2007 Annual Report to Congress e t a c o This publication is referenced in an v endnote at the Bradford Tax Institute. d s CLICK HERE to go to the home page. s A e r g n r o e C y o a t t p r o p x e a R T l 2007 A R a NNUAL EPORT u n C l TO ONGRESS a n A n 7 o 0 Volume 0ne 0 i t 2 a N 2007 eport to Congress This page intentionally left blank. e t a c o v D d e A d i c r This report is dedicated to the taxpayers of the United States e a who year in and year out y t do their best to comply with complex tax laws and procedures; i a o p n And to the employees of the Internal Revenue Service x who every day try to make it a little easier a for our taxpayers to comply. T l a n o i t a N This page intentionally left blank. iv Preface: Introductory Comments of the National Taxpayer Advocate Honorable Members of Congress: P r I respectfully submit for your review the National Taxpayer Advocate’s 2007 Annual Report e to Congress. As explained below, this year’s report discusses some significant challenges to tax administration – the impact of late-year tax-law changes, the need for a comprehensive f approach to cash economy noncompliance, and the future of face-to-face service, to name a a few. We also provide status updates on three issues we discussed in previous Annual Reports: c Private Debt Collection, IRS Collection Strategy, and Criminal Investigation’s Questionable Refund Program. e As in past years, we include a second volume that contains several research studies conducted or commissioned by the Taxpayer Advocate Service. The studies in this year’s Volume 2 provide support for several themes running throughout the report: n The need to take a strategic approach to solving major tax administration challenges; n The need to better understand taxpayer behavior and the causes of noncompliance; n The need to better understand the influence tax preparers and practitioners have on compliance and noncompliance; and n The need to design services, communications, and compliance initiatives with the specific characteristics of the target population in mind. Among other things, the above themes are reflected in our legislative recommendation for Congress to enact a Taxpayer Bill of Rights, by which we mean a charter that explicitly sets out the rights and responsibilities of U.S. taxpayers. Such a document can only improve tax compliance by clearly stating both what taxpayers have the right to expect from the tax system and what taxpayers, in turn, owe to their government. Significant Challenges to Tax Administration First and foremost, both taxpayers and tax administrators need certainty. The constant changing of tax laws and procedures confuses taxpayers and leads to their making errors or not claiming deductions or credits to which they are entitled under the law. For the IRS, changes in tax laws require programming and process changes, retraining employees, and revising tax forms, instructions, and publications. When such changes are enacted late in the calendar year, there is insufficient time before the start of the filing season to update IRS systems and to conduct the necessary taxpayer education. We saw the real-world impact of late-in-the-year changes during the 2007 filing season, when Congress enacted “extenders” of several tax benefits for middle class taxpayers. It appears that more than a million taxpayers did not claim tax deductions to which they were entitled because they were not mentioned on Form 1040 or the accompanying instructions or included in shrink-wrapped software programs. We will have to wait to see what the impact is of the late year “AMT patch” on taxpayers claiming the Child and Dependent Care Credit or other credits during the upcoming 2008 filing season. But Taxpayer Advocate Service — 2007 Annual Report to Congress — Volume One v Preface: Introductory Comments of the National Taxpayer Advocate history tells us that many affected taxpayers will not claim these credits, despite claiming them in prior years. Although easier said than done, the solution to this situation is straightforward: the IRS should inform Congress, explicitly and directly, by the middle of the calendar year about (1) the provisions in current law that are sunsetting that year; (2) the impact on taxpayers if such provisions are not extended; (3) the date by which legislation must be enacted in order for the IRS to complete all programming and training before the start of the filing season; and (4) the impact on the filing season if Congress enacts the extenders after that date but before the filing season. The IRS should provide monthly updates, if warranted, beginning in September. With the benefit of that information, Congress should take action by the date that will ensure a smooth filing season. In our report, we also highlight the issue of cancellation of indebtedness income. This issue received considerable attention in 2007 as homeowners defaulting on subprime mortgages were poised to receive hefty tax bills. Congress enacted legislation in December temporarily exempting most debts cancelled in connection with home foreclosures from tax, yet the fact remains that approximately two million Forms 1099 reporting COD income are issued to taxpayers annually. Common causes are defaults on automobile loans or credit card bills. Our review concluded that the IRS has done little to advise these taxpayers about various exclusion provisions, including the insolvency exception. The IRS has also declared the preparation of returns involving canceled debt issues to be “out of scope” for Taxpayer Assistance Centers (TACs). If this issue is too complex for IRS employees (or VITA volunteers) to handle in preparing returns, how are taxpayers – especially low income taxpayers who cannot afford to pay for return preparation – going to be able to report their income correctly? It is likely that the IRS’s short-sighted decision to declare canceled debt issues “out of scope” will result in many more Automated Underreporter notices later in the year, as taxpayers simply omit this confusing income item. With better outreach and assistance, we could avoid this situation. The Need to Take a Strategic Approach to Solving Major Tax Administration Challenges In the report, we propose a comprehensive strategy to address the cash economy, which is the largest portion of the tax gap.1 We recognize that many commentators believe that it is neither possible nor practical to close this portion of the tax gap. While we agree with this statement with respect to eliminating the cash economy tax gap, we believe that the cash economy tax gap can be significantly reduced. We need a strategic, comprehensive approach that identifies particular areas of noncompliance and develops the administrative and legislative tools necessary to reduce that noncompliance without imposing undue compliance burdens. In this report – in the Most Serious Problem and the Key Legislative Recommendation about the cash 1 Although there is no universally agreed-upon definition of “cash economy,” we use the term to mean taxable income from legal activities that is not reported to the IRS by third parties. This definition can include businesses dealing strictly in cash as well as others that handle a portion of their transactions in cash or receive other payments not subject to information reporting. For example, a retailer who receives most of his revenue through debit and credit cards can be considered part of the cash economy because these forms of payment are not subject to information reporting. vi Preface — Introductory Comments of the National Taxpayer Advocate Preface: Introductory Comments of the National Taxpayer Advocate economy and in the comprehensive strategy set forth in Volume 2 – we propose the beginnings P of such a plan. To achieve progress in this area, however, the IRS must first acknowledge that it does not now have a strategic plan to address the cash economy and that what it is doing in r e this area is ad hoc. Unfortunately, in its response to our Most Serious Problem discussion, the IRS acknowledges no such thing. If the IRS mistakenly believes it now has a strategic plan, it is f unlikely to take the bold steps required to develop one. It is particularly disturbing that, for the a third year running, the IRS declines to create a Cash Economy Program Office to coordinate its c various initiatives. Ad hoc measures will not get the job done. e The Need to Better Understand Taxpayer Behavior and the Causes of Noncompliance For a tax administrator to maintain and improve taxpayer compliance, he or she must first understand what factors influence taxpayer behavior and what causes noncompliance. Such an understanding must go beyond merely categorizing behavior as “intentional” or “unintentional” and instead requires a more sophisticated analysis. In our Volume 2 study titled “IRS Earned Income Credit Audits – A Challenge to Taxpayers,” for example, we report on the results of surveys and focus groups of EITC taxpayers and their representatives, respectively, who were involved in EITC audits. The study shows that many of the reasons for inaccurate audit results and, by extension, noncompliance are attributable to the particular characteristics of the EITC population. However, a great number of these reasons can be minimized or eliminated by factors and processes within the control of the IRS, such as clearer notices and instructions. In fact, the Most Serious Problem “EITC Examinations and the Impact of Taxpayer Representation” shows that the IRS has improved its EITC examination processes significantly and has applied many of the findings from recent studies of the EITC audit process, even as there is more work to be done in this area. Tax administrators in today’s complex world must be flexible and willing to use new tools and disciplines to address the age-old problem of noncompliance. In this report, we discuss a few such approaches. The National Taxpayer Advocate commissioned two research studies – one, by Professor Marjorie Kornhauser, to review the state of scholarship on why taxpayers do what they do and the impact of “taxpayer morale” on compliance; and the second, by Professor Kathleen M. Carley, to use agent-based modeling to predict taxpayer behavior in a given situation. Professor Kornhauser’s report led us to recommend that the IRS develop an applied research lab that could conduct empirical studies of taxpayer behavior and understanding, the results of which would enhance service and enforcement initiatives. (See Most Serious Problem, “Taxpayer Service and Behavioral Research.”) Professor Carley’s work, by replicating in a modeling environment the results of the Tax Year 2004 Hartford EITC Certification test, enabled us to test various scenarios and better understand the impact of positive and negative messages on taxpayer behavior. While neither of these studies is conclusive – they raise as many questions as they answer – they demonstrate the importance and value of using new technologies and different disciplines to improve tax compliance. Congress needs to encourage and fund the IRS’s exploration of these approaches. Taxpayer Advocate Service — 2007 Annual Report to Congress — Volume One vii Preface: Introductory Comments of the National Taxpayer Advocate The Need to Better Understand the Influence Tax Preparers and Practitioners Have on Compliance and Noncompliance More than 62 percent of individual tax returns are now prepared by paid preparers. It stands to reason that these preparers can influence their clients’ compliance or noncompliance with the tax laws.2 Similarly, tax practitioners who are authorized to practice before the IRS (known as “Circular 230” practitioners) can also affect how their clients view and fulfill their tax obligations. In this report, we explore several issues relating to preparers and Circular 230 practitioners. As with all of our discussions and research, we hope to improve tax administration by going beyond superficial discussions of “good” and “bad” taxpayers or preparers and instead look at the impact of representation, the methods of regulating preparer and practitioner behavior, and the protection of taxpayer information in the hands of these professionals. First, in three Most Serious Problem discussions, we consider the regulation of Circular 230 practitioners, the application of preparer penalties and preparer “bypass” procedures, and the use and disclosure of tax return information by preparers. Second, we report on a TAS study of the impact of representation on the outcome of EITC audits. As we discuss in the Most Serious Problem “EITC Examinations and the Impact of Taxpayer Representation” and the corresponding Volume 2 research study titled “IRS Earned Income Credit Audits – A Challenge to Taxpayers,” represented taxpayers are twice as likely as unrepresented taxpayers to be found eligible for EITC and to have no changes made to their EITC as a result of an examination. Moreover, represented taxpayers retained, on average, $623 more in EITC than unrepresented taxpayers. Finally, in Volume 2 we present a study by Professor Leslie Book, “Study of the Role of Preparers in Relation to Taxpayer Compliance with Internal Revenue Laws,” that reviews the literature relating to tax practitioners’ influence on tax compliance and considers a typology of the practitioners’ role in sole proprietor and EITC noncompliance. The Need to Design Services, Communications, and Compliance Initiatives with the Specific Characteristics of the Target Population in Mind I commend the IRS for its progress in understanding the needs and preferences of individual taxpayers, its creation of a Taxpayer Service Executive Steering Committee and TAB Program Management Office, and its commitment to research the impact of taxpayer service on compliance as part of its Taxpayer Assistance Blueprint. As highlighted in the Most Serious Problem discussions titled “Exempt Organization Outreach and Education,” “Outreach and Education on Disability Issues for Small Businesses/Self-Employed Taxpayers,” and “Nonfiler Program,” the IRS now needs to expand this analysis to other taxpayer segments and specific taxpayer populations. Moreover, it must apply some of its preliminary findings from the TAB 2 See generally Government Accountability Office, GAO-06-563T, Paid Tax Return Preparers: In A Limited Study, Chain Preparers Made Serious Errors (2006). This study focused on tax returns prepared by paid tax return practitioners at 19 different sites. GAO staff posed as taxpayers and had tax returns prepared by practitioners at the different sites. Errors were made on all 19 returns ranging from small misstatements that had little or no effect on the tax liability to large mistakes that would have resulted in significant overpayments or underpayments of tax. viii Preface — Introductory Comments of the National Taxpayer Advocate Preface: Introductory Comments of the National Taxpayer Advocate and other surveys to its current service offerings. For example, the IRS now acknowledges that P there will always be a part of our taxpayer population that requires – not just prefers – face- to-face service in order to comply with the tax laws. The next step is to ensure that Taxpayer r e Assistance Centers are adequately staffed to meet the needs of that population and adequately trained to answer the questions most likely to be asked by that population. By declaring f certain subjects or services “out of scope” at the TACs, the IRS may be reducing its “wrong a answer” rate, but that approach hardly serves taxpayers who come to the TACs looking for c assistance. Different taxpayer populations in different geographic locales have different needs for assistance. A 21st century tax administrator can accept the challenge of meeting those e needs, first by listening to taxpayers and second by utilizing technology – not only the Internet and telephones, but also kiosks in TACs for converting cash to money orders and mobile tax assistance units that travel to taxpayers in their communities. Why a Taxpayer Bill of Rights? To my mind, tax compliance in the United States occurs because, by and large, taxpayers want to comply with the tax law. They view themselves as civilized folk who understand that “taxes are what we pay for civilized society.”3 But this willingness to comply is directly related to the way in which the tax system treats its taxpayers. I believe taxpayers and tax administration will benefit from an explicit statement of what taxpayers have a right to expect from their government’s tax system and what the government has a right to expect from its taxpayers. This expression of the social contract between taxpayers and their government will enable taxpayers and administrators alike to understand the fundamental principles upon which all taxpayer protections and responsibilities are built. Our present hodgepodge of taxpayer rights, enacted over three decades of legislation, can be linked to these fundamental rights, and these rights, in turn, will rest on corresponding taxpayer responsibilities. This clarity of expression and structure can form the basis of a national dialogue of what it means to be the “lifeblood of government” – that is, the U.S. taxpayer. With a greater awareness of one’s rights and responsibilities, taxpayer compliance may well increase. Respectfully submitted, Nina E. Olson National Taxpayer Advocate 31 December 2007 3 See Compania General de Tabacos de Filipinas v. Collector of Internal Revenue, 275 U.S. 87, 100 (1927) (Holmes, J., dissenting). 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