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The Tax Gap

The "tax gap" is a concept developed by the Internal Revenue Service to measure voluntary compliance with the tax laws by taxpayers. The tax gap is the difference between what taxpayers should have paid and the amount that is actually paid voluntarily and timely.

According to the latest tax gap figures, about 83% of all taxes owed are paid as due. That leaves a 17% noncompliance rate for a tax gap of about $450 billion. IRS enforcement activities, including tax return audits, collect about $65 billion of this tax revenue shortage.

There are three components to the tax gap: nonfiling, underreporting, and underpayment. The tax gap does not include taxes that should have been paid on income from illegal activities.

Underreporting accounts for about 84% of the tax gap. The largest sub-component for underreporting involves individual taxpayers understating their income, taking improper deductions, and overstating business expenses. Noncompliance is highest where there is no third-party reporting and/or withholding such as there is with W-2s and 1099 information slips.

The current IRS measurement of the tax gap was done using tax returns from a few years ago. The information on the tax gap assists the IRS in selecting tax returns for audit. The intent is to select those tax returns that will lead to the greatest amount of additional tax. This not only improves IRS efficiency, but it also demonstrates to taxpayers that others will be paying according to the tax laws.

What does all this mean to you? If a large portion of your income is not subject to third-party reporting, you may be in a group that is on a potential tax return audit list this year.