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95–484—PDF 2004

S. HRG. 108–703

BRIDGING THE TAX GAP

HEARING

BEFORE THE

COMMITTEE ON FINANCE

UNITED STATES SENATE

ONE HUNDRED EIGHTH CONGRESS

SECOND SESSION

JULY 21, 2004

(

Printed for the use of the Committee on Finance

COMMITTEE ON FINANCE

CHARLES E. GRASSLEY, Iowa, Chairman

ORRIN G. HATCH, Utah

DON NICKLES, Oklahoma

TRENT LOTT, Mississippi

OLYMPIA J. SNOWE, Maine

JON KYL, Arizona

CRAIG THOMAS, Wyoming

RICK SANTORUM, Pennsylvania

BILL FRIST, Tennessee

GORDON SMITH, Oregon

JIM BUNNING, Kentucky

MAX BAUCUS, Montana

JOHN D. ROCKEFELLER IV, West Virginia

TOM DASCHLE, South Dakota

JOHN BREAUX, Louisiana

KENT CONRAD, North Dakota

BOB GRAHAM, Florida

JAMES M. JEFFORDS (I), Vermont

JEFF BINGAMAN, New Mexico

JOHN F. KERRY, Massachusetts

BLANCHE L. LINCOLN, Arkansas

KOLAN DAVIS, Staff Director and Chief Counsel

RUSSELL SULLIVAN, Democratic Staff Director

(II)

(III)

C O N T E N T S

OPENING STATEMENTS

Page

Grassley, Hon. Charles E., a U.S. Senator from Iowa, chairman, Committee

on Finance ............................................................................................................ 1

Baucus, Hon. Max, a U.S. Senator from Montana ................................................ 2

Conrad, Hon. Kent, a U.S. Senator from North Dakota ...................................... 27

AGENCY WITNESSES

Wagner, Hon. Raymond T., Jr., member, IRS Oversight Board, U.S. Department of the Treasury, Washington, DC ............................................................. 5

Brostek, Mike, Director, Strategic Issues, Government Accountability Office,

Washington, DC ................................................................................................... 7

Gardiner, Pamela J., Acting Inspector General, Treasury Inspector General

for Tax Administration, Washington, DC .......................................................... 8

Everson, Hon. Mark, Commissioner, Internal Revenue Service, Washington,

DC .......................................................................................................................... 31

Olson, Nina E., National Taxpayer Advocate, Taxpayer Advocate Service,

Washington, DC ................................................................................................... 35

Godici, Nick, Commissioner for Patents, U.S. Department of Commerce,

Washington, DC ................................................................................................... 37

WITNESSES

Bankman, Joseph, Ralph M. Parsons Professor of Law and Business, Stanford

Law School, Stanford, CA .................................................................................... 10

Brown, Dale, taxpayer who engaged in an offshore tax shelter, Incline, NV,

accompanied by Steven Wilson, Esq. .................................................................. 11

Mr. ABC, an anonymous witness ........................................................................... 13

Morgenthau, Robert M., District Attorney of New York County, New York,

NY ......................................................................................................................... 33

Langsea, Debbie, manager, California Franchise Tax Board, Sacramento, CA . 34

ALPHABETICAL LISTING AND APPENDIX MATERIAL

Mr. ABC:

Testimony .......................................................................................................... 13

Prepared statement .......................................................................................... 59

Bankman, Joseph:

Testimony .......................................................................................................... 10

Prepared statement .......................................................................................... 65

Baucus, Hon. Max:

Opening statement ........................................................................................... 2

Prepared statement .......................................................................................... 67

Brostek, Mike:

Testimony .......................................................................................................... 7

Prepared statement .......................................................................................... 70

Brown, Dale:

Testimony .......................................................................................................... 11

Prepared statement .......................................................................................... 139

Conrad, Hon. Kent:

Opening statement ........................................................................................... 27

Page

IV

Everson, Hon. Mark:

Testimony .......................................................................................................... 31

Prepared statement .......................................................................................... 145

Responses to questions from Senators Baucus and Rockefeller ................... 155

Gardiner, Pamela J.:

Testimony .......................................................................................................... 8

Prepared statement .......................................................................................... 185

Godici, Nick:

Testimony .......................................................................................................... 37

Prepared statement .......................................................................................... 194

Grassley, Hon. Charles E.:

Opening statement ........................................................................................... 1

Prepared statement .......................................................................................... 204

Langsea, Debbie:

Testimony .......................................................................................................... 34

Prepared statement w/attachment .................................................................. 205

Morgenthau, Robert M:

Testimony .......................................................................................................... 33

Prepared statment ............................................................................................ 293

Olson, Nina E.:

Testimony .......................................................................................................... 35

Prepared statement w/attachment .................................................................. 303

Rockefeller, Hon. John D., IV:

Prepared statement .......................................................................................... 368

Wagner, Hon. Raymond T., Jr.:

Testimony .......................................................................................................... 5

Prepared statement .......................................................................................... 369

(1)

BRIDGING THE TAX GAP

WEDNESDAY, JULY 21, 2004

U.S. SENATE, COMMITTEE ON FINANCE, Washington, DC.

The hearing was convened, pursuant to notice, at 10:40 a.m., in

room SD–215, Dirksen Senate Office Building, Hon. Charles E.

Grassley (chairman of the committee) presiding.

Also present: Senators Thomas, Baucus, Conrad, and Lincoln.

OPENING STATEMENT OF HON. CHARLES E. GRASSLEY, A U.S.

SENATOR FROM IOWA, CHAIRMAN, COMMITTEE ON FINANCE

The CHAIRMAN. The hearing will come to order.

This hearing is to consider what still is a very serious subject:

the tax gap and ways to close the tax gap.

As members of the Finance Committee know, that gap is the difference between the amount of tax due and owing versus the

amount actually collected.

Due to a number of factors, especially the war and increased

spending, our Nation is looking at deficits. At the same time, the

administration and many in Congress do not want to increase the

tax burden on the vast majority of honest citizens who pay their

fair share of taxes.

Therefore, we must look at ways of dealing with the tax gap to

bring revenues to the Treasury and fairness to the Tax Code.

This is even more important as we look to the fall, where we will

hopefully have conferences concluding on several issues, each of

them with a significant demand for possible new revenue raisers.

In addressing the problem of the tax gap, we have to recognize

that we have finite resources and that we are not going to place

a heavy burden on honest taxpayers. We must retain the balance,

and a proper balance, of service and enforcement, coupled with the

respective taxpayers’ rights. To achieve that, it is clear that we

have to work smarter and more efficiently. We have to target limited resources where they do the most good.

This hearing provides the Finance Committee that opportunity to

consider both what the IRS is doing to address the tax gap, and

also learn about new ideas and innovations that are being implemented, or could be implemented, at the State level that are being

proposed by witnesses today.

I now turn to one of the most consistent members of the committee on this issue of tax gaps because he has spoken out on it

so many times, particularly as he questions people who are being

2

appointed to the Treasury Department and the IRS, Senator Baucus.

OPENING STATEMENT OF HON. MAX BAUCUS, A U.S. SENATOR

FROM MONTANA

Senator BAUCUS. Thank you very much, Mr. Chairman. I appreciate your holding this hearing. As always, you are persistent and

do not let a little thing like an evacuation get in the way here, and

I deeply appreciate it.

One of the strongest features of our democracy is our system of

collecting income taxes through individual self-assessment. President Franklin D. Roosevelt referred to this point, and I am going

to quote him.

He said, ‘‘In 1776, the fight was for democracy and taxation. In

1936, that is still the fight. Taxes, after all, are the dues that we

pay for the privileges of membership in organized society. As society becomes more civilized, a government is called on to assume

more obligations to its citizens.

The privileges of membership in a civilized society have vastly

increased in modern times, and I am afraid we have many who still

do not recognize their advantages. They want to avoid paying their

dues.’’

I think those words remain as true today as they were in 1936.

It is easy, of course, to bash the Federal Government. It is easy to

bash the IRS. It is easy to bash. That is why it is important for

public officials, I think, to take the high road and remind taxpayers

of why we pay taxes.

There is a reason. The easy way is to be critical and say that

that is taxpayers’ money, and it is, and that the IRS is being very

abusive in trying to collect taxes, and sometimes it is abusive.

But the main point is, we have got to strike a balance here. We

do pay dues for civilized society, and at the same time we want an

IRS that is efficient and fair.

After all, people are the employers, and the IRS, as well as us

here in this committee, are the employees, and as we are here to

serve people, we just have to help make sure the service is the best

as it can possibly be.

The dues we pay for privileges of membership in civilized society

provide many benefits. For example, education for our children, police and fire protection, safe and efficient highways.

Our Nation’s parks are available for not only ourselves, but for

generations to come. The elderly through Medicare, and Social Security, for example. They help take care, as I said earlier, of our

children.

It does not mean that taxpayers should pay more than they owe.

As stated by the great jurist, Learned Hand, ‘‘If anyone may arrange his affairs so that his taxes shall be as low as possible, he

is not bound to choose the pattern which best pays the Treasury.’’

There is clearly a balance that we must strike, and unfortunately

we are now not in that balance.

Over the past 3 years, we in the United States have been on a

destructive fiscal path, as we all know. As a result, our Federal

budget has gone from the largest surplus in our Nation’s history

3

to the largest deficit in our Nation’s history. This year’s deficit will

likely top $400 billion.

But if that sea of red ink is not bad enough, it is even more disturbing when you consider that a growing percentage of Americans

do not believe that paying taxes is their civic duty.

In 1999, 81 percent of Americans agreed that it is their civic duty

to pay taxes. In 2002, just a few years later, only 72 percent, a decline of almost 10 percent, agreed with that statement. Last year,

the group fell to just 68 percent of the population. Obviously, a disturbing trend.

But it is also very clear that more people believe that cheating

is acceptable. This mind-set undermines our Nation’s democracy.

While honest Americans are doing their part, a number of others

are trying to get by without doing theirs, and that is what this

hearing about.

Some call it the tax gap, the difference between the amount of

the taxes that taxpayers owe the government and the amount of

taxes that taxpayers voluntarily and timely pay.

This is not about raising taxes, it is about enforcing tax laws on

the books. This is about collecting the taxes that are owed, especially to the Treasury, under the existing Code. The IRS Office of Research estimates a gross tax gap of $300 bil- lion for taxable year 2001, and only about $55 billion of this will

ever be recouped, in part because the IRS does not currently have

the resources to ensure that everyone pays what they owe, leaving

a net tax gap of $245 billion.

Those figures are based on the IRS’s current estimate of an overall taxpayer noncompliance rate of 15 percent. Playing this out, if

we have just a 1 percentage point swing in voluntary compliance,

we could change revenues and reduce the deficit each year by more

than $20 billion.

Moreover, the tax gap exacerbates the long-run imbalance of the

Social Security Trust Fund. In 2001, sole proprietors under-reported their income by amounts that reduced Social Security payroll taxes by about $40 billion.

The Social Security actuary tells us that if we could reduce this

tax gap by even 20 percent, we could reduce the 25-year actuarial

imbalance of Social Security by over 5 percent. This would push

back the date that the Social Security Trust Fund exhausts by 1

year, and this would help stave off an increase in payroll taxes or

a cut in benefits.

In the same vein, the Medicare actuary tells us that Medicare’s

75-year actuarial imbalance would be reduced by almost 3 percent,

and its exhaustion date would be pushed back 1 year, from 2019

to 2020.

It is just common sense for us to set a goal, a benchmark of

where we should be on tax compliance. In April, I proposed that

we shoot for at least a 90 percent tax compliance rate by the end

of the decade. That means that by 2010, at least 90 percent of

Americans will be filing their taxes and paying their dues. I do not

think that is too much to ask.

As we face a Federal deficit of over $400 billion, the government

has got to do a better job and we need a plan. Any organization

worth its salt has a plan, has dates, has names of people responVerDate 11-MAY-2000 11:27 Feb 02, 2005 Jkt 095484 PO 00000 Frm 00007 Fmt 6633 Sfmt 6633 95484.000 SFINANC2 PsN: SFINANC2
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sible and has data estimates and benchmarks. I do not think the

IRS has that, astoundingly. At least, I am not aware of it.

I have pushed very, very hard for names, data, and dates, just

a good old business plan. We need a plan, and we do not have a

plan that I am aware of. I hope this hearing will show that we are

at least beginning to get a plan and some dates, and some end

points so we can get a better handle on this problem. As we face a Federal deficit of over $400 billion, the government

has just got to do better. I am also concerned that the IRS does

not have the resources it needs to enforce the tax laws.

The IRS’s fiscal year 2005 budget request does not account for

mandatory pay raises, unbudgeted mandatory expenses such as

rent increases and postage, and the inability of the IRS to achieve

its projected savings from internal productivity growth.

Just last week, the House Appropriations Subcommittee on

Transportation, Treasury, and Independent Agencies reduced the

administration’s budget request for the IRS, incredibly, by $382

million.

I am concerned that the IRS will not have adequate funding to

increase enforcement initiatives and maintain its taxpayer service

at the same time. At some point, the IRS could no longer do more

with less, and I believe we have reached that point.

It is not just a question of resources, though. We need to ensure

that the IRS modernizes the computer systems and improves its research so that it operates smarter and more efficiently.

We must also pass, and have on the President’s desk for signature, tax shelter, Enron-related corporate governance and simplification legislation that the Senate has passed many times.

Not only will that help reduce the gap, but it sends a very strong

signal to the world and to the community that we are serious about

closing loopholes and the Congress is serious about addressing this

problem. The failure to enact that legislation, I believe, also sends

an equally strong signal in the wrong direction that we are not serious.

There is clearly no silver bullet to close this tax gap. Nevertheless, increasing IRS resources, ensuring a smarter, more efficient,

more responsive IRS and a more cooperative Congress, working together, will go a long way toward closing the gap. I very much hope

that this hearing marks a signal date and event where we are finally beginning to do something about it.

Thank you, Mr. Chairman.

The CHAIRMAN. You bet.

Our first witness is Mr. Ray Wagner, member of the IRS Oversight Board, and chairs the Board’s Human Capital Committee;

then Mr. Michael Brostek, Director of Strategic Issues, Government

Accountability Office; Pamela Gardiner, Acting Inspector General,

Tax Administration, Treasury; Mr. Joseph Bankman, Professor of

Law and Business at Stanford Law School; and Mr. Dale Brown,

a taxpayer who is awaiting sentencing for his participation in an

offshore tax shelter. Then we have an anonymous witness, confidential, we are going to refer to as Mr. ABC.

All of you will have your total longer statement placed in the

record. Because of getting started late, it is all the more important

that we stay to five minutes, if you can.

5

I do not want to cut somebody off in the middle of a sentence or

a thought, but if you can complete the thought you are on when

the red light goes on, we would appreciate it very much.

Mr. Wagner?

STATEMENT OF HON. RAYMOND T. WAGNER, JR., MEMBER, IRS

OVERSIGHT BOARD, U.S. DEPARTMENT OF THE TREASURY,

WASHINGTON, DC

Mr. WAGNER. Thank you, Mr. Chairman, Senator Baucus, members of the committee. Thank you for the opportunity to present the

Oversight Board’s view on the tax gap.

As you know, the tax gap is most recently estimated to be approximately $311 billion. However, that figure is based on data and

models more than 15 years old. Given the sea change of taxpayer

demographics and behavior since then, the tax gap could be much

higher. For example, from 1990 to 2001, the number of individual

taxpayers with the adjusted gross incomes over $1 million grew by

215 percent.

At the same time, the Tax Code is more complex and more readily exploited. We have seen a flood of abusive tax avoidance

schemes and an erosion of both taxpayer attitudes towards compliance and professional standards. All of these contribute to the national disgrace we call the tax gap.

The tax gap is not just a statistic. Its consequences are all too

real and unjust. Honest taxpayers must bear the financial burden

of those who do not pay what they owe. Further, we need the extra

revenues that closing the tax gap would provide. The tax gap undermines confidence in the fairness of our tax administration system and fuels noncompliance.

Mr. Chairman, the tax gap was not created overnight, nor can

it be solved in a single year. It can be attacked, however, by following a multi-year strategic plan offered by the board today.

I will discuss the four complementary parts. First, the board

must improve the IRS effectiveness. The board recently approved

the IRS’s new 5-year strategic plan. Its major theme is service plus

enforcement equals compliance.

The board fully endorses this approach and believes that the IRS

can achieve the goals that this theme represents through its people, processes, and technology. Commissioner Everson will present

a description of this plan, I am sure.

However, I will touch upon the Business Systems Modernization

component for a moment. The board has been deeply concerned at

the pattern of delays and cost overruns that have plagued the BSN

program from its inception.

We applaud the Commissioner’s efforts to bring discipline and accountability to BSN, and his actions closely track with the board

and others that recommended to get it back on track. Clearly, we

cannot allow Business Systems Modernization to fail if we are to

address the tax gap appropriately.

The second component of our plan is to provide appropriate additional resources. The board believes that funding for our tax system should be strengthened, not merely maintained at current levels.

6

In a special report on the IRS 2005 budget, the board argued for

reinvesting in the IRS and called for a pragmatic budget that reflects the complex world in which the IRS must operate.

We also need to reevaluate the criteria used to appropriate funding to the IRS to take into account the return on investment realized from the application of additional funding. The IRS is

outmanned and outgunned when it comes to enforcing tax laws.

Unscrupulous tax professionals exploit this weakness. We have

gotten to the sad point where you can drive an armored car

through the tax gap because the IRS does not have the resources

to go after known tax cheating.

The numbers speak for themselves. In 2002, the IRS was able to

pursue only 18 percent of the known cases of abusive shelters, leaving an estimated $447 million on the table. There is only one

chance in four that the IRS will go after someone who does not file

a return. I could go on and on.

Mr. Chairman, the IRS is not turning a blind eye toward tax

cheating, but we would be blind not to recognize that it cannot do

its job without the necessary funding.

The third component of the plan is to measure results. The national research program will provide a solid estimate of voluntary

compliance. The NRP will provide accurate baseline measurements

from which the IRS can begin to set long-term goals or tax system

compliance to help close the tax gap.

Establishing long-term goals can be a very powerful tool in energizing the organization. Take e-filing, for example. Although the 80

percent goal may not be fully realized by 2007, its positive impact

has been undeniable.

Long-term compliance goals can similarly energize the IRS and

the tax community to work to close the tax gap. Recently, Senator

Baucus, as you alluded and mentioned, you proposed that the IRS

raise voluntary compliance to 90 percent by the year 2010.

We applaud the spirit of this proposal and we will need to exercise caution in setting that specific numeric goal until we know

what voluntary compliance is today.

The fourth, and final, component of the plan is to simplify the

tax administration system. The costly, confusing and debilitating

complexity of the Tax Code directly feeds the tax gap.

Rather than tinkering at the margins, the board strongly encourages Congress and the administration to explore fundamental ways

to simplify our Tax Code, thereby easing the enormous burden and

cost of administration for the IRS and taxpayers alike.

Mr. Chairman, in conclusion, the tax gap is an affront to all honest taxpayers. It saps our Nation of precious resources when it

needs them most. It is an enormous problem, but in time it can be

solved through the strategic approach I have outlined today.

However, the IRS cannot do it alone. This is a shared responsibility. The ultimate success in closing the tax gap rests in all of our

hands.

Thank you.

The CHAIRMAN. Thank you for your testimony.

[The prepared statement of Mr. Wagner appears in the appendix.]

The CHAIRMAN. Now we go to Mr. Brostek.

7

STATEMENT OF MIKE BROSTEK, DIRECTOR, STRATEGIC

ISSUES, GOVERNMENT ACCOUNTABILITY OFFICE, WASHINGTON, DC

Mr. BROSTEK. Mr. Chairman, Senator Baucus, and members of

the committee, I am pleased to participate in today’s hearing.

In addressing the tax gap, IRS uses many strategies, including

obtaining corroborating information from others and analyzing

data from taxpayers themselves. Just as IRS sometimes obtains

corroborating information, some Federal agencies obtain tax data

from IRS to use in ensuring that benefits are properly awarded to

applicants.

Related to obtaining corroborating information from others, my

testimony covers the extent to which IRS and Citizenship and Immigration Services within the Department of Homeland Security

share data.

Related to analyzing information obtained from taxpayers, my

testimony provides information on the characteristics of taxpayers

that came forward under IRS’s offshore voluntary compliance initiative.

Currently, IRS and CIS do not share data. IRS may benefit from

using immigration information to select taxpayers that appear to

be non-compliant and follow them up with enforcement actions. For

example, IRS could benefit if CIS data helped to identify taxpayers

who failed to file returns or who under-report their income.

Regarding non-filing, we found that from 1997 through 2004,

about 20,000 businesses and organizations nationwide applying to

sponsor immigrant workers were unknown to IRS. They were not

in any of their data systems.

For under-reporting, we found 10 organizations in a small sample of immigration applications that reported, as a group, over half

a million dollars more income to CIS than to IRS.

Although we do not know whether these businesses reported accurately to either CIS or IRS, discrepancies like these can help IRS

select firms and individuals for enforcement.

IRS may also benefit if immigration applicants were required to

be current on their tax obligations before applying for immigration

benefits, because in that case taxpayers would need to come to IRS

to have their tax issues resolved.

Regarding the number of potentially non-compliant taxpayers

who might come to IRS under such a rule, we found, for instance,

that about 19,000 businesses nationwide—again, from 1997

through 2004—had unpaid tax assessments at the time that they

applied to sponsor immigrants, with total assessments totaling $5.6

billion as of December, 2003.

CIS may also benefit from IRS’s information. IRS data may help

CIS officials identify those businesses and organizations that may

not be able to pay wages or may not be legitimate businesses when

they apply to sponsor immigrant workers, two factors relevant to

decisions on immigration eligibility.

As shown in the chart, we found about 68,000 businesses and organizations nationwide had not filed one or more tax returns at the

time they applied to sponsor an immigrant worker. In addition,

about 20,000 were unknown to IRS.

8

Especially for smaller businesses, failure to file a return may indicate that a business is struggling financially and cannot support

the workers it is attempting to bring into the country.

Although they may benefit from sharing data, CIS and IRS face

challenges. For example, CIS does not automate financial data,

such as an applicant’s income, and the agencies use different tracking numbers.

In addition, the Tax Code does not authorize IRS to disclose taxpayer information for immigration eligibility decision making. CIS

would need to see a change to the Code or seek tax applicants’ consent for CIS to obtain their tax data directly from the IRS.

Because of the confidentiality of tax data being considered crucial

to voluntary compliance, executive branch policy calls for a business case to be made before data sharing occurs. We are recommending that IRS and CIS assess benefits and costs of data sharing.

The Offshore Voluntary Compliance Initiative attempted to bring

taxpayers with funds held offshore back into compliance, while

gathering information about them and offshore promoters.

Eight hundred and sixty-one taxpayers came forward and IRS officials said they gathered more than $200 million. Taxpayers who

applied had incomes ranging from well over $500,000 to substantial

net losses.

They lived, as the chart shows here, in 47 States, but with over

half the applicants being in just 5 States. They reported over 200

occupations. Some appeared to be intentionally noncompliant and

others appeared to have unintentionally fallen into noncompliance.

More than half of the OVCI applicants had complied with their

tax obligations and paid their taxes, even on their offshore income,

but they had failed to file a Report of Foreign Bank and Financial

Accounts, as required by Treasury. Less than 16 percent said they

used a promoter.

Given this diversity, multiple compliance strategies may be needed. Because additional tax, interest and penalties collected to date

from OVCI applicants who owed tax was a median of only $5,400,

personnel-intensive investigations of individual taxpayers who have

hidden money offshore may not be very cost-effective.

This puts a premium on IRS developing a means to identify

those cases that should be subjected to such investigations and, if

possible, alternative compliance strategies for the rest.

This concludes my statement. I would be happy to answer questions.

The CHAIRMAN. Thank you very much.

[The prepared statement of Mr. Brostek appears in the appendix.]

The CHAIRMAN. Ms. Gardiner?

STATEMENT OF PAMELA J. GARDINER, ACTING INSPECTOR

GENERAL, TREASURY INSPECTOR GENERAL FOR TAX ADMINISTRATION, WASHINGTON, DC

Ms. GARDINER. Chairman Grassley, Ranking Member Baucus,

and distinguished members of the committee, I appreciate the opportunity to appear before you today to discuss the tax gap probVerDate 11-MAY-2000 11:27 Feb 02, 2005 Jkt 095484 PO 00000 Frm 00012 Fmt 6633 Sfmt 6633 95484.000 SFINANC2 PsN: SFINANC2
9

lem, what the Internal Revenue Service is doing to address it, and

additional actions that could be taken.

In the past, the prevailing view was that the tax gap was primarily composed of unreported and delinquent taxes from the underground economy. For example, self-employed contractors were

suspected of failing to report and pay taxes on the cash payments

they received.

However, it has become apparent that, in addition to the problems with tax reporting and payment in those areas, there has

been an ever-increasing problem with compliance by corporations

and individuals, both domestically and abroad.

The legal and accounting professions have also been identified as

contributing to the overall tax gap problem by promoting illegal or

questionable tax avoidance schemes.

Additionally, the increased globalization of our economy provides

opportunities for corporations and individuals to avoid taxes using

tools available in the worldwide marketplace.

These recent increases in participation in tax avoidance schemes

and the promotion of them by highly respected firms has evidently

fueled a more cavalier attitude toward the tax system among the

general population.

Survey results recently released by the IRS Oversight Board indicated that the percentage of people who believe it is acceptable

to cheat on their taxes has grown from 11 to 17 percent from 1999

to 2003.

Although the tax gap appears to be growing, no one really knows

its true size. The IRS estimates the annual gross tax gap increase

from $283 billion in tax year 1998 to $311 billion in 2001. However,

IRS would readily admit that this figure is based on outdated information and conservative assumptions, and it may be considerably

higher.

Nevertheless, the IRS is making some progress in addressing certain components of the tax gap. For example, in fiscal year 2003,

enforcement revenue collected increased by 10 percent after remaining fairly constant during the prior 3 years. In addition, after

steadily rising for 6 years, the gross accounts receivable declined

in fiscal year 2003.

The IRS is focusing considerable effort on combatting tax shelters. As part of its efforts, the IRS is expanding its partnership

with State tax agencies to pursue abusive tax transactions and address other criminal activity.

The IRS has also begun addressing taxpayers’ attempts to avoid

taxes through the use of offshore techniques, but the results here

have been mixed. Although millions in additional assessments have

been made, over half of the cases have been closed without any additional assessment.

All in all, we continue to be concerned that the IRS cannot be

sure it is deploying its critical compliance resources to most effectively address the latest tax avoidance schemes because its compliance strategy is based on 16-year-old data.

In recent years, TIGTA has made recommendations that address

various components of compliance and could supplement the IRS’s

overall strategy to address the tax gap.

10

Because noncompliance in the self-employed population remains

a significant component of the tax gap, TIGTA maintains that implementing a provision to mandate withholding on non-employee

compensation could reduce the tax gap by billions of dollars.

Additionally, various actions could be taken to improve compliance with estimated tax payments such as legislative changes to

require monthly payments, and increased promotion of electronic

payments. A comprehensive matching program for business tax

documents could also identify significant pockets of noncompliance.

Further actions are also needed to ensure compliance among

partnerships with foreign partners. Various studies have confirmed

the connection between higher examination rates and better rates

of voluntary compliance, even beyond that of the individuals audited.

Increasing staffing in the enforcement functions is a necessary

component of improving both examination rates and the collection

of taxes assessed. The combined collection and examination functions of enforcement staffing has declined from 25,000 at the beginning of fiscal year 1996 to 16,000 at the end of 2003.

Activities of the IRS’s Criminal Investigation Organization also

have a strong measurable impact on voluntary compliance. However, as TIGTA noted in the report earlier this year, improvements

are needed to ensure convicted criminals comply with the terms

that were imposed as part of their sentence.

In closing, I would like to reiterate that the IRS has numerous

significant efforts under way to address the various components of

the tax gap. However, it is particularly critical that the IRS continue to obtain updated information to enable it to revise the compliance data models.

It needs to make more accurate forecasts of the extent of noncompliance and ensure it uses its limited resources in the most effective manner. TIGTA has recommended more actions which, if

taken, could assist the IRS’s efforts.

Finally, it is important to remember that the complexity of the

Tax Code affects both the compliance of the general population and

the ability of the IRS to identify and take action on noncompliance.

This concludes my statement.

The CHAIRMAN. Thank you very much.

[The prepared statement of Ms. Gardiner appears in the appendix.]

The CHAIRMAN. Now, Professor Bankman?

STATEMENT OF JOSEPH BANKMAN, RALPH M. PARSONS PROFESSOR OF LAW AND BUSINESS, STANFORD LAW SCHOOL,

STANFORD, CALIFORNIA

Professor BANKMAN. Thank you for having me.

The tax gap is a topic. I am going to limit my comments today

to the tax gap associated with cash business, the cash economy,

which is a large segment of the tax gap.

Staff suggested that I further limit comments to outside-of-thebox ideas they thought this committee might not have already considered.

My first suggestion is to consider expanding the reach of thirdparty reporting. Income that is subject to third-party reporting, like

11

wages, dividends or the income that may or may not find its way

to the tax return.

It is obviously impossible to get all transactions in the reporting

system, but I think we could do better and your staff has in writing

some of my suggestions of what we might do there.

Having suggested we expand the region of reporting, let me acknowledge a draw-back. It is going to burden taxpayers, at least

initially, who are innocent. They are the reporters. Of course, this

is a generalized problem with tax enforcement.

That leads me to my second suggestion, that, where feasible, you

ought to consider having reimbursement programs for innocent taxpayers that are bearing the burden and are compliant. New Zealand expanded third-party reporting and it is my understanding

that they have a reimbursement program.

We could extend this to audits as well. Twenty years ago, Congresswoman Nancy Johnson (Connecticut) suggested that the government consider reimbursement in connection with the old TCMP,

now NRP, audits. I thought it was a good idea then and still think

it is a good idea. I draw out part of that idea and discuss that in

a paper that your staff has.

I have also suggested the idea of reimbursement for garden variety of audits, but limited to cases where taxpayers who go through

the audit relatively unscathed. I think reimbursement starts with

a common sense notion of fairness, and I think it would reassure

your constituents that, in increasing enforcement, you’re considering those who are compliant.

My third suggestion is to cross check income tax returns with

State property tax returns. Eventually, the cash economy, when

enough money accumulates, gets used not to fund consumption, but

for property purchases. You will find individuals that have brought

millions of dollars worth of property, but have little or no reported

income. Ideally, the function used to isolate returns for audits could

look at this discrepancy.

My final suggestion is to work with the preparer community, enrolled agents and CPAs, to root out the few bad apples among

them, who I think you will find out that a surprisingly high portion

of flagrant abuses are associated with a very few number of preparers.

These put the other preparers in an impossible competitive situation. In my belief, they help maintain an equilibrium of low reporting rates in certain segments of the economy.

Tax shelters have been mentioned. I have worked a lot in that

area and helped work with California on their legislation. In the

interest of time, though, I have not prepared any comments on

that, though I am happy to answer questions on that, or on anything else.

[The prepared statement of Professor Bankman appears in the

appendix.]

The CHAIRMAN. Now, Mr. Brown?

STATEMENT OF DALE BROWN, TAXPAYER WHO ENGAGED IN

AN OFFSHORE TAX SHELTER, INCLINE VILLAGE, NEVADA;

ACCOMPANIED BY STEVE WILSON, COUNSEL TO MR. BROWN

Mr. BROWN. Thank you, Mr. Chairman. Good morning.

12

My name is Dale Brown. This is Mr. Steve Wilson, my counsel.

I am 47 years old. I reside in Incline Village, Nevada.

Since leaving the U.S. Air Force in 1986 where I served as a U.S.

Air Force B–52 and FB–111 navigator-bombardier for 8 years, I

published 22 military aviation novels under my own name, and as

a co-author, 17 of which were New York Times bestsellers.

In April of 2004, I plead guilty to one count of violating 26 U.S.C.

7206(1), filing a false tax return, in 1998. I listed deductions on my

tax return knowing they were not real. I had control of foreign

bank accounts and did not report them. I signed the tax return,

knowing they were false entries.

With the Chairman’s permission, I would like to, first, tell my

family, my friends, and my fellow Americans that I take full and

complete responsibility for my actions. I am truly and sincerely

sorry for what I have done and I promise it will never happen

again. I will guarantee, it is never going to happen again.

I filed the false tax returns because I was greedy, I was vain, I

was selfish, and I took bad advice from financial professionals that

I trusted. We are all human, and humans make mistakes. But I

also believe that we must all pay for our mistakes, and I am prepared to accept any punishment ordered by the court.

How did I get involved in this scheme? Back in 1998, I expressed

a desire to pay off my home mortgage. My financial advisor told me

that it made no tax sense to do so because of the home mortgage

deduction, and told me of a better way to proceed under a program

run by Terry Neal of Portland, Oregon.

The plan was to expense corporate funds from the U.S. to an offshore entity, transfer funds by wire from the first to a second entity, then borrow the money from the second entity in the form of

a mortgage to which I would pay principal and interest payments

like a conventional mortgage.

I would then deduct the transfers as business expenses on my

corporate tax returns and deduct the interest paid on the mortgage

on my personal tax return.

Why did I not report that I had ownership or control of a foreign

bank account on my tax return? It was explained to me by Mr.

Neal and my financial advisors that I did not have to report it because the account was not in my name and I had no actual ‘‘signature authority’’ over it. In reality, I had full control of the money

and I should have reported it on my tax return. I believed the lie

because I wanted to believe it.

Why did I claim all those phony business expenses? For many

years, I had been participating in an income-splitting routine set

up by my financial advisors, expensing money between various domestic corporations.

The expenses simply became income on some other corporation’s

tax return, and that company would pay the taxes, usually at a

lower rate. The offshore scheme was simply a more sophisticated

extension of that same income-splitting program I had been doing

for many years. It was supposed to be tax deferral, not tax evasion.

Most of all, however, I believed that if I was doing something

really wrong, something so serious that I could land in prison, my

so-called financial advisors would steer me clear of it, if not for me,

13

then at least to protect themselves. That was an extremely bad assumption.

The scheme did not save me one cent. I paid more in interest and penalties than I did in taxes owed, a total of almost $1 million,

plus almost 2 years’ of attorneys’ fees, potential loss of income from

two canceled publishing contracts, adverse publicity, enormous

stress on myself and my family, and all the penalties associated

with being a convicted felon.

I have humiliated myself in front of my family, friends and

neighbors, and lost an incalculable amount of business and personal trust and goodwill that may never be recoverable. I am currently awaiting sentencing in Federal court in Portland.

With the Chairman’s indulgence, the following is my primary

recommendation to the committee regarding my involvement in the

offshore scheme. I do not make this recommendation as a way to

assign blame or make excuses, but as a possible avenue to resolve

similar issues more efficiently.

I subscribed to this scheme because of greed, vanity, selfishness,

and taking bad advice from bad persons. But I do not believe I am

a bad guy. I think I am a good and law-abiding guy who listened

to a bogus sales pitch from unscrupulous persons and was

schmoozed, flattered, and conned into signing up for something I

knew was not right. I heard only one message, but it was the

wrong one.

If the government wants to efficiently recover lost revenue and

provide the maximum level of deterrence, it seems to me that they

should widely publicize their investigations early on using media

outlets that guys like me watch or listen to every day.

If I had been watching ‘‘America’s Most Wanted,’’ ‘‘The O’Reilly

Factor,’’ ‘‘MSNBC,’’ or ‘‘Larry King Live’’ and heard that the IRS

had started an investigation on a program even remotely resembling the one I was involved with, I would be on the phone instantly to a lawyer and another accountant, wanting to get out

fast.

As in the U.S. Air Force Strategic Air Command nuclear war

fighting game that I was involved in for 8 years, deterrence only

works if the other side knows what nuclear weapons you have and

you make them believe as clearly as possible that you will use

them.

I would like to conclude by thanking the committee for allowing

me the opportunity to make this statement, and I pledge to continue doing everything I can to atone for the wrongs I have done,

and to earn back the faith and trust of my family, friends, and fellow citizens. Thank you.

The CHAIRMAN. Thank you, Mr. Brown.

[The prepared statement of Mr. Brown appears in the appendix.]

The CHAIRMAN. Now, Mr. ABC?

STATEMENT OF MR. ABC, AN ANONYMOUS WITNESS

Mr. ABC. Mr. Chairman and members of the committee, I want

to thank you for giving me the opportunity to testify today.

I am speaking to you about my experience as an IRS confidential

informant who provided original information concerning significant

and ongoing tax fraud involving major Wall Street firms.

14

I speak from firsthand knowledge. I work for a Wall Street investment bank, and through my professional experience I am intimately aware of competitors’ fraudulent tax shelters.

The schemes, in some cases, have been ongoing for more than a

decade. A couple of the schemes involved Enron. The Wall Street

fraud is complex and involves hundreds of millions, if not billions,

of dollars of U.S. tax liabilities.

In a nutshell, I blew the whistle on three types of abusive tax

shelters. The first abusive concerns the fraudulent transfer of U.S.

tax liabilities to foreign entities not subject to U.S. tax.

There are various permutations to the scheme, but one essential

component of this fraud is the creation of sham domestic partnerships to serve as fronts for foreign owners who acquire the U.S. tax

liabilities, but who have no intention of ever paying U.S. tax.

The second abuse involves the transfer of U.S. tax liabilities to

the foreign branches of U.S. taxpayers in order to artificially generate foreign source income and claim additional U.S. tax credits.

The third abuse, which is generally performed in conjunction

with the above two, concerns the artificial replication of tax bases

solely for the purpose of creating false deductions to be sold to outside taxpayers. These duplicate deductions are then claimed by the

unrelated taxpayers as an offset to their otherwise taxable income

from other sources.

As a Wall Street insider, I am very knowledgeable about these

abuses. I can tell you from experience that about 75 percent of all

the transactions specific to my expertise ended up in abusive tax

shelters.

Because the IRS has moved too slowly or not at all, the abuses

are still ongoing. That has resulted in huge liabilities being avoided. I estimate that the U.S. Treasury has lost at least $400 million

of tax revenues every year from these particular schemes.

Another important consequence of this fraud is that U.S. taxpayers who want to engage in transactions legally are being undercut by those engaging in tax abuse. The transaction’s true market

value depends on compliance with applicable U.S. tax laws.

If the associated tax liability is simply ignored through sham domestic partnerships or by the artificial generation of offsetting

credits, then the market value of the transactions erode significantly.

As a result, my livelihood and the business interests of honest

U.S. taxpayers are being seriously harmed by the fraudulent practices of others.

In 1998, I decided to come forward and report a particularly abusive group of entities that I knew were engaged in this fraud. I contacted the IRS’s Criminal Investigation Division, and through them

was put in contact with an IRS Civil Examination agent who just

happened to be auditing one of the partnerships that I was concerned about.

That first contact concerned three particular entities, and then

over the next few years I provided detailed information concerning

more than a dozen other entities and related groups engaged in

similar tax abuse.

15

From the time of that first contact until today, my efforts to correct the abuses have resulted in a series of frustrating and often

unproductive dealings with the IRS.

Over the past 6 years, I have literally spent thousands of hours

educating and prodding the IRS, urging them to take action. I have

traveled across the country at my own expense to have face-to-face

meetings with agents.

I have provided the IRS with hundreds of pages of evidence and

submitted numerous writings and diagrams explaining the fraud

and analyzing the abusive shelters in detail.

As I mentioned, when I first contacted the IRS they had one of

the partnerships under audit. Not to fault that particular IRS audit

team, but they truly did not know what they were looking at.

These are sophisticated tax avoidance strategies concocted by Wall

Street.

As a general matter, I observed that the IRS is consistently

outgunned and outmatched. From my vantage point, the IRS simply does not understand how the tax shelters work or how these

structures and transactions fit together.

When I first met with the IRS in 1998, I submitted an IRS Form

211 concerning the overall abuse. Later, I submitted detailed and

separate Form 211s for each of the entities involved. Form 211 is

the IRS form for confidential informants to supply information and

to apply for a reward under the IRS’s Whistleblower Program.

Later in 1998, I provided information about two more entities engaged in significant partnership fraud. In 1999, I provided detailed

information about six or seven more entities involved in abusive

baseless replication schemes, and about five other entities involved

with fraudulent domestic partnerships.

I also identified a major Wall Street bank that was involved in

the foreign branch abuse. In 2000, I provided information about yet

another Wall Street bank’s foreign bank approach, as well as two

other additional entities that were utilizing fraudulent domestic

partnerships.

In 2003, I provided information concerning two entities that were

acting as promoters of various types of transaction scams. In 2004,

I provided information to the IRS concerning two other entities

conducting baseless replication schemes.

Finally, over all these years, I provided detailed documentation

and analysis of the abuses to the IRS through meetings, phone

calls, e-mails, and faxes.

I hope that you now have a sense of the quantity of information

and assistance that I have provided, as well as the pervasiveness

and persistence of the tax shelters themselves.

Together I estimate that the numerous fraudulent schemes on

which I provided original information involved over $10 billion of

taxable income. Obviously, there are very serious U.S. tax liabilities associated with this income that are being avoided. The combined loss to the U.S. Treasury is immense.

In providing all this information, my experience with the IRS has

been extremely frustrating and discouraging. What I have encountered is an agency that is resistant to, and suspicious of, confidential informants, that is, private citizens who are trying to do the

16

right thing by coming forward and blowing the whistle on significant tax fraud.

I have also encountered an agency that is disorganized and is

generally not equipped to deal with the complex and sophisticated

tax shelters in an effective fashion.

Let me give you some examples. At the same time that I was actively supplying vast quantities of quality information to the agency, the IRS’s service center that was processing my Form 211s simply rejected them out of hand in 2003. There was no valid basis to

reject them.

It was just that the IRS center had no idea what was going on,

but chose to act anyway, probably just to get the paper of their

desk. It then took months to get the Form 211 claims reinstated.

The IRS is also resistant to outside information, even when it

comes from a knowledgeable insider like myself. I have often been

treated suspiciously, as if I were the bad guy.

There appears to be more of a willingness at the IRS to believe

the taxpayer perpetrating the scheme than the informant justly

questioning the fraud. I have never understood this attitude because I am putting myself at great personal risk by coming forward.

I stand to lose my career if my identity is discovered, since employers are uniformly hostile to employees who interact with regulators. I just do not understand why the IRS has not welcomed the

help and information.

In addition, from my perspective the IRS lacks the staff and resources to take on serious enforcement against Wall Street. Since

1998, I have provided detailed information on over 20 entities and

related groups that have engaged in complex and material tax

abuse through numerous tax shelters.

To date, action has been taken against only a couple of the entities. I have yet to receive any reward for my efforts as a confidential informant.

In many cases, the information that I provided was simply ignored. One example that I find particularly troubling involves

Enron prior to its collapse in 2001. In particular, in 1999, I provided detailed information about a series of fraudulent tax shelters

involving a major Wall Street firm and Enron.

The shelters involved the artificial duplication of tax deductions

for the sole purposes of generating fictitious book income. Approximately half a billion dollars of taxable income was evaded as a result of Enron’s fraudulent tax schemes and, conversely, hundreds

of millions of dollars of fictitious book income appeared on Enron’s

financial statements.

Not only did I provide drafts of a suspect Arthur Andersen opinion letter comforting the shelter, but I also supplied a copy of the

investment bank’s pitch book to the IRS.

The pitch book specifically outlined the questionable structure

and its purported benefits, which included the almost-too-good-tobe-true effect on Enron’s GAAP financial statements.

So, although these were tax abuses that Enron and Wall Street

were engaged in, at the end of the day the tax shelters permitted

Enron to inflate its book earnings.

17

Obviously, if IRS authorities had pursued the information back

in 1999, the Federal Government might have seen what was happened at Enron and Arthur Andersen long before there was a total

meltdown.

Remarkably, no one at the IRS inquired about the information

or pursued it. The one agent that I worked most with questioned

the lack of follow-up internally with the resident Enron IRS audit

team and was rebuffed for raising the issues.

Part of the problem is that the regional organization of the IRS

audit teams has generated regional in-fighting, so that inquiries

from one region are often treated dismissively by another region.

Part of the problem also is that on-site IRS audit staff seem to

have divided loyalties, since they work on a daily basis with the entities they audit and often go to work for them after completing

government service.

At other times, audit staff can be very protective and rigid because they do not want to reopen audit periods that are formally

complete. The lack of staffing and high turnover, generally, also

take their toll.

For example, I often had to resubmit the same information multiple times because it would get lose, and the high staff turnover

meant that I repeatedly had to bring new people up to speed.

I think that the greatest problem, however, is the agency’s resistance to take seriously outside information from knowledgeable insiders. If I had not persisted, all my claims would have been rejected and my information would have been lost.

Actually, the biggest loser in this is the U.S. Treasury, since confidential informants can help the IRS recover hundreds of millions,

if not billions, of dollars of lost tax revenues.

Let me end by saying that if the IRS ever wants to put an end

to Wall Street tax shelter schemes, they are going to need the help

of Wall Street insiders to get the information and expertise that it

will take.

Right now, the IRS does not have such resources or expertise and

they should welcome the assistance from knowledgeable insiders.

Thank you, Mr. Chairman and members.

[The prepared statement of Mr. ABC appears in the appendix.]

The CHAIRMAN. We will have five-minute rounds of questioning.

Mr. Brostek, you made a very common-sense recommendation

about checking to see that taxes are paid before foreign workers

would be admitted.

I would like to have you not go into greater depth about that, but

I would like to have you give us other examples that should be considered where there would be a requirement that an individual or

business show that they are current in taxes before government

benefits would be provided.

Mr. BROSTEK. Yes, Mr. Chairman. There are, of course, other

various benefits that people receive by applying to the Federal Government, ranging from research grants to maybe small business

loans. So, there are a number of opportunities where a mechanism

like this could be employed.

To date, the primary use seems to be from the States. A number

of the States have requirements, for instance, that before you can

practice law or before you can get a liquor license, or before you

18

can be a probation officer, you need to provide them a tax compliance check from IRS that shows that you are in compliance with

the law.

The CHAIRMAN. Mr. Brostek, I would like to have a broader perspective of how taxpayers get involved with offshore shelters like

Mr. Brown referred to, what the Web sites are saying, and the

services the promoters are offering.

Mr. BROSTEK. Yes. We had provided a hypothetical illustration in

our statement, which will be displayed here in a moment, that

shows a very similar situation, actually, where an individual used

a promoter who helped him set up an off-shore charity and a business entity that the individual controlled, and then transferred

substantial sums of money—$500,000, I believe it was—to the offshore charity, thus being able to take a charitable deduction for

having done so.

Money was transferred to the business entity. The business entity then loaned money to the individual for the mortgage, and the

mortgage payments from the individual then became deductible.

In essence, I think once someone has decided that they are going

to do this kind of thing, they are only limited by their imagination

or the imagination of their promoters about what kinds of things

could be done here.

There were other instances in which promoters suggested that

they could provide a scholarship to the individual’s child and that

could be deducted.

The CHAIRMAN. Mr. Brown said that he trusted his financial advisor. So for Mr. Brown, but also you, Mr. Brostek. This would be

advice to other people. At what point do you start hearing about

these tax shelters, that you ought to be concerned about their legality and whether or not you are violating tax law? Mr. Brown, for

you, when was that?

Mr. BROWN. I think I knew probably right from the very beginning that there was not something quite right with it, but the advantages, I think, outweighed the risks. I really did not believe

there was any true risk. I did not believe I would ever go to prison.

I think if my financial advisors ever said, well, you know, if you

sign up for this, there is a good chance that you can go to prison,

I do not think I would have ever signed up for it. Of course, they

never promoted it that way. But I never thought about going to

prison.

The CHAIRMAN. So they obviously would not tell you that, even

if they knew you would go to prison, because then they would not

get the benefit of selling it to you.

Mr. BROWN. Obviously. Yes.

The CHAIRMAN. Mr. Brostek?

Mr. BROSTEK. Yes. I think Mr. Brown makes a very good point.

It is not clear to me that individuals always realize up front that

they are getting into something that is not actually allowed by law.

To the extent that they are relying on a financial professional,

an attorney, or paid preparer that is assisting them in doing their

taxes, if they are trusting that individual and they are not aware

from other sources that this is a questionable transaction to be entering into or a questionable financial strategy to be following, they

do not know that they should not be distrustful.

19

The CHAIRMAN. Mr. ABC, I want to thank you for your testimony. I think it shows what whistleblowers mean in terms of

bringing forth information that is very valuable in almost any area,

but in this area of tax fraud.

I think you touched on this a little bit, but for emphasis, what

would you say that the IRS does or does not understand about tax

shelters? Second, what do you think needs to be done to improve

the IRS’s understanding of abusive transactions?

I think maybe the second part of that question, for time’s sake,

is more important than the first one, because I think you pointed

out some of those problems.

So, then to repeat, what do you think the IRS needs to do to have

a better understanding of abusive tax transactions?

Mr. ABC. Mr. Chairman, I think the problem stems from how

the IRS is structured. The field service level does not understand

the technical tax issues and the Office of Chief Counsel level, while

they understand the theory, they do not understand the application

to the real world.

So what I believe is necessary, is that you need knowledgeable

insiders who could bridge the gap, sort of, between the ivory tower

in the field, and bring expertise and resources to a collective effort.

Wall Street professionals create these tax shelter schemes, and

it is going to take Wall Street professionals to deconstruct them.

So, I think what is needed is an effective informant program.

The CHAIRMAN. Thank you, Mr. ABC.

Senator Baucus?

Senator BAUCUS. Thank you very much, Mr. Chairman.

I would like to, first, ask Mr. Wagner about the plan that you

mentioned in your testimony. What is it? It sounded pretty general

to me.

The CHAIRMAN. Can I interrupt you? I will go vote. We are voting

on Morocco.

Senator BAUCUS. All right.

The CHAIRMAN. I will go vote and then come back. I will hurry

right back.

Senator BAUCUS. All right. Good.

What are the components of that plan? Could you kind of help

this committee?

Mr. WAGNER. Yes, Senator. The components of the plan were,

first and foremost, to study and approve——

Senator BAUCUS. Right. Do you have any numbers with that?

When you described it, it sounded pretty general to me. To be honest, the more we get more specific with numbers, data and dates,

maybe we could get someplace. But do you have any of those?

Mr. WAGNER. In the testimony that I have submitted we have included some numbers, the goals that we are seeking in terms

of——

Senator BAUCUS. Can you tell me right off the top what those

are? If you cannot, we will submit a request for them. But it just

seems to me, we need a more specific plan.

Mr. WAGNER. Senator, probably the most important number to

articulate is the budget recommendation that we have made for fiscal year 2005 to support the IRS in its enforcement activities, in

particular, the staffing of enforcement officials, auditors, and indiVerDate 11-MAY-2000 11:27 Feb 02, 2005 Jkt 095484 PO 00000 Frm 00023 Fmt 6633 Sfmt 6633 95484.000 SFINANC2 PsN: SFINANC2
20

viduals to address some of these tax schemes that you have heard

about.

Senator BAUCUS. What does the Oversight Board do?

Mr. WAGNER. Well, Senator, we are charged to approve the Strategic Plan, to approve the budget of the IRS.

Senator BAUCUS. To be honest, you have a great opportunity and

great responsibility here. To be honest, when I hear about the

Oversight Board, I just hear words. I do not hear a lot. Do you

have any power to tell the IRS what to do?

Mr. WAGNER. Senator, RRA 98, which created the board, did provide a number of powers to the Oversight Board, including, as I

mentioned, approving the annual and long-term Strategic Plan of

the IRS.

Senator BAUCUS. Can you change the plan?

Mr. WAGNER. Senator, I think that we do have the leverage to

provide the input. With our approval authority, we do have the

power to change the plan.

Senator BAUCUS. Do you report separately and independently to

anyone else besides the IRS? Do you report to the Congress?

Mr. WAGNER. We do report.

Senator BAUCUS. Separately and independently?

Mr. WAGNER. We do provide separate reports to the Congress.

We have a report that is required by RRA 98 to submit to Congress, which I have here in my hand, that speaks to the activities.

Senator BAUCUS. Do you make recommendations to the OMB, to

the government, about resources, budgets?

Mr. WAGNER. We do. We independently look at the budget and

submit our own budget and send that to Congress, independent of

OMB.

Senator BAUCUS. And what is your recommendation?

Mr. WAGNER. This year, the budget recommendation was $11.2

billion, Senator.

Senator BAUCUS. $11.2 billion. And what is the trend in the IRS

budget?

Mr. WAGNER. In the past 4 years since the board has been created, the trend has been to request additional resources for the

IRS. Starting in 2002, we were at $9.7 billion and we have now

worked our way up to the number of $11.2 billion.

Senator BAUCUS. I think Commissioner Rossotti said that an annual 2 percent real increase is necessary to get the IRS back on

track.

Mr. WAGNER. In his end-of-term report, he did suggest that a 2

percent increase would bring——

Senator BAUCUS. Real. A real increase.

Mr. WAGNER. Real increase. Yes, Senator.

Senator BAUCUS. Does that make sense to you?

Mr. WAGNER. I cannot speak to the things that existed when

Commissioner Rossotti was Commissioner, but I can tell you that

the board has taken a good look at it. The numbers that we have

recommended do track the numbers that Commissioner Rossotti

had recommended.

Senator BAUCUS. I would like anybody to address this. What is

the biggest category of noncompliance? What group? Is it international? Is it independent contractors? What is it?

21

Professor BANKMAN. It is the cash economy, which is your gardener, the family that owns the corner restaurant. Anyone that is

getting cash or checks that is not subject to third-party reporting.

Senator BAUCUS. All right.

Now, would everybody agree with that? Is there anybody on the

panel who would disagree with that, that that is the major problem? There are a lot of problems, clearly, but that is the major one.

Would anybody disagree with that? [No response]. All right. So

everybody agrees. Let the record show that everybody agrees.

[Laughter.] I see heads nodding approvingly. All right.

Second, if that is the major problem, and assuming we should attack the major problem with more vigor, and earlier, what is the

solution? Mr. Bankman or Ms. Gardiner? You grabbed the microphone, Ms. Gardiner. Why do you not proceed?

Ms. GARDINER. I grabbed it.

Senator BAUCUS. You own the microphone.

Ms. GARDINER. I think Mr. Bankman and I actually have made

similar kinds of comments in terms of third-party reporting. But

also, we recommend, as the Taxpayer Advocate has as well, that

there be withholding on independent contractors. Some of the

things that people have suggested, is that that would be a burden.

I agree, it would be a burden.

On the other hand, there are just numerous reasons why it

would be a good idea, the aspect that they failed to pay the estimated payments during the year, therefore they have a big, huge

tax bill April 15. The most compliant groups of taxpayers are those

that do have withholdings.

Senator BAUCUS. Right. Now, that is an interesting thought. You

are suggesting what, that the employer or contractor, the person

who hired the business person in the first place, withhold a certain

percentage of payment?

Ms. GARDINER. Yes. And we have not recommended what that

percentage should be.

Senator BAUCUS. I am sorry. You have or have not?

Ms. GARDINER. We have not. The National Taxpayer Advocate, I

believe, recommended between 3.5 and 5 percent, depending on the

type of income.

Senator BAUCUS. And, second, do you agree with Professor

Bankman’s point that perhaps there should be some compensation

to accommodate the burden of those who comply, or not?

I do not know if in this case you could suggest that or not. A lot

of business people are going to say, oh, wait a minute. Gosh, that

is an extra burden. That is an extra expense. Why should I not be

compensated?

For example, the typical employer, it is pretty easy. It is wages,

and you just take off a certain percentage of wages when calculating the paycheck, whereas I, as the independent contractor, it is

a little different for me. It is more work. Or my employer has to

do more.

Ms. GARDINER. Well, there is truth in that. On the other hand,

the recommendation would generally be that businesses are the

ones that would withhold. Let us use salespeople as an example,

where they would be getting a 1099-Miscellaneous on sales revVerDate 11-MAY-2000 11:27 Feb 02, 2005 Jkt 095484 PO 00000 Frm 00025 Fmt 6633 Sfmt 6633 95484.000 SFINANC2 PsN: SFINANC2
22

enue. Say they sell books for a company. Right now, there would

be no withholding on that.

That same company, though, most likely would have employees

that they are doing withholding on. They already have a payroll

process in place. They have secretaries, people to answer the

phone, they have people that manufacture goods, so that added

burden would be somewhat incremental. Now, that is a simple

case, but I think there are many of those simple cases where, right

now, that income can just be reported.

Senator BAUCUS. And presumably, the independent business person has to pay an estimated tax.

Ms. GARDINER. They are supposed to.

Senator BAUCUS. Supposed to. Supposed to. Is supposed to pay

an estimated tax.

Ms. GARDINER. Right.

Senator BAUCUS. Which is some burden. And you are suggesting,

though, a considerably smaller percentage withheld by the employer, the person who employs the business person, the subcontractor. Is that right?

Professor BANKMAN. You know, there are a lot of approaches to

this. The good news is, the reporting rates are so low that there

has got to be some low-hanging fruit that a lot of these approaches

will pick up.

The one thing I will say that I did not mention, because I wanted

to focus on things you have not considered, is that increasing the

old-fashioned audit rate will also pick up a lot of income.

That is one of the reasons why I also mentioned the idea of reimbursements for taxpayers who undergo and do not owe much, because even with all these other approaches, audits still play a role,

and higher audit rates will bring you money, though obviously at

an expense.

Senator BAUCUS. That is true. But just playing this out, if there

is some reporting up front, the IRS presumably is in a better position.

Professor BANKMAN. Oh, absolutely. Absolutely. To the extent

you can easily get things in the reporting system, the audits are

much, much less important. The problem is with a lot of small

businesses, it is going to be hard getting a lot of these transactions

in the reporting systems because you are talking about a business

that might be a restaurant and sell food for cash, so there is a limit

to how much of this big tax gap you can solve through reporting.

But to the extent you can do it, that would be the first place to

start.

Senator BAUCUS. This is sort of a political question. Is anybody

working with NFIB, the National Federation of Independent Businesses, or other organizations to try to see if there is some way to

kind of work together and work this out?

Because presumably they are going to be very upset with any

strong push in this area. But, still, it sounds like the evidence is

quite overwhelming that that is where the greatest problem lies.

Professor BANKMAN. That is right. I might say that, on the politics of it, it is a little bit funny. I think generally, of course, Senator, you are right. But you also have franchisees and franchisors

and they are paying every penny in tax because the nature of their

23

relationship just does not allow people to put dollars in their pocket.

What you find out is, as a political matter, in the restaurant industry, for example, you have some chains that very much resent

having their competitors not pay tax.

Senator BAUCUS. Yes, Mr. Brostek?

Mr. BROSTEK. Senator, I agree with just about everything that

has been said on this topic. Joe, in the past, has recommended

withholding and information reporting as mechanisms to deal with

some components of the tax gap.

One of the things I would mention, is that if a requirement like

this were levied, it could be levied at businesses at differing levels

of assets, for instance. There are major national companies that

use contractors for doing work and they might be the place to start.

Maybe we would have the larger firms that have the more sophisticated accounting systems start with information reporting for

their contractors and see how much is gained there, and then make

a judgment about how to do it.

Senator BAUCUS. Is there some way to break down this category

a little more finely, discretely in different areas? We are talking

generally, what, about the cash economy, generally. You are talking about non-C corporation entities and organizations. What size

are we talking about? Can this be broken down a little bit more?

Professor BANKMAN. Well, it can, a little bit. Because once an enterprise gets large, even if it is family-owned, the rate of non-compliance falls. That is because it is thought that either the owners,

their trusted employees, or their families have to cheat, and you

cannot if you have nine outlets. You can really only cheat at the

one controlled by the family. This is simplifying things enormously.

So you are talking about smaller enterprises, but you are talking

about smaller enterprises that, apart from that, may have nothing

in common. That is, they are in different industries. What they

have in common is the opportunity to cheat because they are getting a lot of cash or checks, which are almost as good as cash for

cheating.

Senator BAUCUS. All right. This is kind of rolling participation

here. There is a vote going on.

Senator Thomas, do you want to take over? You are in charge.

Senator THOMAS. Well, are you going to continue on?

Senator BAUCUS. Yes.

Senator THOMAS. Are there going to be people returning?

Senator BAUCUS. I think Senator Conrad may want to come back

and ask questions of the panel. I am going to go vote. The Chairman is coming back after he votes. So you are the man.

Senator THOMAS. All right.

I am sorry I missed your statements, because it is an interesting

thing. So I suppose any questions I might have, you may already

have dealt with.

But I guess I have to say, when I read the background material,

I was kind of stunned at the amount of money that is apparently

estimated to be lost. Then I also understand that the number of audits for the IRS has decreased. Is there a relationship there? How

does that work?

24

Professor BANKMAN. I certainly think that taxpayers are alive to

the audit rates. I did a study with Professor Carlinsky where we

interviewed the small business persons in a medium-sized town.

They were very alive to the lack of audits.

Of course, nobody likes increasing audits and they are expensive

and painful. But there is clearly a relationship between people getting audited and people paying more tax. I think that audits directed at this community would give you revenue.

Mr. BROSTEK. Mike Brostek from the General Accounting Office.

If I could add on slightly to that. IRS has done some research on

the compliance effect of audits.

Now, this research is a little bit old, but the finding of that was

that for each audit that was done, there is sort of a multiplier effect on compliance, not only for the individual that was audited,

but for other taxpayers. So when you have a decline in the audit

rate, it is not a one-to-one relationship, the decrease in the deterrence effect on the population as a whole.

We do not know what the effect on compliance has been factually

of that decline in audits, but the research that IRS is doing currently right now on the compliance rate for individual taxpayers

will give us a benchmark about whether individuals’ tax compliance has risen or fallen since it was last measured fairly rigorously

about 16 years ago.

Senator THOMAS. What about the complexity of the Tax Code? If

there were a simpler system of taxation, would that make it easier

to audit or be accurate?

Professor BANKMAN. Well, it would certainly help on the high end

with the tax shelter side. The small business, I do not think it is

a matter of complexity. They are cheating on their State sales

taxes, too, which are not that complex. So the cash economy, I

think, is less sensitive to the problems of complexity than the highend schemes you hear about.

Ms. GARDINER. I would actually say it is the high end and the

low end, things like the Earned Income Tax Credit and the Child

Care Tax Credit, aspects of the Tax Code that are designed for

lower income families, are some of the more complex aspects of the

Tax Code as well.

Mr. WAGNER. Senator, the IRS Oversight Board has also looked

at the question of complexity and has determined and concluded

that it is, indeed, a large source of the tax gap, the complexity both

on the high end and on the low end.

In fact, it is a primary component that has led to some of the

abusive tax schemes that we have heard about from Mr. Brown

and Mr. ABC, and that simplification of the Code, while there are

many, many policy questions involved in there, would certainly

ease the burden of compliance and tax administration and result

in many, many dollars.

Earlier, the comment about hiring more auditors and bringing

more auditors in, and the audit rate, the board has studied that

as well and has reviewed some information that suggests, for every

dollar that is invested in enforcement activities and auditors, five

dollars is returned to the Treasury. So, that, coupled with eliminating complexity would go a long way toward addressing the tax

gap.

25

Senator THOMAS. I see. You kind of have maybe the general notion that because of increased technology and the availability of

computers and all the fancy stuff we have, that it would be easier

to keep track of what is going on. Is that necessarily the case?

Ms. GARDINER. Some of the IRS’s matching programs are extremely effective. The problem is, they identify more non-filers and

more taxpayers that have not paid their accounts receivable, and

they cannot even keep up with what they currently have.

Mr. BROSTEK. I would like to follow up on that for a moment, to

link back to the discussion we were having earlier about the practicality of more information reporting or withholding on payments.

It is my observation—I do not have a lot of facts to back this

up—that a lot of small businesses now have fairly sophisticated

computer systems that they use for their billing operations. When

I take my car in to the small, independent garage that I go to, they

have a computer system that can tell them when they worked on

my car and how many times they have worked on different vehicles.

So, the sophistication, I think, of the systems that are available

to record payments and provide information and reports may have

increased in the economy generally. That is something that is probably worth taking a look at to see if information reporting could be

expanded, that being one of the most powerful drivers at the high

level of compliance.

Senator THOMAS. I see.

Welcome back, Mr. Chairman. I walked in at the wrong moment

and ended up here and over my head.

The CHAIRMAN. I am glad you did.

Senator THOMAS. So, welcome.

The CHAIRMAN. Are you done with your questions?

Senator THOMAS. I am, sir.

The CHAIRMAN. I have been told that Senator Conrad wants to

ask questions. Then what I will do until he comes back, is ask a

question of Mr. Bankman and Mr. ABC that I did not get a chance

to ask.

Some people believe that tax shelters are kind of a fad that are

going to go away like hula hoops go away. What are your views

about tax shelters being yesterday’s news? Professor Bankman, and

then Mr. ABC.

Professor BANKMAN. Well, I do think there has been a decrease

in the most hyper-aggressive, publicly marketed tax shelters, the

things some of the Big Four accounting firms were marketing

around the turn of the century.

On the other hand, any time you have hundreds of billions of dollars at stake in ambiguous statutes, ambiguous just because they

are written by human beings, you are going to have what we call

tax shelters. When you have got kind of a leaky, creaky tax system

like we have that is very complex, that is just going to magnify all

the problems.

So, I do not think they would go away completely under a simple,

ideal tax system, but under our tax system, they are certainly

going to be with us for a long time.

The CHAIRMAN. Mr. ABC?

26

Mr. ABC. I have not seen any material decrease in the amount

of tax shelter activity. It is not as public. It is done quieter. Initially with Enron, people were a little bit reticent. They waited to

see if there would be any kind of follow-up. There was not a lot of

publicity in terms of IRS enforcement action, which hurts. Then everyone just jumps back into the game.

It is very hard to make money. In finance, you are usually dealing with transactions where your focus is on basis points, which is

a hundredth of 1 percent. With the Tax Code, you are dealing with,

not basis points, but you are dealing with whole percentage points.

You are dealing with 40 percent, 35 percent.

So, tax is a very lucrative area for finance professionals to focus.

Until the IRS makes it apparent in public that they are not going

to tolerate these types of activities, business people are going to

look at it as an area of opportunity.

Senator BAUCUS. Mr. Wagner, I appreciate your testimony on the

amount of resources that the IRS might need. I do not talk against

that, but I do not highlight that quite as much as you do. I also

know that the Oversight Board’s recommendations have been made

for cost savings and some improved efficiency.

I would like to ask, to what extent you feel that that is part of

the problem, particularly related to what you said for the need for

more resources, and does the Oversight Board have any initiatives

on making IRS maybe work smarter instead of just harder and better?

Mr. WAGNER. Senator, of course efficiency and cost savings is a

key component of a new IRS. The IRS created after RRA 98 is now

up and running, and the board continually looks at the way it is

operating and works with the Commissioner and the entire organization to ensure that it is as efficient as it can be.

We are, indeed, focused on efficiency, customer service, finding

the right cases, watching out to make sure the IRS is finding the

appropriate cases to pursue. We as a board have supported an aggressive approach toward these abusive tax shelters because it is

an efficient place to close the tax gap.

Measurements. The board has been very focused on asking for

and directing the IRS to create measurements so that we can

measure our success and measure the efficiencies within the organization. So, these are some of the things that the board is doing

to try to make the IRS a more efficient organization.

Of course, we have a constant eye on the Business Systems Modernization project. We have been very focused on that and somewhat critical of the progress to date. We released a report some

time ago.

We are monitoring the human resources/human capital components of the IRS, and as we move from a paper-driven environment

to a technology/electronic environment, watching the allocation of

human resources. Then, very importantly, is the issue of training,

which the board has been concerned about.

The workforce of the IRS is becoming increasingly older, eligible

for retirement, and it is important that we bring in capable young

professionals, and that they are properly trained to address some

of the concerns that Mr. ABC raised a while ago, and the board has

27

been focused to ensure that training resources are efficiently allocated.

The CHAIRMAN. While Senator Conrad asks questions, I will step

out and see some high school students for a minute right outside

here. Then when you are done, we will bring up the second panel.

Senator CONRAD. All right. First of all, Mr. Chairman, I want to

thank you very much for holding this hearing. It is unfortunate

what happened this morning with the delay, but I think this is an

extraordinarily important hearing and I thank you for organizing

it. I think it has been excellent already. So, I wanted to thank you.

The CHAIRMAN. Well, thank you very much, Senator Conrad.

OPENING STATEMENT OF HON. KENT CONRAD, A U.S.

SENATOR FROM NORTH DAKOTA

Senator CONRAD. This is, I think, a scandal of enormous proportion. Every honest taxpayer ought to be outraged at what they

have heard here today because there are a handful of people and

companies that are taking advantage of all the rest of us, and they

are doing enormous damage to our country.

Let there be no doubt, these phony tax schemes, this failure to

pay what they legitimately owe, is shifting the burden onto the rest

of us. In addition, we are failing to pay our bills. It has got enormous consequences for the future. All of us know here, we have got

the largest deficit in the history of the country, over $400 billion

this year.

I believe the tax gap is not $300 billion. I have looked at the

numbers, and I am a former tax commissioner and a former chairman of the Multistate Tax Commission. This tax gap is not $300

billion. It is well over $400 billion. It may be approaching $500 billion.

All one has to do is look at the size of the economy and look what

is happening to Federal revenues to understand, this tax gap is

enormous. Revenue, as a share of Gross Domestic Product this

year, is going to be the lowest it has been since 1950. Part of the

reason, obviously the biggest part of the reason, is tax cuts and economic slow-down.

Another big part of the reason is cheating. Let us just be clear,

that is what is going on. People are cheating. Who are they cheating? They are cheating all the rest of us who are paying what we

legitimately owe.

I will tell you, I am eager to get these people behind bars. Lock

them up. I will tell you, we will see a lot less cheating when people

see there is real punishment for those who do.

The tax gap. Witness ABC here said about the IRS being overwhelmed. He has got it exactly right. The IRS is overwhelmed, and

a big part of the reason is this Congress and this administration,

because this Congress and this administration have consistently

undercut the Internal Revenue Service.

And that may not be politically popular, but if people start paying attention to the implications of the failure to collect what is legitimately owed, you will see what I am saying is true. All the rest

of us are hurt. The ability of this Nation to defend itself is hurt

by a failure to collect the revenue that is owed this Nation.

28

Audit rates are down dramatically. Let us just put up a chart

that shows what has happened to audit rates. Audit rates from

1997, you can see, have plunged. Now they are starting to stabilize,

but we are down dramatically from where we were, and down even

more dramatically from where we need to be if we are going to

start to close this gap.

Mr. Wagner, you made the point on resources. I thought you

made it very well. I hope somebody is listening. Frankly, what you

are asking for is far too modest.

As a former tax commissioner, when I was tax commissioner I

went to my legislature and I told them I needed 20 percent more

money. Not 2 percent, 20 percent. I said, you give me 20 percent

more money, I will get you a payoff of $16 for every dollar you give

me, and I did.

I got audited left, right and sideways by the legislature to make

certain that that was not any funny money accounting, that that

was real payoff for the money that they invested in my agency. I

will tell you, it can be done at the Federal level.

The first thing we need to do is send a signal that this day of

gamesmanship is over and these people who are cheating everybody else are headed to jail. I will tell you, that is when you are

going to get a change in attitude and a change in compliance.

When people see, as one of the witnesses here said, I think

maybe Mr. Brown, on the media that you watch, if you would have

heard that there is an aggressive effort, why, all of a sudden, people get the message.

They get the message when the message is delivered and it is the

responsibility of this administration and this Congress to deliver

the message, that this game is coming to an end and folks had better get straight and get right or they are going to go to jail. I will

tell you, then you will see compliance improve.

Mr. Bankman, I thought you had some excellent ideas. On the

property tax front, looking at the property tax returns and checking those with income tax returns, we did that as part of our program when I got the additional money and it paid significant dividends. You could not be more right.

Matching documents. That is absolutely critical. It is the single

most important thing. You have got to go out there and cross

check. You have got to look at, what are indicators that people

have substantial income and cross check it with your tax files. That

will have enormous benefit.

I also wanted to say to Mr. Bankman, you had another idea I

could not agree with more, and that is with respect to the handful

of preparers who are renegades, who are engaged in these schemes

and in promoting them and selling them. We ought to have a target group that goes after those folks who are engaged in these

schemes and we should make a lesson of them. That would have

enormous benefits.

It also is the right thing for the vast majority of preparers who

are honest, because they are being undercut by those who are not.

Mr. Brown, you sent a powerful message here today. You sent a

powerful message. I commend you for being an honest man. You

did something bad. That does not make you a bad person. I think

you are not a bad person. I think you are somebody that got enVerDate 11-MAY-2000 11:27 Feb 02, 2005 Jkt 095484 PO 00000 Frm 00032 Fmt 6633 Sfmt 6633 95484.000 SFINANC2 PsN: SFINANC2
29

gaged in a scheme that is totally wrong, but you ‘fessed up and you

are trying to make good, and I applaud you for it.

Mr. BROWN. Thank you, Senator.

Senator CONRAD. If I can just conclude, the ABC witness, Mr.

Chairman, I hope we get the message that Mr. ABC has delivered,

that we have got to have at the IRS people who are capable of understanding complex financial schemes. They are absolutely overwhelmed there.

This is something we ought to put a focus on. We ought to have

a SWAT team at the IRS that goes after abusive tax shelters, and

as part of those SWAT teams we need to bring in people who have

engaged in these enterprises themselves. You ought to bring in people who know how it works, and I hope we will do that.

Thank you, Mr. Chairman.

The CHAIRMAN. Yes. And one other message from Mr. ABC, and

that is the value of whistleblowing. We could not do our job of Congressional oversight if we did not have it.

Senator Lincoln?

Senator LINCOLN. Mr. Chairman, thank you. I will try to be brief

and quick with my questions. I know you want to move on.

We are grateful that you are here to help us work through these

issues. You must have some idea of how frustrating it is to us as

we continue to work towards trying to pass legislation that is so

necessary for the livelihood and the economy of this country.

Yet, it is always the revenues that we are looking for. We see so

much of this as just a missed opportunity. Three hundred and eleven billion dollars a year we know is owed to our country.

Having worked through the prescription drug package, it is the

cost of the prescription drug package, almost, over 10 years. We

had to really hunt to find a way to pay for that bill.

So, I think it is important, when we look at, 60 percent of identified debt is not pursued and 79 percent of the people that we identify using abusive devices, tax cheats are caught red-handed, are

not even pursued. It is enormously frustrating.

Sixty percent of our U.S. corporations pay no taxes. With all of

that, you would think that we are trying to fund the men and

women, our troops, that we are trying to support in the field, it

really borders on something that is enormously difficult for us to

handle.

So I guess everybody is looking for where blame can be laid. We

wonder if it is Congress, and have we written the laws incorrectly,

or is it the IRS? I would imagine it is a little bit of both. We have

got to work to figure that out, and the American people are depending on us.

Just a couple of questions. Ms. Gardiner, this is not a fun question to ask, but it is your job and it is my responsibility in Congress, I think, to ask the question.

Do you have any reason to believe or suspect that politics has

any influence over any aspect of tax administration? Any evidence

that certain groups or classes of people are receiving different levels of attention from the IRS, or that budgets are maybe being

skewed for those reasons, or enforcement actions are dropped to

avoid political problems?

30

Ms. GARDINER. No, Senator, I do not have any reason to believe

that. We have in the past received allegations about some political

influence in certain areas. Quite honestly, the results of those types

of reviews, we were never able to say absolutely certainly there

was no political influence. It was usually a case of, there was not

enough documentation to say one way or the other. Yet, we still believed that the IRS employees were doing things for all the right

reasons.

As fa as going after certain individuals or not, everything that

we look at, we do a report every year on compliance trends and

compare it to staffing and how they are using their resources. It

simply is a case of, they have too much work and too few people.

Senator LINCOLN. Well, that kind of leads me to a second question which I had. I guess, Mr. Bankman, maybe you might be the

best one to answer this question.

All of our States have balanced budgets amendments. We often

struggle to bring every dollar we can into our States. The States

also have a tax administrator who has the legal authority to review

taxpayer information.

If the IRS, year in and year out, cannot go out and enforce the

Federal tax laws because of lack of funds, lack of individuals, or

lack of what have you, would it be such a bad idea to grant some

of the States the power to review those Federal tax returns and collect on behalf of the Treasury? Even if we brought in just half of

what we are missing, would it not make sense to take a look at giving them the ability to do some of that?

Professor BANKMAN. You are asking me?

Senator LINCOLN. It does not matter. Anybody that wants to answer it. But I thought you might be the one.

Professor BANKMAN. All right. Yes. It is kind of a novel form of

out-sourcing. We out-source it not to private industry, but to the

States. Everything is worth an experiment. My guess is, some

States would be very good at it and other States would not be very

good at it.

Senator LINCOLN. We could certainly set parameters.

Professor BANKMAN. That is right. That is right. That is not

much of an answer for you. I think it really depends on the States.

I think you will find some States that have terrific bureaucracies,

and the IRS, while it has a million problems, still looks good compared to other States. So, it is like everything else, the devil is in

the details.

Senator LINCOLN. Well, I guess my thought is, if the IRS was

having problems in terms of the resources it needed and the manpower to do it, perhaps partnerships might be a way to look at

that. The States certainly have a vested interest because much of

what I know we do in our States actually stem from Federal dollars

that we are able to get to the States.

If the Treasury here is more flush or certainly more successful

in bringing in the revenues that it is supposed to be bringing in,

then it makes sense that you could partner with those groups.

The CHAIRMAN. Thank you, Senator Lincoln.

Mr. WAGNER. Senator?

The CHAIRMAN. Oh. I did not realize she was asking questions.

Finish that question, then we will go to the next panel.

31

Mr. WAGNER. If I may make a comment. I, like Senator Conrad,

am a former State tax commissioner. I can tell you, there is a tremendous amount of cooperation between States and the IRS at this

point in time, from my experiences, and now in my capacity on the

board I am aware of some of that. But it can be improved. I think

Mr. Bankman mentioned sort of another form of out-sourcing,

third-party collection.

I know that has been an issue that has received some attention

here before this committee and elsewhere in the States, and could

very well be a reliable source to forge greater partnerships, just as

States are doing so with local governments and local prosecutors

and so on to collect uncollected State taxes. So, it is another idea

that certainly warrants serious discussion.

The CHAIRMAN. I thank you all very much for your kind attention.

I would now invite our second panel to the podium. I am not

going to wait until they get here to introduce them because of time.

IRS Commissioner Mark Everson. He comes before our committee quite frequently.

This is probably the first time I have ever had a chance to meet

our second witness, Mr. Robert Morgenthau, District Attorney of

New York County, but obviously anybody that has been interested

in prosecution knows that name very, very well, because he has

been in that position for a very long time.

Then we have Debbie Langsea, auditor manager for the California Franchise Tax Board; Ms. Nina Olson, the IRS Taxpayer Advocate. That is a new position, and I did not say it right. It is the

National Taxpayer Advocate.Finally, Commissioner for Patents,

Nick Godici.

We will start, just as soon as everyone is seated, with Commissioner Everson, then Mr. Morgenthau, then Ms. Langsea, then we

have Ms. Olson, then Mr. Godici.

Mr. Everson?

STATEMENT OF HON. MARK EVERSON, COMMISSIONER,

INTERNAL REVENUE SERVICE, WASHINGTON, DC

Commissioner EVERSON. Good morning, Mr. Chairman, Senator

Lincoln.

Thank you for the opportunity to testify today regarding the tax

gap and tax shelters. I also want to thank you for the opportunity

to meet a living legend, Mr. Morgenthau. I got to New York in

1976, 1 year after he took his job.

And because of your selection of him as a witness today, he

called me a couple of days ago and we had a very productive meeting that was extended by the fact that you were called out of the

office. So, there was some good that came of that.

I appreciate the support this committee has given the IRS in our

battle against abusive shelters, in particular, and your dedication

to securing adequate funding for the IRS so that we can achieve

a balanced program comprising of both service and enforcement.

Our recently issued strategic plan for 2005 through 2009 has established three goals: improved taxpayer service; enhanced enforcement of the tax law; and modernize the IRS through its people,

processes, and technology.

32

The first two goals, improving service and enhancing enforcement, derive from our working formula at the IRS, service plus enforcement equals compliance, not one or the other. The IRS must

do both.

Before turning to the tax gap and our attack on abusive shelters,

let me touch on our third goal, modernizing the IRS.

I have some good news to share with you this afternoon. After

many false starts over a period of decades, last week the IRS began

processing the first 1040–EZ returns with the new CADE system.

For the first time since the 1960’s, the IRS is processing returns

and issuing refunds on a new computer system. It is a small number, but it is a start.

While long overdue, this is an important first step in modernizing our return processing technologies. But we still have a long

way to go and a lot of work ahead of us.

The significant annual tax gap, the difference between what taxpayers are supposed to pay and what they actually pay, the components of which are non-filing, under-reporting, and non-payment,

runs to many billions of dollars.

Beyond the tax gap itself, a point of additional concern is the fact

that our surveys indicate that over the last 4 years, the number of

Americans saying it is all right to cheat on their taxes has risen

from 11 to 17 percent.

We believe both of the operational goals articulated in the strategic plan, improving service and enhancing enforcement, are integral to addressing the tax gap and improving attitudes about compliance.

By service, we mean helping taxpayers understand their tax obligations and facilitating their participation in the system. We have

improved our services to taxpayers and will continue to do so.

But to the degree that the complexity of the Tax Code leads to

confusion and difficulty for taxpayers trying to comply with the

law, I would respectfully suggest that any efforts by Congress to

simplify the Code would be welcome.

The members of the committee know that we are working to reinvigorate enforcement at the IRS. I very much appreciate your

support for the 10.7 percent increase the President has requested

in his 2005 budget to this end.

We will use these monies to pursue our four enforcement priorities: discourage and deter noncompliance with emphasis on corrosive activity by corporations; high-income individual taxpayers and

other contributors to the tax gap; ensure that attorneys, accountants, and other tax practitioners adhere to professional standards

and follow the law; detect and deter domestic and offshore-based

tax and financial criminal activity; and the subject of your hearing

several weeks ago, deter abuse within tax-exempt and governmental entities and misuse of such entities by third parties for tax

avoidance or other unintended purposes.

Aggressive pursuit of these priorities will help compliance and

reduce the tax gap. The centerpiece of these efforts is our fight

against abusive tax shelters. It touches all four points. Our efforts

in this arena are significant beyond the billions lost each year in

abusive transactions developed and marketed by the tax shelter industry.

33

Our same surveys of taxpayers about which I spoke a moment

ago have also indicated that 80 percent of Americans feel it is particularly important for the IRS to enforce the law for corporations

and high-income individuals.

This speaks to the sense of fairness which Americans rightly feel

should be the cornerstone of tax administration. That is why our

shelter efforts, including our criminal investigations and settlement

initiatives for abusive shelters like Son of Boss, are so important.

Thank you.

The CHAIRMAN. Thank you, Commissioner.

[The prepared statement of Commissioner Everson appears in

the appendix.]

The CHAIRMAN. Now, Mr. Morgenthau?

STATEMENT OF ROBERT M. MORGENTHAU, DISTRICT

ATTORNEY OF NEW YORK COUNTY, NEW YORK, NEW YORK

Mr. MORGENTHAU. Thank you for the opportunity to testify.

I am just delighted that this committee is looking into the gap

between taxes that should be paid and taxes that are actually paid.

It is a huge problem.

Let me just give you a couple of examples. Two years ago, after

consultation with the IRS and the Treasury Department, we issued

subpoenas to one credit card company for credit cards issued by tax

shelter banks and used in the New York metropolitan area in 2001.

It came up to 115,000, much more than we had anticipated.

The problem with what we had, was there was a transcript of

these transactions and they had accessed more than $110 million

in tax secrecy jurisdictions. But they did not know the name.

They had no record of the name of the account holder, so it has

been a very difficult investigation. I think that is an issue that

needs to be addressed. You can get a credit card from an offshore

bank without disclosing the name of the credit card holder.

The largest issuer of these credit cards was a bank called

Leadenhall Trust in the Bahamas. We went on the Internet to find

out how we can open an account with Leadenhall.

We found an outfit called Beacon Hill, seventh floor of a building in Manhattan, that had sent by wire transfer $6.5 billion overseas,

some of it going to the Middle East, some of it narcotics money,

completely unregulated. It had 40 accounts at one of New York’s

biggest banks, and the bank had done nothing about it in New

York.

They kicked them out of the London office, but they were operating in New York. You have got to assume that the bulk of this

money was for illegal purposes because if it was legal, you would

have just gone into a major bank and sent a wire transfer. It was

$6.5 billion. They kept no records. You find ‘‘$100 million from a

valued customer.’’ That’s all. So you do not know who is sending

the money. In many cases, you do not know who is receiving it.

I would like to call your attention once again to the Cayman Is- lands. As of December 31, 2003, $1 trillion U.S. dollars were on deposit in the Cayman Islands. One trillion U.S. dollars.

When I have testified before, it was $500 billion. It has gone

from $500 billion to $1 trillion. I am glad it is at $1 trillion, because I think that is a number that maybe will stick in people’s

34

minds. That is double the amount of the Defense Department budget. It is more than twice as much money that is on deposit in the

banks in the U.S. metropolitan area.

Some of it is obviously there for legitimate purposes, but an

awful lot of it is there because of the bank and corporate secrecy

rules of the Cayman Islands.

What are we going to do about it? There has got to be better supervision by the banks of who their customers are because the

money involved is so big, that it has to go through the banking system. So the banks have got to be much more alert to this illegal

trafficking. the regulators have got to be much more careful about

the supervision of banks.

One quick point. As a result of Beacon Hill, we found a New

York Stock Exchange listed bank, Hudson United, which, in 14

months, had transferred $1.4 billion overseas. That branch had

been sold to them by the Federal Deposit Insurance Corporation.

So, these are all problems that have to be addressed. I am very

happy that this committee is taking a major interest in it.

The CHAIRMAN. Thank you, Mr. Morgenthau.

[The prepared statement of Mr. Morgenthau appears in the appendix.]

The CHAIRMAN. Now, Debbie Langsea?

STATEMENT OF DEBBIE LANGSEA, CALIFORNIA FRANCHISE

TAX BOARD, SACRAMENTO, CALIFORNIA

Ms. LANGSEA. Good morning, Mr. Chairman, Senator Baucus,

and members of the committee. I am testifying on behalf of California State Controller Steve Westly and the Franchise Tax Board.

On their behalf, thank you for the opportunity to testify on California’s efforts to combat the tax gap and tax shelters.

The California income tax gap is about $6.5 billion, and this gap,

as you have heard already, is attributable to taxpayers who underreport income, who underpay taxes, or fail to file their tax returns.

However, California is increasing its efforts to identify unreported

income, consider deterrence to noncompliance, and to modify public

perception about voluntary compliance.

During California’s Voluntary Compliance Initiative, or our VCI

Abusive Tax Shelter Amnesty Program, about 1,200 taxpayers reported over $1.3 billion in additional tax. Of these taxpayers, about

800 individuals reported $900 million, and 400 businesses reported

the remaining balance.

Of the 2,200 amended returns filed, 90 percent of VCI revenues

came from tax years 1999 and 2002. Essentially, about $13 million

a day was raised during VCI, or more than two times more money

than any other amnesty program in U.S. history.

So how did California receive $1.3 billion in additional revenues?

Well, you have already heard testimony today of many egregious

and tax-engineered transactions designed to undermine the tax

system. But more disturbing is the rate at which tax shelters were

proliferated and marketed.

New variations of complex tax schemes were devised by tax professionals. They were buried in layers of transactions using multiple entities to escape detection. They are packaged as generic tax

35

products and sold to thousands of taxpayers generating millions of

dollars in fees.

As California considered legislative solutions to curtail the tax

shelters, Mr. Chairman introduced S. 476, the CARE Act of 2003.

Such tax shelter provisions provide desperately needed tools for tax

officials otherwise doomed to fight a losing battle to close the tax

gap. Due to the number of tax shelters sold in the late 1990’s, California quickly moved forward and adopted its own legislation.

On October 2, 2003, California passed S.B. 1614 and A.B. 1601

that enacted new tax shelter penalties. They adopted Federal disclosure and reporting requirements and provided for our Voluntary

Compliance Initiative.

Key to VCI’s success was publicity from federal, State, and individuals challenging abusive tax shelters, committee hearings, IRS

initiative summonses, and information provided through various

media.

Another essential element was a joint information sharing agreement between California and the IRS, New York, and other States.

California received thousands of leads from the IRS and other

sources on potential investors and promoters. These agreements

avoided duplication of government resources and took a united approach against abusive tax shelters.

In addition to the thousands of tax shelter leads, we are reviewing information from about 800 taxpayers disclosing reportable

transactions and 7,000 investors disclosing over $62 billion of listed

transactions.

We recently issued subpoenas on insurance companies suspected

of issuing insurance policies to protect clients from adverse tax

shelter rulings. We received more information and issued another

subpoena to an insurance broker.

California is proposing legislation prohibiting insurance companies from insuring or defending losses due to abusive tax shelters.

If we are to effectively curtail the tax gap and abusive tax shelters,

we urge Congress to pass tax shelter legislation.

The AICPA and States should follow the SEC’s interpretation

prohibiting contingency fee transactions, and Congress should fund

IRS’s compliance and enforcement efforts to address long-term implications of abusive tax transactions.

We are far from closing the tax gap and face ongoing challenges

to effectively combat abusive tax shelters. We thank the committee

for leading this endeavor and ask that Congress help us bridge the

tax gap.

Thank you.

The CHAIRMAN. Thank you, Ms. Langsea.

[The prepared statement of Ms. Langsea appears in the appendix.]

The CHAIRMAN. Now, Ms. Olson?

STATEMENT OF NINA E. OLSON, NATIONAL TAXPAYER

ADVOCATE, TAXPAYER ADVOCATE SERVICE, WASHINGTON, DC

Ms. OLSON. Mr. Chairman, Senator Baucus, and members of the

committee, thank you for inviting me here today to testify on approaches to reducing the tax gap.

36

Tax evasion and tax cheating is a serious problem for the tax

system and has real victims. If you divide the estimated $255 billion net tax gap by the roughly 130 million individual taxpayers,

you see that each individual taxpayer pays, on average, about

$2,000 extra in taxes each year. That is why my 2003 annual report to Congress ranked the tax gap after the AMT as the most serious problem facing taxpayers.

The IRS is to be commended for aggressively attacking corporate

tax shelters and tax cheating by wealthy individuals. However, IRS

must do more to address the fact that the majority of the known

tax gap is attributable to under-reporting, non-filing, and underpayments by self-employed persons. We clearly cannot ignore a

compliance problem of this magnitude.

In my written testimony, I discuss several ways to reduce opportunities for noncompliance. Where income is reported to the IRS by

a payor on a Form 1099, tax reporting and compliance by the payee

is very high, roughly 95 percent.

We must do a far better job of ensuring that information required to be reported by third parties under present law is actually

reported by them, and in turn reported by the payee on his or her

tax return.

The IRS could require taxpayers to affirmatively state on their

sole proprietorship schedules whether they have issued all required

1099 forms. It could require taxpayers to report 1099 income separately from other gross receipts.

It could receive information from State and local authorities that

issue licenses or impose taxes on the basis of gross receipts. Many

businesses have an incentive to correctly report gross receipts for

licensure purposes.

Local audit initiatives based on this information could make inroads into the cash economy, what I call ‘‘infection audits,’’ because

they spread and have a ripple effect.

When a service recipient withholds tax and pays it over to the

IRS directly, tax reporting and compliance is almost 100 percent.

While no one wants to increase burdens on small business, as a

matter of basic fairness the size of the tax gap compels us to explore non-wage withholding.

To decrease the tax gap, the IRS could use voluntary withholding

agreements or its Federal payment levy authority, particularly

against Federal contractors. Congress could expand the back-up

withholding authority and also require withholding at the source in

particular instances.

Tax preparers can contribute to noncompliance either by incompetence or by facilitating cheating. The IRS is aggressively targeting practitioners who facilitate improper transactions by corporations and wealthy individuals.

By adopting a regulation regime for unenrolled preparers, as in

S. 822, Congress can ensure that these preparers who prepared the

majority of returns for middle and low-income taxpayers are also

held to high standards.

As IRS ramps up enforcement programs, it is important to ensure that aggressive enforcement of the laws is balanced by aggressive protection of taxpayer rights.

37

Taxpayer rights are easy to talk about, but how do we make

them a reality? In my June 30 report to Congress, I identified three

measures to bolster protection of taxpayer rights in an enforcement

environment.

First, the Taxpayer Advocate Service will prepare a taxpayer

rights impact statement on major IRS initiatives to help the IRS

incorporate an awareness of taxpayer rights into its program, planning, and implementation.

Second, TAS is reviewing IRS training to ensure that all employees learn about taxpayer rights on an ongoing basis, including the

importance of the access to TAS.

Third, the Taxpayer Advocate Service is working to be no longer

the best-kept secret in the IRS. We are conducting an outreach

campaign to taxpayers that Congress clearly intends TAS to help.

In closing, I note that taxpayers, too, must claim the moral high

ground where tax cheating is concerned and refuse to condone acts

of tax cheating, not only with respect to corporations, high-income,

or low-income individuals, but also in their own backyards. We

need to remember that, just because someone else cheats, that does

not make it all right for us to do so. Tax compliance begins at

home.

Thank you for your efforts, and I appreciate it.

The CHAIRMAN. Thank you.

[The prepared statement of Ms. Olson appears in the appendix.]

The CHAIRMAN. Now, Mr. Godici?

STATEMENT OF NICK GODICI, COMMISSIONER FOR PATENTS,

U.S. DEPARTMENT OF COMMERCE, WASHINGTON, DC

Mr. GODICI. Chairman Grassley, Ranking Member Baucus, thank

you very much for inviting me to testify today on the patenting of

business method inventions, and specifically on patents concerning

tax strategies and financial products.

As you know, patents in this area of innovation are a topic of

considerable interest and debate. Concerns have been raised about

whether business methods should be patentable and whether these

patents will help or hinder innovation and commerce. Given the

importance of these issues, I commend the committee for holding

this hearing.

Mr. Chairman, the basis of our patent system is found in Article

1, Section 8 of the constitution, which provides that ‘‘Congress shall

have the power to promote the progress of science and useful arts

by securing, for limited times, to inventors the exclusive rights to

their discoveries.’’

In order to implement this constitutional directive, our founding

fathers designed a patent system based on principles that are proven remarkably successful in promoting 210 years of innovation that

has spurred the creation of new industries and jobs.

In administering the U.S. patent laws, the U.S. PTO takes its directive on what subject matter is patentable from Congress and

from our reviewing courts. The current act specifies four basic statutory requirements that must be met to obtain a patent.

First, the claimed invention must define eligible subject matter

and have utility. Second, it must be novel. Third, it must not have

been obvious to a person of ordinary skill in the art at the time the

38

invention was made. And fourth, it must be fully disclosed so that

the skilled practitioner would be able to practice the claimed invention without undue experimentation.

With respect to the first statutory requirement, 35 U.S.C. 101

states, ‘‘any person who invents or discovers any new and useful

process, machine, manufacture, composition of matter, or any new

or useful improvement thereof, may obtain a patent.’’

Furthermore, the granting of a patent does not give the patent

owner the legal right to practice the invention, but only the right

to exclude others from doing so.

Congress and our reviewing courts have shaped the current state

of patent protection. In the most well-known case with respect to

business methods, the State Street Bank decision, the Federal Circuit upheld patentability of a data processing system that transformed data representing discrete dollar amounts into a final share

price for reporting purposes.

This constituted the practical application of a mathematical algorithm because it produced a useful, concrete, tangible result.

The Federal Circuit in State Street explicitly rejected the notion

that a business method exemption exists in the U.S. patent law.

While State Street did not change U.S. law and practice, it did

create a new awareness that business method claims could be patented. Today, the computer-implemented business method area includes business method practices in many fields, such as insurance

and insurance processing, reservation and booking systems, financial market analysis, tax processing, and financial management.

While the courts have spoken regarding the eligibility of patents

of the subject matter, some have suggested concerns that in certain

cases these patients may be overly broad or not truly novel. These

fears raise legitimate issues, and the U.S. PTO has taken a number

of steps to address them.

In 2001, the U.S. PTO announced a new Business Method Initiative. This includes establishing partnerships with the industries involved.

Additionally, to assist our examiners in finding prior art, we

have established electronic information centers which provide examiners with access to over 1,000 non-patent literature databases,

over one-third of which contain business, financial, and tax information.

We believe that our Business Methods Patent Initiative has positively impacted the quality of examination of business method inventions.

Today’s patent system is one of transparency. Not only are all

patents published, but most applications are published 18 months

after filing, giving interested parties knowledge of pending patent

claims.

Mr. Chairman, we will continue to closely monitor the situation

in order to ensure the issuance of high-quality business method

patents. In addition, if further administrative action is warranted,

the U.S. PTO will take appropriate action.

We can assure that we will comply with the law and that our

practices and policies will promote innovation, as Congress and the

courts have directed. We look forward to continuing to work with

39

the committee and to ensure that the U.S. patent system remains

the envy of the world.

Thank you, Mr. Chairman.

The CHAIRMAN. Thank you, Mr. Godici.

[The prepared statement of Mr. Godici appears in the appendix.]

The CHAIRMAN. I am going to start my questions with Ms.

Langsea. You state in your testimony that California raced against

the clock to enact its tax shelter legislation before the statute of

limitations expired. I assume that was in connection with what is

referred to as Sons of Boss tax shelter transactions.

I would like to have you expand on the statement and tell the

committee the revenue losses you were facing from expiring statute

of limitations.

Ms. LANGSEA. Certainly. About 2 years ago, California began examining or auditing abusive tax shelters, and we identified about

40 tax shelters at that time. Within 2 years, that number escalated

to about 600 cases, totalling about $1 billion in potential abusive

taxes.

We basically identified not only tax shelters related to Sons of

Bosses, but many variations of other tax shelters in addition to

that. Although there were only about 600 cases identified, we had

very high income taxpayers and corporations that were involved in

schemes that were involved in millions of dollars.

Our tax years that we were mostly focused on, we found were

most prevalent through 1999, 2000, and 2001, hence why our legislation addressed those open years for us.

The CHAIRMAN. All right.

Now, along that line, we might be coming up to a problem here

at the Federal level on statute of limitations.

If I could have Senator Baucus’ attention, I would like to say

that our JOBS bill contains a measure that would hold open the

statute of limitations on a transaction listed by the Treasury Secretary or the Treasury Department as a tax shelter.

The Son of Boss is a listed transaction, but this measure only applies to taxable years that are still open to audit after the JOBS

bill is enacted.

The IRS has a voluntary self-disclosure program where Son of

Boss investors can turn themselves in and have their penalties reduced. However, there are a large number of Son of Boss investors

who did not enter this self-disclosure program and are hoping,

quite frankly, that the clock would run out on the statute of limitations before the IRS would find them.

On August 15, it is my understanding that the statute of limitations will close for calendar year 2000 tax returns. These non-disclosing Son of Boss investors will escape IRS prosecution after that

date.

What is really troubling is, most of the Son of Boss transactions

were sold in the year 2000, and the IRS will procedurally lose these

cases by August 15. I was just wondering if you would agree with

my assessment of that situation.

Senator BAUCUS. Yes, Mr. Chairman, I am fully aware of this.

I also hear that the IRS recently discovered several hundred of

these non-disclosing investors, and suspects that there are many

more hiding in the weeds.

40

The IRS will find them as they continue to audit the promoters.

I do not think we should let these tax cheats off the hook. I think,

therefore, we should modify the JOBS bill to extend the August 15

statute of limitations for Son of Boss investors that did not participate in the self-disclosure program.

The CHAIRMAN. Of course, I agree. Tax cheats should not get the

chance to escape by the bell. The IRS now knows who they are and

just has not had time to bring them to court. We need to extend

the time to catch the people avoiding taxes. I hope that our colleagues in the House would help us do that.

Senator BAUCUS. There is also another problem with these cases

concerning the suspension of interest while the case is pending. Because of a provision enacted as part of the IRS Restructuring and

Reform Act of 1998, the accrual of interest on most Son of Boss

cases was suspended.

This means that abusive taxpayers who participated in these

transactions and have now been caught will not have to pay the

IRS interest, despite their huge understatements. The JOBS Act

contains a provision that would turn off the interest suspension in

the case of listed transactions, a provision that was effective as of

March 5, 2004.

The CHAIRMAN. That is an abuse that we should also shut down.

As you said, the JOBS bill fixes this problem, but does not do it

in time to hit the Son of Boss transactions.

I suggest that we repeal the interest suspension general rule for

transactions that are listed as the date of the enactment of the legislation, and that we continue to allow it for taxpayers that turn

themselves in under these voluntary disclosure programs.

Senator BAUCUS. Good idea.

Commissioner EVERSON. Mr. Chairman, may I make a comment?

Senator BAUCUS. Before you do, Mr. Commissioner, I just have

one final statement here. That is, that we get the staff started on

this. That is, for inclusion in the final JOBS bill, making it much

more costly to hide in the weeds, it should push more taxpayers to

come forward.

The CHAIRMAN. I would agree with you, and our staff will cooperate with your staff on that.

Mr. Everson, it is all right for you to speak.

Commissioner EVERSON. I just want to thank you for those

strong statements and for your strong support for our Son of Boss

settlement initiative that you have had throughout this process.

We are pleased with where we stand, but we absolutely need to

take firm actions, and are already doing so with those who have

not come forward. What you are suggesting sends a strong message

that you support us, so thank you.

The CHAIRMAN. All right. And thank you for your leadership, because I know that you briefed us on it several months ago, and I

hope it is working according to your expectation.

Obviously, there is a lot that do want the clock to run out. As

you can tell, we are a bipartisan team here. We want to make sure

that your job will be easier, and if people owe taxes, they will pay

it.

I want to get back to Ms. Langsea. You state in your testimony

that California has issued subpoenas against two insurance compaVerDate 11-MAY-2000 11:27 Feb 02, 2005 Jkt 095484 PO 00000 Frm 00044 Fmt 6633 Sfmt 6633 95484.000 SFINANC2 PsN: SFINANC2
41

nies that are writing policies to insure taxpayers against liability

from shelters.

On May 5, a Wall Street Journal article described the growth of

these policies after the IRS and after the Treasury Department removed insurance coverage as a factor in disclosing shelters as reportable transactions. The article says many taxpayers are doing

this to cover low-risk transactions.

Is that what you have found in your investigations, and are taxpayers taking insurance policies on harmless transactions?

Ms. LANGSEA. Basically, the subpoenas that we are assessing to

insurance companies are those that we have identified that were

involved with insuring taxpayers that were involved in high-risk

transactions such as the abusive tax shelters.

We are currently going through that information now, but we

hope to be able to identify those investors who utilized or accessed

themselves to that type of insurance coverage.

The CHAIRMAN. Mr. Everson, and also I think Ms. Olson, might

want to listen to this question. The General Accounting Office report highlights a disturbing trend.

It seems that much of the Federal Government not only has little

interest in helping the IRS do its job, but sadly it seems several

government agencies seem to be actively hindering the work of the

IRS to enforce tax laws.

You were a former number-two person at the Immigration Service. Why not take the simple step of the General Accounting Office

testimony and its recommendations?

Why not just require a business, that before they can bring in

a foreign worker, that they have to be square with the IRS. And

if it makes sense to require it here, what about in many other situations?

I would ask Ms. Olson to comment on this matter. It is similar

to your suggestion that Federal contractors be right with the IRS

before they get Federal tax dollars.

Mr. Everson?

Commissioner EVERSON. I think, Mr. Chairman, this is a question of competing public interests. As you know, one of the fundamental principles in the tax law is the confidentiality of information.

That notwithstanding, I think it is entirely appropriate for the

Congress to weigh other considerations where law enforcement is

served or sound principles of tax administration are served. Right

now, we are limited, though, in this area.

The CHAIRMAN. That is the privacy section. Is that what you are

saying?

Commissioner EVERSON. Yes, sir.

The CHAIRMAN. All right. Then we will just have to take that

into consideration, because that will be a problem for our committee then.

Ms. Olson?

Ms. OLSON. I think there are ways of doing that information

checking without even messing with 6103, the confidentiality statute, using a consent agreement, making it a condition for someone

who is a sponsor to obtain a document that states from the IRS

that they are in compliance.

42

There are ways of doing that procedurally. The beauty of the

Federal contractor provision is that the IRS already has the information on Federal contractor payments made by Federal agencies,

and we are doing very little with that information to collect on

that.

The CHAIRMAN. Yes.

I am going to turn to Senator Baucus. But I hope that you can

stay, because I have another round of questions I need to ask. Particularly, I want to ask Mr. Morgenthau some questions.

Can you stay, Mr. Morgenthau?

Mr. MORGENTHAU. Absolutely.

The CHAIRMAN. All right.

Go ahead, Senator.

Senator BAUCUS. Thank you, Mr. Chairman.

Mr. Everson, I want to get started off the top here. What is the

size of the tax gap, do you think, today?

Commissioner EVERSON. Well, we do not precisely know, Senator.

Senator BAUCUS. Your best guess. You are the IRS. You are the

Commissioner. You have to have some sense. You had better have

some sense or we are in more trouble than I thought.

Commissioner EVERSON. Well, I think you know that the old figures that have been issued and are cited in three different sources

in your testimony have it at over a quarter of a trillion dollars.

That is based on the old models, last updated in 1988, and then

carried forward for changes in demographics and changes in economics. It does not reflect changes in behaviors of taxpayers during

the 1990’s.

As you know, under some pressure from Congress, we did not update the methodologies during the 1990’s to get better information.

We are doing that now. We have 46,000 individuals under audit

and are just about to complete that. So, early next year we will be

able to come back to the committee with much better information

on this.

Senator BAUCUS. I thought that the figure based on 1988 assessments was $311 billion. That is what I heard.

Commissioner EVERSON. That is the gross gap. The net gap after

slow payments or payments over time and enforcement actions gets

us down another $55 billion.

Senator BAUCUS. Well, let us just talk about gross because that

is apples and apples.

Commissioner EVERSON. Sure.

Senator BAUCUS. And that is 1988.

Commissioner EVERSON. That is 2001, based on the 1988 model.

Senator BAUCUS. Excuse me. That is 2001, based on 1988. That

is correct.

Well, what do you think it is today?

Commissioner EVERSON. I hesitate to say.

Senator BAUCUS. Best guess. Best guess.

Commissioner EVERSON. I do not have a best guess. I think what

I am disturbed about——

Senator BAUCUS. Surely you have a best guess.

Commissioner EVERSON. No, I do not. Honestly, I have had lots

of discussions with our research folks and asked them the same

43

question just as doggedly as you are asking me. They are quite persistent in saying, let us wait until we roll this up.

Now, I am concerned, as are you, that there were changes in behaviors, particularly in these abusive shelters, that took place over

the 1990’s that we are addressing, and we will have to see what

the impact of that was, obviously, as we go through this.

Senator BAUCUS. How can you run an organization if you cannot

give at least a best guess? How can you run an organization without knowing what the size of the problem is?

Commissioner EVERSON. Well, obviously we have to understand

the size of the problem and we are working to do that, and we will

continue to do so. I would suggest to you that——

Senator BAUCUS. When are you going to know the magnitude of

the problem?

Commissioner EVERSON. As I indicated, we will start to get the

first results, hard results, from these 46,000 audits early next year.

We will be able to update components of the tax gap. We will then

also work on partnerships and flow-through entities. As you know,

there are different components to it.

Senator BAUCUS. By what date next year?

Commissioner EVERSON. Oh, I would say, in the first half of next

year.

Senator BAUCUS. You said early in the first part of next year.

How about the first quarter?

Commissioner EVERSON. We will give you updates of components

of the tax gap in the first quarter. I am happy to say that.

Senator BAUCUS. And then what are the components?

Commissioner EVERSON. That is the work we are doing now on

individuals. But I have got to explain to you that once these audits

are completed, and they will be completed over the course of the

next few months, they then need to be modeled for some of the

things you have already discussed.

For example, what about the people who are not even under the

audits and the assumptions as to those folks who are not filing? So,

there are a lot of different components and a lot of different testing

that the statisticians do before they tell me that I have got a number that is good to go.

Senator BAUCUS. So we have a date, March 31.

Commissioner EVERSON. I will give you what we have by then.

Yes, sir.

Senator BAUCUS. All right. I appreciate that.

I was intrigued with some of the comments that Ms. Langsea

was saying. What lessons can we learn from California’s experience? Let me ask this question. What is California’s tax gap?

Ms. LANGSEA. California’s tax gap is $6.5 billion.

Senator BAUCUS. Six and a half billion.

Ms. LANGSEA. Correct.

Senator BAUCUS. And how much did this program bring back, did

you say?

Ms. LANGSEA. $1.3 billion.

Senator BAUCUS. $1.3 billion out of $6 billion. That is about 16

percent. Well, my math is not great, but it is in there somewhere.

It would be great if we could knock that much out of the Federal

44

tax gap. What have they done right in California that we can

learn?

Commissioner EVERSON. Well, I think that Ms. Langsea spoke to

some of the things that worked, which include the cooperation of

the Federal Government with the State government. As you know,

we executed an agreement with 46 States some months ago. We

have now shared 28,000 leads with different States.

The impact of our aggressive efforts, like Son of Boss, and active

criminal investigations that involve the technical tax shelter area

send a very strong signal. For the first time, we are working very

closely with prosecutors where, when we go criminal, we do not neglect the civil side.

Before, our criminal investigators would back away if a case was

being pursued on the civil side. We are working on all of these

things now. I think there is some understanding out there—to go

back to Mr. Brown’s comments earlier—that risks are greater than

they were before. He spoke about risk.

I think there is clearly an understanding that the risk of noncompliance is greater. That means, when Ms. Langsea comes up

with something that she came up with or we come up with Son of

Boss, more people will come forward to get right with the law.

Senator BAUCUS. Let me ask Ms. Langsea the same question.

What are some of the lessons learned in California that might be

applicable to the Federal level?

Ms. LANGSEA. I would say the primary advantage that California

had was its tax shelter legislation. If you do not have increased

penalties and curtailments to assess against people who are involved in tax shelters, the IRS, California, and other States will

face the same issues.

California’s legislation increased substantially its penalties. We

issued almost 15 new or increased penalties so that those who have

participated in these abusive tax schemes would be penalized.

Currently, I think some of the data that the committee has reviewed, some of these promoters are basically assessed $14,000

worth of penalties, but in return are receiving millions of dollars

in fees.

Under the current statutes that the IRS has, there certainly is

no incentive for tax shelter investors to come forward because there

is not the substantial penalties that they would be assessed by

being involved.

Senator BAUCUS. Could you compare California’s recently enacted penalty provisions along with the anti-shelter provisions that

this committee enacted that has not yet passed in the Congress?

Ms. LANGSEA. Correct. We actually modeled our legislation after

the Chairman’s S. 476 bill. Many of the provisions and penalties,

we tailored after. We modified it for California’s purposes, but basically with those penalties, taxpayers came forward because without

it there was no enforcement that we could wield without that type

of legislation.

So I would say that the legislation is probably the most key factor in bringing these taxpayers forward. Otherwise, you will get the

same result.

Senator BAUCUS. All right.

45

Now, based on your experience, would you modify the provisions

that this committee and that the Senate passed, but has not yet

passed the Congress?

Ms. LANGSEA. I would go with any provision at this point. I

would agree with the provisions that this committee is bringing forward, yes. We definitely need that type of legislation.

The other danger, is California is under a great deal of criticism

because we are the only State that has such tax shelter legislation.

If we do not have support from the Federal level, we are getting

highly criticized for being out of conformity with Federal legislation.

Senator BAUCUS. Could you expand on that, please? I am just

trying to build a record as much as possible to get this legislation

passed and on the President’s desk.

Ms. LANGSEA. Right. Basically, most taxpayers are looking at the

Federal legislation as taking the lead against these abusive tax

shelter schemes. When California has penalties that are distinctly

different from the Federal legislation, taxpayers complain that we

are out of conformity with what the Federal legislation provides,

and therefore must abide by or be subject to different rules and different penalties at a State level that the Federal Government is not

in support of.

Senator BAUCUS. So when taxpayers make those arguments, who

do they make them to, what relief are they trying to get, and how

often do they get relief based upon that differential?

Ms. LANGSEA. Well, I have heard them. They make them to the

agency. They also raise them to our State legislature as well, too.

Senator BAUCUS. Mr. Everson, this sounds pretty compelling that

we have got to get this passed.

Commissioner EVERSON. We have had this discussion before.

Getting these penalties is absolutely an imperative. You know the

work that you have done on this, and that the Permanent Investigations Subcommittee did, where things that were made public

last year clearly indicated that the penalties were just considered

speed bumps for the attorneys and accountants.

Senator BAUCUS. Do you raise this with the White House?

Commissioner EVERSON. This is a priority and it has strong support. Yes. Everybody is for this.

Senator BAUCUS. A priority out of how many priorities? One of

a thousand or one of one?

Commissioner EVERSON. I cannot speak to the whole basket of

priorities for the administration. This is strongly advocated right

up the line.

Senator BAUCUS. I hear you, Mr. Commissioner. I just suggest

you make this a big issue, and publicly. Start speaking about this.

Commissioner EVERSON. I am happy to do that.

Senator BAUCUS. We have to get this passed. I mean, that will

help you and your work, it seems to me.

Commissioner EVERSON. I agree.

Senator BAUCUS. And according to Ms. Langsea, significantly.

Commissioner EVERSON. The penalties are central. But the other

pieces of this, as I have indicated, are sending the strong criminal

message. I would suggest to you, if I could, a couple of other things

that need to be done. We do need to augment the resources.

46

I am very concerned about the President’s request for an almost

11 percent increase in IRS enforcement funding. Thus far, that has

met with, as I have made the rounds, a great reception, until we

get to the point of the mark-up. Then you get the traditional clash

over dollars.

It is just so important that you get us the resources. The other

thing that we need to do, touching on a couple of points that were

made is to upgrade our workforce.

For example, I was very disturbed that an arbitrator ruled a

week ago that the IRS may not increase the standards for its revenue agents to have more accounting skills. This is what we are

up against as we try to upgrade the workforce. So, we are doing

a lot of things, but the penalties are certainly amongst the most

important.

Senator BAUCUS. My time has expired. But before I do, I also ask

you to strongly suggest to your boss, the Secretary of Treasury, to

make a big issue out of this, too, publicly. We need to get this tax

shelter legislation passed this year.

Commissioner EVERSON. Yes, sir.

Senator BAUCUS. Because just think of the consequences if we do

not. What signal does that send? Congress discusses and talks

about tax shelter legislation, but then does not do anything about

it.

If I were a practitioner or a taxpayer and I attempted to skirt

the law a little bit, I would think they were not serious over there

in Washington, the White House is not serious, the Treasury Department is not serious.

We passed this legislation over here. The problem is over there,

the other body. I think the White House would have a great influence, and the Treasury Secretary could have a great influence, on

getting this legislation passed. You have to speak up.

Commissioner EVERSON. I will certainly carry that message.

Senator BAUCUS. Thank you.

The CHAIRMAN. Thank you.

Mr. Morgenthau, your District Attorney’s Office, of course, is in

the front line of fighting financial crime and detecting terrorism financing, and you are to be commended for the great job you have

done. Tax cheats and terrorists use the same illegal tricks to move

their money.

The crimes that your office has uncovered and scandals in the

banking industry made me concerned that maybe we are not being

vigilant enough against fighting terrorism. If we cannot stop terror

funding through regulated banks, I do not know how we are ever

going to stop it through other methods.

It is clear in your testimony and recent events that we are catching the financial misdeeds at big banks too little and too late. Your

office alone has uncovered millions of illegal transactions and tax

evasions that banks should have caught.

So, to my question. First, do you think the regulators are hesitant to get tough with banks because they worry primarily about

safety and soundness, or is there some other reason?

Mr. MORGENTHAU. Well, I think that there is certainly concern

about the stability of the bank. If you start charging one of the big

47

banks or one of the small ones with misconduct, it can create all

kinds of problems for them.

But I think, from time to time, there are political pressures. I

mean, I remember, back when I was U.S. Attorney, getting the Regional Director and the Controller of the Currency in and asking

him to take a look at the agencies of several foreign banks. He

said, oh, Mr. Morgenthau, I cannot do that. I said, why not?

He said, because ten minutes after I did that the clearinghouse

banks would be calling my bosses in Washington and complaining.

I said, why would they do that? Because they would be concerned

that there would be retaliation against the branches of American

banks overseas.

I remember when we were investigating in Abu Dhabi—that was

the BCCI investigation—and the ruler called in the American ambassador and said if anybody close to me is indicted, we are going

to withdraw our money from the United States, and we have $18

billion on deposit.

So, the American ambassador reported that to the State Department, and the Office of International Operations in the Justice Department called me. I said, you are in great shape. All you have

got to say is, we do not control that crazy bastard in New York.

[Laughter.]

But I mean, there is no doubt that there are political pressures

brought from time to time. There is nothing corrupt about the

FDIC. They did not realize that that branch, a branch of the Connecticut Bank of Commerce that went belly-up, was sold to Hudson

United.

So when we started saying that no records were being kept,

money was going to the Middle East to known terrorist organizations, we said, how could you let that happen? They said, FDIC

sold it to us. It never occurred to us that there was a problem

there.

So, some of it is incompetence. Some of it is concern about the

bank’s ability. From time to time, there is political pressure. We do

not want to offend our foreign allies. We are in a nice position because we do not have any foreign policy responsibilities.

The CHAIRMAN. I believe you have seen some information about

the Treasury’s new plan to insure Bank Secrecy Act compliance. I

would like your opinion on that. And what do you think of the idea

of a central regulator to monitor Bank Secrecy Act compliance?

Mr. MORGENTHAU. I thought about that quite a bit. I do not

think it is a good idea because the way you are going to find out

about tax abuses is at the working level. When an auditor is in

there, they should uncover that.

If you set up a whole new superstructure, they are going to have

to send investigators in and start all over again. I think we have

got to lean hard on the current supervisors and make sure that

they are doing their job, rather than create a new organization.

I think the banks have got to be put on notice and they have got

to be penalized if they do not do the job. Basically, the job is, know

your customer. Know your customer. What we are saying is, the

banks do not know their customers, in many cases.

The CHAIRMAN. All right.

48

I am very concerned about tax cheats, as this whole hearing has

said. But I am also even more concerned about terrorism financing,

a real threat to our National security. As you know, terrorists often

use the same tricks as crooks do to move their money.

I would like to get your perspective on what kind of suspected

terrorism financing your office has seen, and I would also like to

hear what you think of how it is being investigated by authorities,

and what the challenges are in these cases.

Mr. MORGENTHAU. I think it is a very serious problem. You take Beacon Hill, which moved $6.5 billion overseas and kept no records

of who the customers were. So we go in there and they honestly

who they are sending it to. We find somebody that sent $100 million over, and the notation is ‘‘a valued customer.’’

Well, that is easy to understand. A hundred million dollars

makes you a valuable customer. But you do not know who is sending the money and you do not know in detail who is receiving it.

I mean, you find the Arab bank in Ramallah is receiving the

money. You can make some assumptions, but you do not really

know who is receiving it.

So, I think that the banks have got to be much more vigilant in

knowing their customers. They have got to keep the proper records.

Then the bank examiners, whether it is FDIC, or the Federal Reserve, or the Controller of the Currency, have got to be much more

alert to what is going on in those banks.

I mean, I could not be more happy that you are holding these

hearings, and I think you ought to hold them every three or 4

months and find out what people are doing, because it is pretty

simple. You have got to know your customers and you have got to

make sure that that is enforced.

The CHAIRMAN. Your written statement includes examples of foreign countries who are helpful in your investigation, such as the

Channel Isles. But tracking down money and financial records

overseas is obviously difficult. Can you tell us what some of the

problems are, such as the slow MLAT process and what could be

done to fix this?

Mr. MORGENTHAU. The MLAT process is pretty close to a disaster, with the ability to move money anywhere around the world

almost simultaneously. We go in and we use the MLAT procedure.

By the time we get the records, which is anywhere from 6 months

to 2 years, the money is long gone.

So I am hoping that, under the Patriot Act, the banks will have

to give us that information directly. In other words, the bank that

clears in New York for a foreign bank, give it to us directly so we

do not have to go through that MLAT procedure. For State and

local prosecutors, that is a disaster.

The CHAIRMAN. Yes.

What do you think of the idea of the Treasury Department and

the IRS helping you and other local agencies by bringing in the big

guns when foreign entities do not cooperate?

Also, if Treasury or the IRS cut off access to U.S. markets for not

cooperating, or even threatened that sanction, do you think that

you would see better cooperation?

Mr. MORGENTHAU. Let me say this. I mean, I think the IRS,

under Commissioner Everson, has taken an entirely new direction

49

in terms of law enforcement. I am just delighted by what they are

doing.

There was a Commissioner of Internal Revenue when I first became U.S. Attorney who publicly stated he did not believe in criminal enforcement of the tax laws. This Commissioner believes in it,

and he is devoting resources.

But in terms of putting pressure on, I think it is got to be the

Treasury Department, because obviously they can help with some

of these jurisdictions like Switzerland. If you say it is a tax case,

they say we will not touch it.

If you tell them it is a fraud case on narcotics, they will help you.

So in some of these situations, the IRS, even though they want to

be helpful, cannot be because the foreign companies do not want

to help us enforce the tax laws.

The CHAIRMAN. Senator Baucus?

Senator BAUCUS. Thank you, Mr. Chairman.

I would just like to generally ask all of you whether you agree

or disagree with the earlier panel. I asked that panel whether the

greatest problem, the biggest category, is sole proprietorships and

the cash economy. I went down the list of everybody on the prior

panel and I did not find anybody who disagreed with that. They all

nodded their agreement.

I would like your response. Mr. Everson, what do you think? Is

that right or not?

Commissioner EVERSON. I agree, that is the biggest problem. But

as you know, where we have started is with the corporations on the

high end. We have done that because of the perception of fairness

and the permeation that goes through the system. We do need to

focus, though, increasingly, as you say, on the smaller businesses

and the individuals at that end.

Senator BAUCUS. How about the thought of requiring withholding?

Commissioner EVERSON. I think that one word that is very important in this is burden. I am not, at this time, in favor of requiring the withholding. I want to work to put some teeth into enforcement so people know that there is a presence if they are not complying, see how we can do with that based on good, strong measurements, as you are advocating. I would be hesitant at this time

to suggest that additional burden.

Senator BAUCUS. Ms. Olson, your response? Does anybody have

a different view, or a slightly different view?

Ms. OLSON. Well, in my annual report we discussed this issue at

great length. And since it was published in January, I have met

with over 30 small business groups and trade associations to discuss this issue, including 22 at one time, which was an interesting

discussion to have.

We actually have had trade associations coming to us saying, our

members want to enter into voluntary withholding agreements

under the laws that are on the books right now.

Others have proposed to us using expanded backup withholding,

so where we actually identifying individuals who are not compliant

based on past NRP document matching and things like that, that

we can go to the payor and, under backup withholding authority,

50

say, in this particular case, withhold a flat 20 percent until the person comes into compliance.

Then that does not even get to just doing some kind of mandatory withholding for types of industries where the NRP data shows

that there is noncompliance.

I also want to support Professor Bankman’s proposal about working with the States. There are many different ways to get information on gross receipts at the State level in terms of licenses.

The property tax is a good approach, but there are many types

of licenses that are based on gross receipts. People who are contractors estimate what the volume is of their jobs, the dollar volume

of the building projects that they do. That is information the States

have. And if that does not jive with what we have got on their tax

returns, that is something we should look at.

Senator BAUCUS. Sure. It just sounds like there could be a cross

comparison here as a pretty fertile field. Professor Bankman also

mentioned looking at State property taxes, because after a while

wealth accumulates and people start investing money in one thing

or another.

We have talked earlier, but I have forgotten the agency. Was it

the Immigration Service earlier today? That data and some of the

benefits there, and some of the privacy issues.

Could some of you address, where can there be cooperation?

Where is the field most fertile for more transferring a comparison

of data?

Commissioner EVERSON. I will certainly let the others comment,

but let me just say one thing that was inexplicable to me. The data

sharing has been one way, where we have given the States a list

of the Federal non—filers for years, but it has never come back to

us.

We have just recently been working it out with the States as a

follow-up to this agreement that I mentioned that we did last year

with the leads that we gave to California and others, that now we

will get the list of all their filers and we will see if somebody has

not filed in the U.S. system. That is incredible. That is a fairly

basic piece of information.

Senator BAUCUS. I am sorry. You say you gave information to the

States?

Commissioner EVERSON. If we do an audit and find somebody

has not done something, the States routinely get that data match.

The State of Virginia will say, because the IRS audited you and

you got an additional assessment of $5,000, you owe us $400. It

does not go the other way. We do not get the list of filers from California so that we can see who did not file federally. Now we are

going to get that.

Senator BAUCUS. You are getting that how?

Commissioner EVERSON. Now we are going to get it. We are in

the status of agreeing with all the States as a follow-up to all of

these exchanges.

Senator BAUCUS. States. All right. So, that is progress.

Commissioner EVERSON. That is progress. But I could not believe

that it was not a two-way street from the beginning.

Senator BAUCUS. All right.

51

Ms. Langsea, could you expand on that? What other kinds of

data sharing would be beneficial here?

Ms. LANGSEA. I would also agree that the information sharing

between the States and with the IRS is essentially critical. We are

also working with the other States who have signed a Memorandum of Agreement.

There are about 45 States and cities who have signed such an

agreement, as well as with the IRS as well. We are also currently

setting up a central repository or database where we can have our

leads shared amongst each other as well, too.

I think that States are definitely committed to providing that

sharing of more data and information. A lot of it has to do with

technology, being able to transfer that information, but we definitely see the added value in doing so.

One other thing that I might add, is you mentioned earlier as far

as the percentage or significance of where most of the under-reporting for the tax gap is. Like the IRS, we believe that 80 percent of

that is from people who do report income, but they under-report

their total amount of their income. So these are taxpayers that we

have access to, however, they are not reporting all of their income

entirely.

Senator BAUCUS. And generally what income are they not reporting?

Ms. LANGSEA. Well, abusive tax shelters fit in that category, as

well as the cash economy that Professor Bankman talked about as

well, too.

Senator BAUCUS. So we have their names and they are reporting

something. At least you have got a start.

Ms. LANGSEA. But you do not know what is not on the return.

Correct.

Senator BAUCUS. Right. Right.

In addition to income tax sharing, what other data is shared that

is potentially fruitful here? You mentioned property taxes. Immigration Service data has been suggested. Where is there more opportunity here? Or is there? Is that about it?

Commissioner EVERSON. I think that i would like to give you a

considered response on the other areas where we can enhance that

sharing. I think we have moved very aggressively. We have got this

agreement that we just signed last year. We have already started

sharing information.

We now sort of have a working network, if you will, to take these

things forward and we have got improving relationships, both with

the States and cities, and other places. So, I think we will see a

lot of creativity here.

Senator BAUCUS. As we discussed earlier, I suggested 90 percent

compliance by 2010. Is that reasonable?

Commissioner EVERSON. I think we should have that discussion,

Senator, after we start to get you some numbers on the tax gap

next year. I am uncomfortable setting a target until we know the

magnitude of the problem more precisely.

Senator BAUCUS. And the percentage currently is what?

Commissioner EVERSON. Well, I would not say that we know

what the percentage is currently, again. It is all based on the old

models.

52

Senator BAUCUS. I know. But you extrapolate.

Commissioner EVERSON. The conclusion in 1988 was that it was

about 5 percent short of that.

Senator BAUCUS. But certainly whatever that cranks out to

be——

Commissioner EVERSON. Yes. It was about 5 percent short of

that.

Senator BAUCUS. Whatever it is, we know we could do a lot better.

Commissioner EVERSON. I could not agree with you more.

Senator BAUCUS. All right.

So whatever it is, can we agree? I am trying to get something

like a percentage improvement over each of the next several years

until 2010.

Commissioner EVERSON. We are going to re-engineer our business processes on the enforcement side, just as we did on the service side. We are going to have ruthless prioritization and do things

with criminal and other areas to get the leverage.

We need help on the resources and on the legislation, as you

have mentioned. If we can get all those things, we can set very ambitious goals, but we need to know the starting point, first.

Senator BAUCUS. Right. Well, I will make you a deal. We will get

the legislation passed if you can increase the percentage by two or

3 percentage points each year.

Commissioner EVERSON. Get me the money, too. [Laughter.]

Senator BAUCUS. Well, you have got no problem with this committee there.

Mr. MORGENTHAU. May I say something?

Senator BAUCUS. Certainly.

Mr. MORGENTHAU. There has been a lot of emphasis on tax shelters and that is important. But there are more and more people

who just are not paying their taxes. They are booking their profits

overseas. They are transferring their cash overseas.

I really think we are at the tipping point. I mean, nobody enjoys

paying taxes, but they will do it as long as they think everybody

else is paying taxes. Once the word gets out that you do not have

to pay, more and more people are not going to pay. I mean, just

take the sales tax business. Going out, originally, there was a referral from FINCEN involving the chairman of the board of a major

Washington bank.

But based on that investigation, we have actually collected $24

million in sales tax, which was evaded by some very prominent

people in New York City. But once the word is out there, you do

not pay, nobody is going to pay.

I just think we are pretty close to that tipping point where more

and more people are going to say, what am I, a sucker? Why should

I pay when other people are not? The tax shelter business is obviously of great importance, but the people are not using any recognized tax shelter. They are just not paying their taxes. When you

have a trillion U.S. dollars on deposit in the Cayman Islands, you

have got to say something is really wrong here.

Ms. OLSON. Senator, if I might make a point about this. My office

has sponsored some research that we called ‘‘The Tipping Point

53

Study.’’ We have attached the first part of that to our testimony

here.

We were concerned that more and more taxpayers, not just very,

very wealthy, but the moderately affluent, were beginning to buy

into things. They were not really the technical tax shelters, but

they were things like slavery reparations, or the home-based business schemes, or the handicapped access scheme.

We have asked the IRS research office to partner with us to look

at why these taxpayers, if I may use the word, tip, where they are

normally compliant taxpayers. Is it the person who is delivering

the message? Is it that their neighbors are doing it? Is it the vehicle?

Is it where they are hearing about it, in churches, in community

groups, or whatever? We are trying to come up with a taxonomy

of schemes and then approaches, what sells them to people, hoping

that the IRS can use this information to identify schemes in the

future before they have tipped. You just see the signs as they are

building up.

Senator BAUCUS. Thank you, Mr. Chairman.

The CHAIRMAN. Mr. Godici, you will be the last question I will

ask. It comes from your testimony about taking cues from Congress

in deciding what to patent.

So, I would like to give a cue: stop issuing patents on tax shelters. Why not just simply check with Treasury in deciding to issue

a patent, and if Treasury says that is a tax shelter, then you do

not patent it? I mean, I think it is that easy. If it is not, tell me.

Mr. GODICI. Well, Mr. Chairman, certainly the patent laws do

not trump the responsibility and oversight that the IRS has with

respect to those regulations. Additionally, when we allow or issue

a patent, that does not give the patent owner or inventor the legal

right to practice that invention, only to exclude others.

Some of the case law that has been decided recently around this

issue seems to concentrate on the fact that other regulatory agencies like the IRS or the FDA should be the agencies responsible for

public policy and protecting the public, and our expertise would be

with respect to intellectual property in deciding whether or not the

inventor is entitled to patent protection.

Having said that, I have had conversation with Commissioner

Everson. We stand ready to work with the IRS in any capacity that

we possibly can. Patents are a transparent process. The patents are

available on our Web site. They can be searched.

The technology and the subject matter can be searched, as well

as applications, now, and are available so we know what is coming

down the pipeline. We can certainly work with the IRS in any way

that they see fit in terms of these types of inventions we are seeing.

The CHAIRMAN. Mr. Everson, do you look at these patents as a

source of information for people who might be avoiding taxes?

Commissioner EVERSON. We have not done much in this area,

and we need to do more. As the Commissioner has indicated, we

have started a dialogue. As in so many areas you have highlighted,

we need to do more on this.

The CHAIRMAN. Senator Baucus?

Senator BAUCUS. Yes. I find this patent matter intriguing. I just

pulled out my trusty constitution. The patent provision of the conVerDate 11-MAY-2000 11:27 Feb 02, 2005 Jkt 095484 PO 00000 Frm 00057 Fmt 6633 Sfmt 6633 95484.000 SFINANC2 PsN: SFINANC2
54

stitution that you referred to says, ‘‘To promote the progress of

science and useful arts by securing, for limited terms, to authors

and inventors exclusive right to their respective writings and discoveries.’’

Well, our founding fathers say it is to promote the progress of

science and the useful arts. I would not describe this as a science

or useful art.

Mr. GODICI. Actually, Senator Baucus, we have had many decisions in our courts, in our oversight courts, particularly one I mentioned in my oral testimony, the State Street Bank decision, which

have explicitly said that this type of technology—they call this

technology—or this type of innovation is eligible for patenting. In

the State Street decision, it was actually a scheme for determining

the value of a mutual fund program.

Senator BAUCUS. For 17 years?

Mr. GODICI. Pardon me?

Senator BAUCUS. What is the life of a patent?

Mr. GODICI. The life of a patent is 20 years from the filing of that

patent.

Senator BAUCUS. The writing. I thought it was 17 years. It is for

drugs.

Mr. GODICI. It has changed in the last several years.

The CHAIRMAN. The treaty changed it to 20.

Mr. GODICI. It was changed in 1999, actually. It is now 20 years

from the filing of the patent.

Senator BAUCUS. Do you have generic versions?

Mr. GODICI. Pardon me?

Senator BAUCUS. Do we have generic versions? We have got

brand-name drugs. Are we going to have generics now?

Mr. GODICI. With respect to patents?

Senator BAUCUS. Yes. Once the 20 years is up.

Mr. GODICI. The bottom line is, obviously, once a brand name in

the drug industry goes past the 20 years, then that technology is

available for all to produce.

Senator BAUCUS. No, no, no. I believe the drug companies have

come up with all kinds of ingenious ways to avoid that. It is incredible.

The CHAIRMAN. Our Medicare law, though, changed some of that.

I do not know whether it changed it all, but it did the scheme they

were using to hold the generic drug off the market. We changed

that.

Senator BAUCUS. Yes. As you know, Prilosec is the same as

Nexium. It is just one modest little thing changed.

Commissioner EVERSON. If I could venture a remark, I think

some of these shelters are more creative and artistic than anything

else. [Laughter.]

Mr. MORGENTHAU. I do not think the people that are getting

these patents want their work protected. They just want the imprimatur of the U.S. Government that this is patented.

Senator BAUCUS. Yes. That is a good point.

Mr. MORGENTHAU. That is what it is all about, I think.

Senator BAUCUS. That is right.

55

Well, we have got a lot more to discuss here, but we do not have

time to do it. I would just like to figure out some kind of way to

get some accountability here, more than we even have.

That is, by certain dates, a certain amount accomplished, a certain percentage of the so-called gap reduced and an assessment of

where the greater problems still lie.

Mr. Morgenthau makes some very good points about the trillion

dollars in the Cayman Islands as an example of the kinds of problems that are probably occurring. Funds travel at the speed of light

anywhere in the world, and so forth.

Mr. Chairman, I am not exactly certain how to do this in a fair,

solid way. But Mr. Everson, you are going to indicate to us by

March 31 what you think the initial results are of the new—I have

forgotten the name it is called.

Commissioner EVERSON. The National Research Program.

Senator BAUCUS. It is the son of the 1988 kind of data.

Commissioner EVERSON. We do not say son, that is Son of Boss.

So, stay away from that.

Senator BAUCUS. All right. Well, anyway, the next generation.

Commissioner EVERSON. Yes, sir.

Senator BAUCUS. The next stage, and so forth.

What else can you suggest to this committee that you can provide? What kinds of information, by what dates, do you think make

sense so we have some mutual understanding and to avoid misunderstanding of where we really are?

Commissioner EVERSON. Right. I think that is the real starting

point. We can go from there. Again, I am very anxious that we get

some of these teeth in with these penalties. If we can get that done,

we have got a new regulatory scheme in place. We are working on

something called Circular 230, which is a governance standard for

practitioners. That is terribly important.

If we can augment our resources in an appropriate way, then we

can have a pretty intelligent discussion, I would suggest, and we

will see things like the results of Son of Boss, or what happened

in California.

Senator BAUCUS. Well, that is just Son of Boss. I am concerned

about the sole proprietor/cash part of all this and you are disinclined to do anything about it.

Commissioner EVERSON. Not at all. I am not disinclined to do

anything about it. What I was talking about was weighing the

issue of the withholding.

Senator BAUCUS. Third party.

Commissioner EVERSON. Yes. That is the issue for me.

Senator BAUCUS. Well, that is such a huge problem, this area, we

all agree. It seems to me we have got to tackle it and figure out

some date by which we are going to address the problem rather

than just saying, well, the burden is an issue. Well, sure it is an

issue, but what is the solution? What is the burden solution?

Commissioner EVERSON. I think that we have to carefully weigh

the burden against how far we get on the reestablishment of the

enforcement programs.

Senator BAUCUS. There is always a way to skin a cat. You can

accomplish your objective a third way, it is not either/or, by reducVerDate 11-MAY-2000 11:27 Feb 02, 2005 Jkt 095484 PO 00000 Frm 00059 Fmt 6633 Sfmt 6633 95484.000 SFINANC2 PsN: SFINANC2
56

ing the burden. There is always a way. There is always a way. We

just do not say no, because it is a burden.

So by the same date, can you provide this committee with ways,

alternatives of how you have the payors provide withholding, or the

third party, or whatever it is?

Commissioner EVERSON. Fair enough.

Senator BAUCUS. And also ways to deal with the legitimate burden.

Commissioner EVERSON. What I do commit to is to look at it and

give you more details on that segment and the various alternatives

that exist.

Senator BAUCUS. And how much would be raised under various

alternatives that you have, how much the tax gap would be reduced by each of the various alternatives that you suggest.

Commissioner EVERSON. If, in fact, the research is being done

will support that, of course.

Senator BAUCUS. Well, do you not think that is the case, that it

will reduce the tax gap? Everybody here thinks so.

Commissioner EVERSON. Well, the question is the level of specificity you get into. I do not want to over-promise you.

Senator BAUCUS. No, no. But you can come up with it. You are

the man here. You are the IRS Commissioner.

Commissioner EVERSON. That sounds pretty good.

Senator BAUCUS. So you can come up with various alternatives,

the most stringent, the most lenient, the moderate, that addresses

this area of the tax gap problem.

Commissioner EVERSON. We can certainly develop options.

Senator BAUCUS. With numbers under the most stringent—you

can call it something else. I do not care what you call it—the most

moderate, and the most lenient.

Commissioner EVERSON. We can certainly——

Senator BAUCUS. Can you do that? Three different alternatives.

One is stronger, one is less strong, and one is still less strong.

Commissioner EVERSON. All right. We will look at alternatives in

that specific area.

Senator BAUCUS. In that specific area, and with the number of

dollars the gap could be reduced, by what dates.

Commissioner EVERSON. There will be a lot of qualifications, just

so you know.

Senator BAUCUS. Well, you do not have to qualify a lot. We will

work with you. We want to work with you.

Commissioner EVERSON. All right. Well, we will do that. We will

start having discussions as to what that would be.

Senator BAUCUS. And if you could really do that. Because, as you

know, your record—and to be honest, my record—is not good on

this. Namely, I have asked similar kinds of questions of you in the

past to which you have not responded very fully by any stretch of

the imagination. I am bad because I have not followed up with

those non-responses in a timely way either. But let us both be

much more responsive, both of us.

Commissioner EVERSON. All right.

Senator BAUCUS. So I hope you are responsive. If you are not,

then it is up to me to be very responsive immediately. Is that fair?

Commissioner EVERSON. That is fair.

57

Senator BAUCUS. All right.

I have no further questions.

The CHAIRMAN. All right.

Well, this has been a very good and informative hearing, and has

given the committee a good grounding as a way to bridge the gap.

It is our responsibility to follow up on it. I thank the panel very

much.

The hearing is adjourned.

[Whereupon, at 1:35 p.m., the hearing was concluded.]

(59)

A P P E N D I X

ADDITIONAL MATERIAL SUBMITTED FOR THE RECORD

PREPARED STATEMENT OF MR. ABC

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PREPARED STATEMENT OF HON. JOHN D. ROCKEFELLER IV

Mr. Chairman, thank you very much for calling this hearing to discuss how we

can eliminate the outrageous disparity between taxes that are rightfully owed and

what is currently collected.

Last April, hundreds of thousands of West Virginians sat down to calculate their

income taxes. They worked their way through all the forms to determine their ‘‘fair

share’’ according to our tax laws. Many folks in West Virginia struggle to make ends

meet, and paying their fair share of taxes can be difficult. But they pay their taxes

because they know it is the right thing to do.

Well, Mr. Chairman, I think that those honest West Virginians would be appalled

by the evidence we are going to discuss today. They have a right to expect that their

government will protect them by fairly enforcing the tax laws. We all understand

that when some people are allowed to get away with not paying their taxes, it imposes a greater burden on every honest taxpayer. And I am embarrassed to tell my

constituents about the inept and unfair enforcement provided by the IRS today.

This year more than $300 billion in taxes, three-quarters of our projected budget

deficit, will go uncollected. Fancy accountants and lawyers will make millions of dollars promoting tax shelters. Indeed from the period 1996 to 2000, a time of unprecedented profits and growth in corporate America, more than 60 percent of U.S. corporations did not pay any federal income taxes.

Three years ago Enron collapsed revealing unscrupulous tax avoidance schemes.

Last year most of the Democrats on this committee cosponsored Senator Baucus’ bill

to close those loopholes, but no law has yet been enacted. It would be shameful for

Congress to enact another piece of tax legislation before taking steps to close the

indefensible loopholes that corporations use to avoid paying their share of taxes.

Closing loopholes is one step that Congress must take without delay. But we also

must ensure that the enforcement of our current laws is fair and reasonable. Nobody wants the Internal Revenue Service to act like loan sharks, harassing people

or threatening them. But honest taxpayers need to know that they are not fools.

They need to believe that their neighbors are also paying their fair share of tax.

Yet the state of the IRS enforcement capabilities is discouraging.

Over the last five years the level of enforcement personnel at the IRS has decreased by 25%. The likelihood of a corporation being audited has decreased by 67%.

And 80% of individuals who are known to use abusive tax shelters are not pursued.

The IRS knows of millions of cases of delinquent taxes that it does nothing to collect. In fact, the Defense Department is aware that more than 27,000 of its contractors owe billions of dollars in unpaid taxes, but the government continues to do business with these companies.

While all of these taxes go uncollected, the IRS has devoted enormous resources

to make it more difficult for low income workers to claim a modest Earned Income

Tax Credit. This pattern of inadequate and selective enforcement is inexcusable.

It is time for us to stop just wringing our hands and expressing outrage. It is the

responsibility of this committee to oversee this nation’s tax collection system. And

I want to work with my colleagues here to ensure that the system is fair and efficient. I look forward to hearing from today’s panelists, especially Commissioner

Everson, what specific recommendations they have for closing the tax gap. And I

hope that all of the panelists will be candid about the reforms necessary and the

resources required.

I want to be able to say to the hundreds of thousands of honest taxpayers in West

Virginia that we have done everything possible to see that they are treated fairly.

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Æ