NDNH)fortaxadministrationpurposes.ThisproposalwouldamendtheSocialSecurityActtoexpand

IRSaccesstoNDNHdataforgeneraltaxadministrationpurposes,includingdatamatching,verificationoftaxpayerclaimsduringreturnprocessing,preparationofsubstitutereturnsfornoncomplianttaxpayers,andidentificationoflevysources.

Permitdisclosureofprisontaxscams.ThisproposalwouldauthorizetheIRStodisclose

certainlimitedreturninformationabouttaxviolationsbyinmatessoprisonofficialscouldpunishanddetersuchconductthroughadministrativesanctions.Thisisexpectedtogenerate$5millionoverthenexttenyears.

Makerepeatedwillfulfailuretofileataxreturnafelony.Thisproposalwouldsubjectany

personwhowillfullyfailstofiletaxreturnsinanythreeyearswithinanyfiveyearperiod,iftheaggregatedtaxliabilityforsuchperiodisatleast$50,000,toanewaggravated

failuretofilecriminalpenalty.Thisproposalisestimatedtogenerate$12millionoverthenexttenyears.StrengtheningPenalties:Enhancedpenaltieswillhelptodeternoncompliance.

Expandpreparerpenalties.LegislationwassignedMay25,2007,implementinga

modifiedversionofthisproposal.Itexpandsthescopeoftheexistingpreparerpenaltiestoincludenon-incometaxreturnsandrelateddocuments.Theproposalalsoincreasesrelatedpenaltyamounts.Thechangewillgenerateanestimated$80millionoverthenexttenyears.

Imposepenaltyonfailuretocomplywithelectronicfilingrequirement.Thisproposal

wouldestablishapenaltyforfailuretocomplywithe-filerequirements.Theamountofthepenaltywouldbe$25,000foracorporationor$5,000foratax-exemptorganization. Createanerroneousrefundclaimpenalty.LegislationwassignedMay25,2007,

implementingaversionofthisproposal.Itimposesapenaltyofupto20percentofadisallowedportionofaclaimforrefundorcreditforwhichthereisnoreasonablebasisfortheclaimedtaxtreatment,orforwhichthetaxpayerdidnothavereasonablecause.Thechangewillgenerateanestimated$98millionoverthenexttenyears.

TheTreasuryDepartmentandtheIRSwillcontinuetoexploreadditionalpossibilitiesforlegislativeproposals,aswellasimprovedmethodsforusingexternaldataanddatafrominformationreports.

Published Guidance

Publishedguidanceintheformofregulations,revenuerulings,revenueprocedures,notices,andannouncementsisacriticalelementintheIRSeffortstoreducetaxavoidance,improvetaxpayercompliance,andclosethetaxgap.

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Publishedguidance: Enhancescompliancebyprovidingdetailedsubstantiveandproceduralrules; Helpscomplianttaxpayersbetterunderstandhowtodetermineandpaytheirtax

liability; ReducesdisputesbetweentheIRSandtaxpayersregardingtheproperinterpretationof

thetaxlawandtheproceduresnecessarytocomplywithit;and Makesitmoredifficultfornoncomplianttaxpayerstoavoiddetectionorincorrectlyclaim

thattheirbehaviorispermittedunderthetaxlaw.SometaxstatutesspecificallydirecttheTreasuryDepartmentandtheIRStoissueregulationsorotherguidance.Certainstatutoryprovisionshavelittleornoeffectuntilimplementedbyregulationsorotheradministrativeguidance,andsomeprovideonlygeneraldirectionandbroadlydelegateauthoritytopublishregulations.Published

guidanceinterpretsthetaxlawandarticulateshowitappliesindifferentcircumstances,thushelpingtaxpayersdeterminehowtocomplywiththeirtaxobligations.TheTreasuryDepartmentandtheIRScontinuetoresolvemanydifficultissuesandremoveimpedimentstovoluntarycompliancethroughpublishedguidance.Theever-increasingcomplexityof,continuingchangesin,andtemporarynatureofthetaxlawalsopresentsignificantchallengestoaddressinglong-standingcomplianceproblemsthroughguidance.Thepublishedguidanceprogramalsoaidsinidentificationofissuesthatguidancecannotaddressandservesasignificantroleindevelopingsuggestionsforlegislativesolutions.Eachyear,theTreasuryDepartmentandtheIRSissueaPriorityGuidancePlan(PGP)thatsetsforththeguidanceprojectstargetedforcompletionoverthecourseofthefollowing12

months.ThePGPtypicallyincludesmorethan250separateguidanceprojects.ExamplesofpublishedguidancedesignedtoimprovecompliancerecentlyissuedbytheTreasuryDepartmentandtheIRSinclude: Regulationsclarifyingthetaxrulesandinformationreportingrequirementsforwidely

heldfixedinvestmenttrusts; Regulationsimplementingandexplainingnewtaxshelterdisclosurerulesand

penalties; Regulationsandotherguidanceonreportingandinclusioninincomeofdeferred

compensationfromnonqualifieddeferredcompensationplans; Regulationsandotherguidanceclarifyingandexplainingthenewdeductionfor

domesticproductionactivities; Guidanceexplainingtherulesgoverningcharitablecontributionsofvehicles;

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Guidanceontransferpricingissuesrelatedtocross-borderservicesandcost-sharing

agreements; Proposedregulationsaddressingthetaxtreatmentofprivateannuities;

Guidancedesignatingalossimportationstrategyasalistedtransaction; Guidanceimplementinganewexcisetaxontax-exemptentitiesandtheirmanagersin

connectionwithparticipationincertainpotentiallyabusivetransactions; Guidanceimprovinginformationreportingforcertainwageringactivities; Proposedregulationsaddressingwhenexpendituresfortangiblepropertymaybe

deductedormustbecapitalized;and Rulingsaddressingtheconsequences,includingpotentialpenalties,offilingreturns(or

failingtofilereturns)basedonfrivoloustaxpositions.IssuingpublishedguidanceisanimportanttoolfortheIRSinclosingthetaxgap.Notwithstandingtheinherentchallenges,theTreasuryDepartmentandtheIRSwillcontinuetoprovidepublishedguidancetoimprovecompliancebyaddressingabusivetaxavoidancetransactions,providingclarificationsandexplanationsofthetaxlaws,ensuringconsistencyoftreatmentofsimilarlysituatedtaxpayers,andwherepossible,reducingburdenoncomplianttaxpayers.Someprojectscurrentlyunderwayincludedevelopmentofguidanceintheseareas: Transferpricing(InternalRevenueCode(IRC)section482)

Foreigntaxcredits(IRCsection901) Patentcrosslicensing Internationalrestructurings(IRCsection367)

Initiatives WorkwithCongresstoenactremaininglegislativeproposalsincludedin

AdministrationsFY2008Budget:

o Requireinformationreportingonpaymentstocorporations;o Requirebasisreportingonsecuritysales;o Expandbrokerinformationreporting;

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o Increaseinformationreturnpenalties;

o Requiree-filingbycertainlargeorganizations;o Implementstandardsclarifyingwhenemployeeleasingcompaniescanbeheld

liablefortheirclientsfederalemploymenttaxes;o ExpandIRSaccesstoinformationintheNDNHfortaxadministrationpurposes;o Permitdisclosureofprisontaxscams;o Makerepeatedwillfulfailuretofileataxreturnafelony;ando Imposepenaltyonfailuretocomplywithelectronicfilingrequirement.

DevelopnewlegislativeproposalsforconsiderationintheAdministrationsFY2009Budget.Approachesunderconsiderationinclude:

o ImprovementsincoordinationwithStategovernments,includingcoordinationconcerninglicensingactivities;and

o Furtherexpansionsofinformationreportingrequirements,includingreportingof

financialactivitythatcurrentlymaynotbesubjecttoinformationreporting.

Developregulationsandotherpublishedguidanceclarifyingambiguousareasofthelaw,targetingspecificareasofnoncompliance,andpreventingabusivebehavior.

o Requireinformationreportingonmerchantpaymentcardreimbursements;o RequireacertifiedTaxpayerIdentificationNumberfromcontractors;o

Requireincreasedinformationreportingforcertaingovernmentpaymentsforpropertyandservices;

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Component2Make a Multi-Year Commitment to Research

Research is critical in helping the IRS understand behavior, develop strategies, andmeasure progress.

ResearchenablestheIRStodevelopstrategiestocombatspecificareasofnoncompliance,improvevoluntarycompliance,allocateresourcesmoreeffectively,andreducethetaxgap.ComplianttaxpayersbenefitwhentheIRSusesthemostup-to-dateresearchtoimproveworkloadselectionformulas,becausethisreducestheburdenofunnecessarytaxpayercontactsandbecauseitenablestheIRStocollectmorewithagivenlevelofresources.ResearchisalsocriticalinhelpingtheIRSestablishbenchmarksagainstwhichtomeasureprogressinimprovingcompliance.TheNRPdemonstratestheimportanceofcomprehensivecompliancedata.Inaddition,accurateNRPdataprovidesacriticalbenchmarkfordeterminingthesourcesofnoncomplianceandformeasuringchangesincomplianceovertime.DatafromtheNRPreportingcompliancestudyhaveallowedtheIRSto: Targetexaminationsandothercomplianceactivitiesbetter,thusincreasingthedollar-

per-caseyieldandreducingnochangeauditsofcomplianttaxpayers;and Improveoperationalauditsbyusinginnovationspioneeredduringthe2001NRPto

reducetaxpayerburden.Continuedcomplianceresearchisavitalcomponentofasoundtaxgapstrategy.AnNRPreportingcompliancestudyof5,000Scorporationtaxreturnsfiledin2003and2004iscurrentlyinprocess.Since1985,Scorporationreturnfilingshaveincreaseddramatically.Inthatyear,therewere722,444Forms1120Sfiled.In2004,thatnumberhadgrownbynearlyfivetimestoover3.6million,whileothercorporatereturnsdeclinedbyapproximately500,000forthesameperiod.By1997,Scorporationshadbecomethemostcommoncorporateentity.In2004,taxreturnsfiledbyScorporationsaccountedforover63percentofallcorporatereturnsfiled.ThelasttimetheIRSconductedanScorporationstudywas1984.Asaresult,theIRSdoesnothavereliablereportingcompliancedatafortheseentities.ThecurrentScorporationstudyrepresentsthefirsttimethattheIRShasconductedareportingcompliancestudyacrosstaxyears,anditwillrequirethatthedatabeknittedtogethertoprovideacomprehensivepicture.Thestudywillcontinuethrough2007.

Withoutnewreportingcompliancestudies,theIRSmustrelyonstudiesconductedover20yearsagotoestimatecomplianceforareasotherthanindividualincometaxorScorporations.Moreover,witheachpassingyear,thedatafromthe2001studyonindividualincometaxcompliancebecomesmoreoutdated.Withoutup-to-datestudiesinallareas,theIRSishamperedinitsabilitytorespondrapidlytotrendsandemergingvulnerabilitiesinthetaxsystem.Amulti-yearcommitmenttoresearchensuresthattheIRScanefficientlytargetresourcesandeffectivelyrespondtonewsourcesofnoncomplianceastheyemerge.

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TheAdministrationsFY2008BudgetrequestfortheIRSfundsforthreesignificantresearchinitiatives.Theseinclude: Increasingcompliancestudies.TheIRSwillconductreportingcompliancestudiesfor

additionalsegmentsoftaxpayersforwhichtheIRSnowreliesonveryolddata(e.g.,corporationincometax,employmenttax,andpartnerships),orforwhichtheIRShasneverconductedanycompliancestudiesatall(e.g.,excisetax).

Updatingexistingdatafromthe2001NRPstudy.TheIRSwillconductanannualstudy

ofcomplianceamongForm1040filersbasedonasmallersamplesizethanthe2001NRPstudy.Thiswillprovidefreshcompliancedataeachyearand,bycombiningsamplesoverseveralyears,willprovidearegularupdatetothelargersamplesizeneededtokeeptheIRStargetingsystemsandcomplianceestimatesuptodate.

Researchingtheeffectofserviceontaxpayercompliance.Thisprojectwillundertake

newresearchontheneeds,preferences,andbehaviorsoftaxpayers.Theresearchwill

focusonfourareas:1. Meetingtaxpayerneedsbyprovidingtherightchannelofcommunication;2. Betterunderstandingtaxpayerburden;3. Understandingtaxpayerneedsthroughtheerrorstheymake;and4. Researchingtheimpactofserviceonoveralllevelsofvoluntarycompliance.

Initiatives Undertakeadditionalcompliancestudies,includingScorporationsandindividuals.

Updatetaxgapestimatesusingnewandexistingdata.

Researchtheeffectofserviceontaxpayercompliance.

Researchtherelationshipbetweencomplexity,burden,andcompliance.

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Component3Continue Improvements in Information TechnologyA combination of new systems and enhancements to existing systems is critical to aproductive use of resources.Informationtechnology(IT)modernizationiscriticaltoensuringthemostproductiveuseofbothtaxpayerserviceandcomplianceresources.Itprovidesthenecessaryinfrastructurethatallowsthemostefficientutilizationofresources,whichinturnallowstheIRStotargetkeycomponentsofthetaxgapbetter.BecauseITmodernizationisacornerstonetoefficientandeffectivetaxadministration,theIRSiscommittedtostrongoversightandaccountabilityofITprojects.TheIRSinformationtechnologyvisionincludessystemsthat: Allowforbetteridentificationofthecasestobeworked; Routethosecasestothemostappropriateworkstream;and Employcosteffectivetechnologyanalyticstobestmanagecasesoncetheyreachthe

correctworkstream.TheIRScurrentinvestmentintechnologyinfrastructureincludesacombinationofnewsystemsandenhancementstoexistingsystems,withemphasisonimprovingbotheffectivenessandefficiency.Includedinthisinfrastructurearetoolstoincreasetaxpayercompliancethroughearlydetection,improvedcaseselection,moreefficientcasedelivery,andbettercasemanagement:

CaseSelection.TheNRPprovidessignificantdataforimprovingcaseselectioncriteria.

NRPdatafacilitatesselectionofthemostproductivereturnstoexamine.Thisnotonlyreducesthetaxgap,butalsoallowstheIRStoupdatetaxgapestimates.Thecaseselectionprocessisfurtherenhancedthroughautomatedclassificationprocesses.TheIRSalsousescurrentauditinformationfromissuemanagementsystemstoprovideforimmediateidentificationofemergingissues. ForCollectionprograms,theIRSwilluseimproveddecisionanalyticstoselectcasesandroutethemtothemostappropriateworkstream.

CaseDelivery.Deliverysystemsalsoarebeingmodifiedtomoveauditworkintothe

systemmoreeffectivelyandefficiently.Bothreturnclassificationanddeliverywillmove

towarddigitalratherthanpaper-basedreturns,eliminatingthetimeconsumingandexpensiveprocessoforderingreturnsandsendingexaminersouttoIRScampuslocationsforclassificationdetails.Additionally,theIRSwillreplacemanualprocesseswithelectroniccasebuildingandinstantaccesstomulti-yeartaxreturninformation.

CaseManagement.Automatedsystemsarebeingdeployedtoallowmorebatched

processingofhighvolumetypesofexaminations.Technologyenhancementswillallow

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TheFY2008Budgetrequestalsoincludesatotalof$282milliontocontinuethedevelopmentanddeploymentoftheIRSBusinessSystemsModernization(BSM)programinlinewiththerecommendationsidentifiedintheIRSModernization,Vision,andStrategy.ThisfundingwillallowtheIRStocontinueprogressonmodernizationprojects,suchastheCustomerAccountDataEngine(CADE),AccountManagementServices(AMS),Modernizede-File(MeF),andCommonServicesProjects(CSP). ContinuedevelopmentofCADEandAMS.ThedevelopmentofCADEandAMSsystems

istheheartofIRSITmodernization.Thesetwosystems,workingtogether,willenabletheIRStoprocesstaxreturnsanddealwithtaxpayerissuesinanearreal-timemanner.TheobjectiveisfortheIRStooperatesimilarlytoabank,whereaccounttransactionsoccurring

duringthebusinessdayarepostedandavailablebythenextbusinessday.Inaddition,AMSwillenabletheIRSrepresentativeswhoworkwithtaxpayerstohaveaccesstoallcurrentinformationregardingthattaxpayer,includingelectronicaccesstotaxreturndataandelectroniccopiesofcorrespondence.Armedwithsuchcomprehensiveandup-to-dateinformation,IRSrepresentativeswillbeinamuchbetterpositiontohelptaxpayersresolvetheirissues,whichbenefitsboththeIRSandtaxpayerswhilepromotingvoluntarycompliance.

employeestoworkcasesinanonlineenvironment,wherereturnsandcase-relateddatacanbedownloaded,andactionscanbetrackedelectronically.TheIRSwillcontinuetolinkmultipleinternalandexternaldatabasestoenhanceoveralleffectiveness,allowingbetteridentification,management,andperformancemonitoringforcomplianceworkload.

TheIRSalsohasseveralprojectsthatwillenhancecriminalenforcement,withspillovereffectstocivilcases.

TheAdministrationsFY2008Budgetrequestincludesanadditional$81millioninfundingtoimprovetheIRSinformationtechnologyinfrastructure,whichisvitaltoimprovingIRSenforcementandservicescapabilities.TheinvestmentsproposedintheBudgetwillallowtheIRSto: UpgradecriticalITinfrastructure. ThiswillprovidefundingtoupgradethebacklogofIRS

equipmentthathasexceededitslifecycle.FailuretoreplacetheITinfrastructurewillleadtoincreasedmaintenancecostsandwillincreasetheriskofdisruptingbusinessoperations.PlannedexpendituresinFY2008includeprocuringandreplacingdesktop

computers,automatedcalldistributorhardware,andWideAreaNetwork/LocalAreaNetworkroutersandswitches. EnhancetheComputerSecurityIncidentResponseCenter(CSIRC)andthenetwork

infrastructuresecurity.ThiswillallowtheCSIRCtokeeppacewiththeever-changingsecuritythreatenvironmentthroughenhanceddetectionandanalysiscapability,improvedforensics,andthecapacitytoidentifyandrespondtopotentialintrusionsbeforetheyoccur.

EnhancetheIRSnetworkinfrastructuresecurity.Thiswillprovidethecapabilityto

performcontinuousmonitoringofthesecurityofoperationalsystemsusingsecuritytools,tactics,techniques,andprocedurestoperformnetworksecuritycompliancemonitoringofallITassetsonthenetwork.

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ThedevelopmentofCADEandAMSalsoincludesacomprehensivere-workingofthenoticesystemtostreamlinetheprocessandenhanceitsefficiency.InJuly2008,CADEisscheduledtopostandsettletaxreturnswithabalancedueconditionandamendedtaxreturns,Form1040X.ThedailysettlementoftheseaccountsthroughCADEandthelinkagewithAMSwillenablethebalanceduenoticestobesentonadailybasisanddeliveredtothetaxpayerasmuchaseightdaysfasterthancurrenttimelines.

ContinuedevelopmentofMeF.MeFisthefutureofelectronicfiling.Itprovidesastandard

dataformatforallelectronicallyfiledtaxreturns,whichwillreducethecostandtimetoaddandmaintainadditionaltaxformtypes.MeFisaflexiblereal-timesystemthatstreamlinestheprocessingofe-filedtaxreturns,resultinginaquickerfilingacknowledgementtothetaxpayerortheirrepresentative.InFY2007,theIRSisbeginningthedevelopmentandimplementationoftheForm1040ontheMeFplatform.TheMeFsystemwillenabletheIRStobetteranalyzetaxcomplianceissuesandaddressnoncomplianceamongtaxpayersbyremovingtheimpedimentscausedbylackofdataavailabilityandcompleteness,access,anddataaccuracy.MeFwillallowthere-engineeringofmuchofthecurrentmanualandtime

consumingcomplianceprocessesincludingthefollowing:

o CompletenessofData.TheMeFsystemprovides100percentofthedatacontainedwithinthereturns,theirschedulesandattachments,third-partydocuments,andamendedreturnsinanelectronicform.Alldocumentationwillbeavailablecompletelyandelectronically,whichisequivalenttoapapercopyoftheentirereturnfile,butinamoreusableandtransportableform.Thecurrente-filingsystemonlyprovidesreturnsanddoesnothavetheabilitytoprovidesupplementaldocumentation,includingattachments,electronically.Papersubmissionsprovideonlylimitedtranscriptionsofreturndataoranimageofthereturn.Allotherdocumentationisrecalledandanalyzedusingtimeconsumingmanualprocesses.

o DataAvailabilityandAccess.Currently,IRSelectronicsystemscapturean

averageof20percentofthedatacontainedwithintaxandinformationreturns.Togatheradditionalinformationforcomplianceneeds,theIRSmustconductmanualtranscriptions,whicharecostlyandtimeconsuming.Foreachform,theamountofinformationretainedortranscribedvariesbyformtype,complexity,andsize.ForthosereturnssubmittedthroughMeF,100percentofthedatawillbeavailabletotheIRSinelectronicformat,includingassociatedschedulesandattachments,regardlessoftheformtypeandwithoutadditionalexpense.

o DataAccuracy.TheIRScurrentlyexpendstimeandresourcesensuringthedata

receivedfromtaxandinformationfilersandtranscriptionsareaccurateand

reliable.TheMeFsystemanditsprocessesincreasedataaccuracybyreducingtheincidenceoferrorsandbyminimizingtheneedformanualtranscriptions.Thisismadepossiblebyvalidatingtheinformationpriortosubmission.Theuseofbusinessrulesalsoensuresthatthereturnsarefreeofcomputationerrors.

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Initiatives Improvehighincomeandnon-EITCexamworkloadselectionandmethodofdeliveryand

assesstheeffectivenessoftheexamtreatmentstreamonselectednonfilercases.(AlsosupportsComponent4)

ExpandAutomatedUnderreporter(AUR)AutoNoticeGenerationtoincludeadditionalincometypesandallForm1040familyreturns.(AlsosupportsComponent4)

DevelopsystemrequirementsforexpandingtheAURSoftNoticeTest,whichinvolvesasking

taxpayerstovoluntarilyself-correctforfutureyears.(AlsosupportsComponent4) EvaluatetheAURmatchingprocess,andimplementanimprovedcasescoringandselection

concepttoselectthemostproductivecases.(AlsosupportsComponent4)

DevelopenhancementstotheComplianceDataWarehousetoimproveworkloadidentificationandprioritizationalgorithms,allowingbetterevaluationofalternativetreatmentstreamsandensuringCollectioncasesreceivethemostefficientandeffectivetreatments.(AlsosupportsComponent4)

o CostEffectiveDataCapture&Storage.Themanualprocessingofreturndata,attachments,andschedulesistimeconsumingandcostly.E-filingisthemosteffectivemeansofcapturing,storing,andrecallingdata.Savingsincludeareductioninsubmissionprocessingandstoragecosts.Additionalsavingswillbe

achievedfromreducedcostforretrievingandre-filingreturnsforexaminationsandtranscriptionforidentificationofcompliancetrendsorresearch.

ComplianceMonitoringProcess.Compliancemonitoringispremisedonthenotionthatthe

IRSshouldmakeuseofeveryavailabletoolandpublicdatasourceintryingtobring

corporationsintocompliance.TheLargeandMid-SizeBusiness(LMSB)divisionhasdesignedaComplianceMonitoringProcess(CMP).LMSBdevelopedandwillbeimplementinganenhancedcomplianceinitiativedependentoninformationtechnologythatleveragestheincreasesintransparencymandatedbySarbanes-Oxleyandotherlaws.ThisprogramalsoleveragestheincreasedtransparencyofpubliccompaniesfinancialstatementsthatwillresultfromimplementationofFinancialAccountingStandardsBoardInterpretationNo.48(FIN48).

ThebenefitsaccruingfromthedeliveryandimplementationofBSMprojectsnotonlyprovidevaluetotaxpayers,andthebusinesscommunity,butalsocontributetooperationalimprovementsandefficiencieswithintheIRS.

Fed/StateElectronicFederalTaxPaymentSystem.TheIRSandtheTreasuryDepartmentsFinancialManagementServicearedevelopingapilotinconjunctionwithSouthCarolinaandIllinois.ThepilotwillenableIllinoistaxpayers(SouthCarolinawillparticipateinalaterphase)topayalltheirfederalandcertainstatetaxesonlineviatheTreasurysElectronicFederalTaxPaymentSystem(EFTPS).Thisinitiativewillprovideonestopfortaxpayerstomaketheirfederalandstatetaxpayments.

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BuildandimplementMeFreceiptofelectronictransmissionsforadditionaltaxforms.

UpdatetheCollectioninventorymanagementsystemtoimprovefunctionalitynavigation,

performance,andefficiency.(AlsosupportsComponent4)

Automateliendelivery,recording,andreleaseprocesseswithstateandlocaljurisdictionstoimprovethetimelinessoflienfilingsandthepaymentoffees.(AlsosupportsComponent4)

TesttheuseofstatisticalmodelingtechniqueswithintheTaxExemptandGovernmentEntities

Division(TEGE)todetecthigh-riskcompliancepatternsinordertousedatatoexpandandimproveexaminationcaseselection.(AlsosupportsComponent4)

Developandimplementasetofcompliancedecisionanalyticaltoolsthatwillsupportanalysis

ofTEGEreturnsandotherdatatodetectcompliancetrendsandimprovecaseandissueselection.(AlsosupportsComponent4)

ImplementanewTEGEelectronicexaminationsystem(TREES)thatwillconsolidateagent

toolstoincreasetheaccuracyandefficiencyoftheexaminationprocess.

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Component4Improve Compliance Activities

Obtaining maximum coverage and yield from available resources is necessary for thegreatest impact on compliance.

TheIRShasmadesignificantprogressinreducingthetaxgapthroughimprovementsinenforcementefforts.Thefollowingexamplesdemonstratethisprogress: Enforcementrevenueshavegrownbynearly$15billionsinceFY2001,totaling$48.7billionin

FY2006. Examinationsofindividualtaxpayerreturnsincreasedby77percentbetweenFY2001andFY

2006,whentheIRSconductednearly1.3millionexaminations.Similarly,thecoverageraterosefrom0.58percentto0.98percentduringthatperiod.

TheIRShasfocusedmoreresourcesonexaminationsofindividualswithincomeover$1

million.Thenumberofexaminationsinthiscategoryrosebyalmost80,000inFY2006ascomparedtoFY2004,thefirstyeartheIRSbegantrackingthemseparately.Thecoverageratehassimilarlyrisenfrom5.03percentto6.30percentinthatperiod.

Auditsofbusinessreturnsincreasedby29percentbetweenFY2001andFY2006.The

coveragerateoverthesameperiodrosefrom0.55percentto0.60percent. Auditsofcorporationswithassetsover$10milliongrewfrom8,718inFY2001to10,578inFY

2006,andthecoveragerateincreasedfrom15.1percentto18.6percent.

Examinationsoftheverylargestcorporations,thosewithassetsover$250million,increasedbynearly30percentgrowingfrom3,305inFY2001to4,276inFY2006. Forauditsoftaxpayerswithassetsgreaterthan$10million,thecycletimeperaudithasbeen

reducedby22.6percentfrom23monthsinFY2001to17.8monthsinFY2006.ThisallowsIRStouseitsresourcesmoreefficientlyandincreasethenumberofcorporateauditsconducted.

TheIRShasplacedmoreemphasisontax-exemptorganizationsbyincreasingthenumberof

examinationsbynearly33percentfrom5,342inFY2001to7,079inFY2006. TheIRSachieveda91.4percentconvictionrateoncriminalinvestigationcasesfromFY2001

throughDecember31,2006. TheIRSestablishedthepositionofDeputyCommissioner,Internationaltoimproveoversightof

andfocusonglobaltaxationissues.TheseresultsreflectthedirectimpactofIRSenforcementinitiatives.Thoughdifficulttoquantify,thereisalsoasignificantindirecteffectofIRSenforcement,whichsomeresearchsuggestscouldbeatleastthreetimesthedirecteffectofenforcementefforts.Thisindirecteffectisseenwhenan

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Thoughitisnotfeasibletoeliminatethetaxgapcompletely,itispossibletomaximizetheuseofexistingresourcestoaddresscoverage,yield,andnoncompliantbehaviorbetter.Asresourcesaremadeavailableduetoshiftsinreturnfilingpatterns,orfromefficienciesachievedfromsystemicchanges(bothtechnologyandprocess),resourceswillberedirectedtoaddresssignificantcomponentsofthetaxgap,keepingthefactorsmentionedaboveintheproperbalance.Forexample,theIRScannotsimplyallocateresourcestothehighestyieldingactivitiesandtherebysacrificebalancedcoverageacrossallelementsofnoncompliance.AuditcoverageratesandreturnoninvestmentinformationisprovidedinFigures8and9.

individualthinkstwiceaboutfailingtoreportincomeoroverstateadeductionifheorsheknowsaneighbororfriendhasbeenaudited.Similarly,iftaxpayersareawarethattheIRSismoreactive,voluntarycomplianceincreases.

TheIRScompliancestrategyattacksthetaxgapbybalancingthreecriticalenforcementprinciples.

Coverage.BalancedauditcoverageisimportantfromanIRSpresenceandnoncompliance

deterrenceperspective. Yield.ItisimportantthatIRSresourcesaddressthosenoncompliantreturnsthatwillyieldthe

greatestrevenueimpactfortheTreasuryDepartment. IntentionalNoncompliantBehavior.Thelargercomponentsofthetaxgapinvolvemorecomplex

issuesand/orunreportedincomethatusuallyrequiremorein-depthauditsorinflagrantcasesoftaxevasion,criminalinvestigation.

Wherepossible,theIRSwilluselow-cost,highlyautomatedsystemsandresourcestomaintainor

increasecompliancecoveragelevels.Manyofthesesystemswillnotinvolveface-to-faceinteractionswithtaxpayers.ThisincludesprogramssuchasAutomatedUnderreporter,AutomatedCollectionSystem,AutomatedSubstituteforReturn,correspondenceexam,andsoftnotices.TheIRSwilluseacombinationoflow-cost,highlyautomatedsystemsandface-to-faceinteractionswithtaxpayerstoaddresshighyieldandcomplexcomplianceissues.Theseincludefieldaudits,fieldcollectioncontacts,andlargecorporateaudits.Resourceswillbedevotedtoaddressingmajorandpersistentareasofnoncompliancethroughface-to-faceinteractionswithtaxpayers.ToensurecoordinationofIRSeffortstoaddressallaspectsofthetaxgap,theDeputyCommissionerforServicesandEnforcementhasformedanexecutiveleveltaxgapcommittee.Thiscommitteeanalyzescompliancedataandmakesrecommendationsontheproperallocationof

complianceresourcessothattheIRScanmaximizeitsabilitytoaddressthetaxgapcomponents.Thisgroupiscurrentlyquantifying:

Coveragerates; Resourceutilization; Returnoninvestment(ROI);and Effectivenessofcomplianceprograms.

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Figure8

FY 2006 Coverage Rates for Key Taxpayer Categories

Enforcement Area Coverage RateCorporations with Assets > $250M 35.3%Corporations with Assets $10M - $50M 14.2%

Corporations

1120S Corporations 0.38%Individuals > $1M 5.23%Individuals > $100,000 1.67%Individuals < $100,000 0.89%

Individual IncomeTax

All Individuals 0.98%Employment Tax Employment Tax Returns 0.11%Estate Tax Estate Tax with Gross Estate > $5M 28.12%

Figure9Estimated Program Marginal Direct Return on Investment (ROI) for FY 2008 Hiring Initiatives*IRS Program ROI

LargeCorporateExamProgram 3:1SmallBusinessExamandCollectionProgram 3:1IndividualDocumentMatching 9:1AutomatedNonFilingProgram 14:1

* Marginal ROIs are computed by applying an assumed marginality factor to the observed averagereturn on investment.

SomespecificexamplesofIRSeffortstoallocateresourcestotargetspecificnoncomplianceattributedtothetaxgapincludeaddressing: Promotersofabusivetaxavoidancetransactions.Whilethesecasesaretimeconsumingto

investigate,civilinjunctionactionsoftenleadtotheidentificationofschemeparticipants,includingmanysmallcorporateandindividualtaxpayers.TheIRSthenallocatesresourcestoexamineandcorrecttheabusivetransactions.TheIRSalsoassessescivilpenaltiesasappropriateagainstabusivepromotersandpreparers.

Highincomenonfilers.TheIRShascampusTaxpayerDelinquencyInvestigation(TDI)and

AutomatedSubstituteforReturn(ASFR)programsthataddressnonfilers.Somehigh-incomecasesarenottypicalandrequirecomplexskillstoexamine.TheIRSallocatesfieldresourcestoinvestigateandresolvethesecases.

Offshoreactivity.Taxpayerswhoengageinoffshoreactivityforthepurposesof

underreportingincomeorparticipatinginataxhaventaxationregimemustbeaddressed.TheIRSisimprovingitsabilitytoidentifythesecasesandthespecializedskillsoftheexaminerswhohandlethem.

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Unscrupulousreturnpreparers.Mostreturnpreparersareprofessional,providevaluableservicetotheirclients,andareeffectiveadvocatesforgoodtaxadministration.Unfortunately,afewunscrupulouspreparerscanhaveasignificantnegativeeffectoncompliance.TheIRSallocatesresourcestoconductvisitstoElectronicReturnOriginators

(EROs),pursuepreparerexaminationswiththegoalofpenalizingimproperbehavior,andseekcivilinjunctionsand/orcriminalindictmentsagainstthemostegregiousbehavior.

Smallbusinesses.Becauseresearchindicatesthereisagreaterlikelihoodofmisreporting

andunderreportingbysmallbusinesses,theIRSplanstoincreasethelevelofForm1040,ScheduleCexaminations.

ImprovingauditcurrencyandidentifyingissuesforexaminationarekeyelementsoftheIRSefforttotargetnoncompliance.Theseeffortsofteninvolvefindingwaystostreamlineexaminationsofcomplianttaxpayers,sothatexaminationresourcescanbefocusedonmoreproblematicareas.Effortstoimprovecurrencyandtransparencyinclude:

ScheduleM-3.Toimprovetransparencyofcorporatetaxpayers,theIRSmandatedanewScheduleM-3forlargebusinesstaxpayers.TheScheduleM-3providesmoredetailonbook-taxdifferences,enablingtheIRStoidentifyandfocusmorequicklyandpreciselyonthosetaxreturnsandissuesthatpresentthehighestpotentialcompliancerisk.

ComplianceAssuranceProgram.TheIRSisalsoexpandingtheComplianceAssurance

Program(CAP),toimprovebothcurrencyandtransparency.TheCAPprogramisareal-timeapproachtocompliancereviewthatallowstheIRS,workinginconjunctionwiththetaxpayer,todeterminetaxreturnaccuracypriortofiling.CAPismoreefficientthanapost-filingexaminationasitprovidescorporationscertaintyabouttheirtaxliabilityforagivenyearwithinmonths,ratherthanyears,offilingataxreturn.Thisprovidescomplianttaxpayerswithgreatercertaintyastotheirtaxandfinancialreportingpositions,andallows

theIRStofocusitsexaminationresourcesonmoreproblematicareas. Pre-FilingAgreement.ThePre-FilingAgreement(PFA)programprovidestaxpayersan

opportunitytorequestthatrevenueagentsexamineandresolvepotentialissuesbeforetaxreturnsarefiled.TheIRScontinuestoexploreotherwaystoworkwithLMSBtaxpayersonapre-filingbasistoaddresstheirfederaltaxliabilitycompliance.

LeverageCorporateE-file.TheIRSisimprovingissueidentificationandtheselectionfor

examinationofhigh-riskreturnsthroughnewmandatorye-filing.Manycorporationsarenowrequiredtofiletheirtaxreturnselectronicallyandthismandatewillexpandinfuturetaxyears.E-filingwillprovidemoreconsistenttreatmentanddataanalysisforefficient,nearrealtimeidentificationofhigh-riskissuesandtaxpayers.E-filingandScheduleM-3

togetheralsoallowtheIRStoidentifyandexcludemoreefficientlylower-risktaxpayersfromfullexaminations.

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AdditionalcomplianceinitiativesinprocessonIRScampusesinclude: Internationalsupport.TheIRSisexpandinginvestigationsofindividualswhoreport

incometoPuertoRicobutfailtofileaForm1040PRtoreportsocialsecurity,beginorend

bonafideresidenceinaU.S.possession,andrequesttolimitpartnershipwithholdingfromforeignsources. Form941nonfilers.TheIRSisexpandingemploymenttaxcomplianceeffortsthrough

matchinginformationreturnsfiledwiththeSocialSecurityAdministrationtothefilingofrelatedemploymenttaxreturns.

Form1120-Scompliance.TheIRSisincreasingreviewsofinvalidScorporationreturns

andtheirshareholders.Entitiesthatdonothavevalidelections,andtheirshareholdersreturns,willbeadjustedtoreflectthepropertaxeffect.

Fed/Statereferrals.TheIRSactivelypursuesleadsobtainedthroughinformationsharing

withthestates,aswellasinitiatesexaminationsbasedonoutcomesofstateaudits.IRSemployeesplayacriticalroleintheefforttoimprovecomplianceintermsofbothtaxpayerserviceandenforcement.Inadditiontoimplementingelementsofanystrategytoimprovecompliance,IRSemployeesalsoserveasasourcefordevelopingtheseelementsinthefirstplace.InordertoensurethattheIRSworkforceisresponsivetotheneedtoimprovecompliance,theIRSrecentlypublishedregulationsthatremovelimitationsontheuseofquantitymeasuresinevaluatingtheperformanceof,orimposingorsuggestinggoalsfor,IRSorganizationalunits.Theseregulationswillimproveaccountabilitywhilenotchangingcurrentprovisionsthatbartheuseofperformancemeasuresbasedonquantitymeasureswhenevaluatingemployeesperformance.TherearesixspecificinitiativesintheFY2008Budgetrequestthatareaimedatsignificantlyimprovingcomplianceactivities.Collectivelytheseinitiativesshouldgenerateanadditional$699millioninrevenuewhenallofthenewhiresreachfullpotentialinFY2010.Theseinitiativeswill: Improvecomplianceamongsmallbusinessandself-employedtaxpayersintheelements

ofreporting,filing,andpaymentcompliance.Thisfundingwillbeallocatedforincreasingauditsofhigh-risktaxreturns,collectingunpaidtaxes,andinvestigatingforpossiblecriminalreferralpersonswhohaveevadedtaxes.

Increaseexaminationcoverageforlarge,complexbusinessreturns,foreignresidents,and

smallercorporationswithsignificantinternationalactivity. UsinginformationfromForm1120,ScheduleM-3andenhanceddataresultingfrommandatorye-filing,thisinitiativewill

addressrisksarisingfromtherapidincreaseinglobalization,andtherelatedincreaseinforeignbusinessactivityandmultinationaltransactionswherethepotentialfornoncomplianceissignificant.ImprovedbusinessprocessesalongwiththisfundingwillallowIRStomaintainitsattentiontotheverylargestbusinesseswhileexpandingtheoverallcoveragerateforlargecorporateandflow-throughreturnsfrom7.9percentto8.2percentinFY2008.

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Expanddocumentmatchinginexistingsitesandtheinclusionofdocumentmatchingatanewsite.ThisenforcementinitiativewillincreasecoveragewithintheAutomatedUnderreporter(AUR)documentmatchingprogram,resultinginanincreaseinAURclosuresfrom2.05millioninFY2007to2.64millioninFY2010.Inaddition,anew

documentmatchingprogramwillbeestablishedattheIRSKansasCitycampus.TheestablishmentofthisnewAURsiteisestimatedtoresultinover$183millioninadditionalenforcementrevenueperyearbeginninginFY2010.

IncreaseindividualfilingcompliancethroughtheAutomatedSubstituteforReturnRefund

HoldProgram.Thiswillminimizerevenuelossbyholdingthecurrent-yearrefundsoftaxpayerswhoaredelinquentinfilingindividualincometaxreturnsandareexpectedtooweadditionaltaxes.Itisestimatedthatthisinitiativewillresultinsecuringmorethan90,000delinquentreturnsinFY2008.

Improvetax-exemptentitycompliancebypreventingthemisuseofsuchentitiesbythird

partiesfortaxavoidanceorotherunintendedpurposes.ThisfundingwillaidinincreasingthenumberofTEGEcompliancecontactsby1,700(6percent)andemployeeplan/exemptorganizationdeterminationsclosuresbyover9,000(8percent)annuallybyFY2010.

Increasecriminaltaxinvestigations,whichwillaggressivelyattackabusivetaxschemes,

corporatefraud,nonfilers,andemploymenttaxfraud.TheseinvestigationswillalsoaddressothertaxandfinancialcrimesidentifiedthroughBankSecrecyActrelatedexaminationsandcasedevelopmentefforts,whichincludeanemphasisonthefraudreferralprogram.

Inadditiontotheseinitiatives,theIRSisbeginningtorealizebenefitsfromthePrivateDebtCollectionprogram.PursuanttoCongressionalauthorization,taxpayersreceivethesametreatmentfromprivatecollectionagencies(PCAs)thattheywouldfromtheIRS,includingaccesstotheTaxpayerAdvocateService.ThePCAsonlyworkcaseswherethetaxpayerdoesnotdisputetheliabilityandcollectmoneytheIRScouldnotcollectotherwise.Ninety-sevenpercentofthetaxpayerswhorespondedtotheIRScustomersatisfactionsurveyregardingcontactbyaPCAweresatisfiedwiththeservicereceived.Improvingcomplianceinthecasheconomyisalsoafocus.AjointIRS/TaxpayerAdvocatete

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