a

GAO

United States Government Accountability Office

Report to the Committee on Finance, 

U.S. Senate

June 2006 CAPITAL GAINS TAX 

GAP

Requiring Brokers to 

Report Securities Cost 

Basis Would Improve 

Compliance if Related 

Challenges Are 

Addressed

GAO-06-603
What GAO Found

United States Government Accountability Office

Why GAO Did This Study

Highlights

Accountability Integrity Reliability

June 2006

CAPITAL GAINS TAX GAP 

Requiring Brokers to Report Securities 

Cost Basis Would Improve Compliance if 

Related Challenges Are Addressed 

Highlights of GAO-06-603, a report to the 

Committee on Finance, U.S. Senate 

For tax year 2001, the Internal

Revenue Service (IRS) estimated a 

tax gap of at least $11 billion from 

individual taxpayers misreporting

income from capital assets

(generally those owned for 

investment or personal purposes). 

IRS did not estimate the portion of 

this gap from securities (e.g., 

stocks, bonds, and mutual fund 

capital gains distributions).

GAO was asked for information on

(1) the extent and types of 

noncompliance for individual 

taxpayers that misreport securities 

capital gains, (2) actions IRS takes 

to reduce the securities tax gap, 

and (3) options with the potential 

to improve taxpayer voluntary 

compliance and IRS’s ability to 

address noncompliant taxpayers. 

For estimates of noncompliance, 

GAO analyzed a probability sample

of examination cases for tax year 

2001 from the most recent IRS 

study of individual tax compliance. 

GAO estimates that 38 percent of individual taxpayers with securities 

transactions misreported their capital gains or losses in tax year 2001. A 

greater estimated percentage of taxpayers misreported gains or losses from 

securities sales (36 percent) than capital gain distributions from mutual 

funds (13 percent). This may be because taxpayers must determine the 

taxable portion of securities sales’ income whereas they need only add up 

their capital gain distributions. Among individual taxpayers who misreported 

securities sales, roughly two-thirds underreported and roughly one-third 

overreported. Furthermore, about half of these taxpayers who misreported 

failed to accurately report the securities’ cost, or basis, sometimes because 

they did not know the basis or failed to adjust the basis appropriately. 

IRS attempts to reduce the securities’ tax gap through enforcement and 

taxpayer service programs, but challenges limit their impact. Through 

enforcement programs, IRS contacts taxpayers who may have misreported 

capital gains or losses and seeks to secure the correct tax amount. IRS also 

offers services to help taxpayers comply with capital gains tax obligations, 

such as guidance on how to determine securities’ gains and losses. 

Challenges that limit these programs’ impact include the lack of information 

on basis, which IRS needs to verify most gains and losses, and uncertainty as

to whether taxpayers use or understand the guidance. 

Expanding the information brokers report on securities sales to include 

adjusted cost basis has the potential to improve taxpayers’ compliance and 

help IRS find noncompliant taxpayers. IRS research shows that taxpayers 

report their income much more accurately when it is reported to them and 

IRS. Basis reporting also would reduce taxpayers’ burden. For IRS, basis 

reporting would provide information to verify securities gains or losses and 

to better target enforcement resources on noncompliant taxpayers. 

However, basis reporting would raise challenges that would need to be 

addressed. For instance, brokers would incur costs and burdens—even as 

taxpayers’ costs and burdens decrease somewhat—and many issues would 

arise about how to calculate adjusted basis, which securities would be 

covered, and how information would be transferred among brokers. 

However, industry representatives said that many brokers already provide 

some basis information to many of their clients and some use an existing 

system to track and transfer basis and other information about securities. 

Many of the challenges to implementing basis reporting also could be 

mitigated. For example, many of the challenges could be addressed by only 

requiring adjusted basis reporting for future purchases, and by developing 

consistent rules to be used by all brokers. To the extent that actions to 

mitigate the challenges to basis reporting delay its implementation or limit 

coverage to only certain types of securities, the resulting improvements to 

taxpayers’ voluntary reporting compliance would be somewhat constrained. 

What GAO Recommends

To reduce securities capital gains 

noncompliance, GAO suggests that

Congress consider requiring

brokers to report adjusted basis to 

taxpayers and IRS and requiring 

IRS to work with the industry to

develop cost effective ways to

mitigate reporting challenges. GAO

also recommends that IRS clarify

its guidance on reporting capital 

gains and losses. 

In commenting on a draft of this 

report, IRS agreed with our

recommendations. 

www.gao.gov/cgi-bin/getrpt?GAO-06-603.

To view the full product, including the scope 

and methodology, click on the link above. 

For more information, contact Michael 

Brostek at (202) 512-9110 or 

brostekm@gao.gov. 
Page i GAO-06-603 Capital Gains Tax Gap

Contents

Letter 1

Results in Brief 3

Background 5

Individual Taxpayers Frequently Misreported Their Capital Gains or 

Losses from Securities Sales, Often Because They Misreported 

the Securities’ Basis 10

IRS Attempts to Reduce the Individual Capital Gains Tax Gap for 

Securities through Enforcement and Taxpayer Service Programs, 

but Various Challenges Limit Their Impact 16

Reporting of Cost Basis Could Reduce the Individual Capital Gains 

Tax Gap for Securities, but Implementation Challenges Would 

Need to Be Addressed 22

Conclusion 32

Matters for Congressional Consideration 33

Recommendations for Executive Action 33

Agency Comments and Our Evaluation 33

Appendixes

Appendix I: Scope and Methodology 35

Appendix II: Comments from the Internal Revenue Service 40

Appendix III: GAO Contact and Staff Acknowledgments 43

Related GAO Products 44

Tables Table 1: Estimated Percentage of Individual Taxpayers with 

Securities Transactions Who Misreported the Gain or Loss 

from One or More Transaction, Tax Year 2001 11

Table 2: Distribution of the Estimated Amount of Net Misreported 

Capital Gains Income From Securities Sales by 

Misreporting Taxpayers, Tax Year 2001 13

Table 3: Estimated Distribution of Individual Taxpayers Who 

Misreported Capital Gains or Losses from Securities 

Transactions and All Individual Taxpayers by Adjusted 

Gross Income, Tax Year 2001 13

Table 4: Estimated Frequency of Types of Noncompliance That 

Caused Individual Taxpayers to Misreport Capital Gains or 

Losses from Securities Sales, Tax Year 2001 14
Contents

Page ii GAO-06-603 Capital Gains Tax Gap

Table 5: IRS Enforcement Programs and Types of Securities Capital 

Gains Tax Noncompliance They Can Detect 17

Table 6: IRS Enforcement and Taxpayer Service Programs and 

Their Principle Limitations on Reducing the Individual 

Capital Gains Tax Gap for Securities 19

Table 7: Challenges to Brokers Associated with Basis Reporting 

and How the Challenges Could Be Mitigated 27

Table 8: Challenges to IRS Associated with Basis Reporting and 

How the Challenges Could Be Mitigated 28

Figures Figure 1: Example of How Failure to Adjust Basis Can Lead to 

Misreporting a Capital Gain or Loss from a Securities 

Transaction 8

Figure 2: Individual Net Income Misreporting Categorized by the 

Extent of Income Subject to Information Reporting, Tax 

Year 2001 25

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Page 1 GAO-06-603 Capital Gains Tax Gap

United States Government Accountability Office

Washington, D.C. 20548

A

June 13, 2006 Letr

The Honorable Charles Grassley

Chairman 

The Honorable Max Baucus

Ranking Minority Member

Committee on Finance

United States Senate

Every year, a gap arises between the tax amount that taxpayers pay 

voluntarily and on time and the amount they should pay under the law. For 

tax year 2001, the Internal Revenue Service (IRS) estimated a gross tax gap 

of $345 billion.1

 IRS estimated that it would eventually recover $55 billion 

of the gross tax gap through late payments and IRS enforcement efforts, 

leaving a net tax gap of $290 billion.2

 The tax gap arises when taxpayers fail 

to comply with the tax laws, whether intentionally or unintentionally. 

Because of their noncompliance, the burden of funding the nation’s 

commitments falls more heavily on taxpayers who voluntarily and 

accurately pay their taxes. In light of the size of the tax gap and the nation’s 

budget deficit, Congress has held several hearings seeking to identify how 

the gap can be reduced. Given its size, even small or moderate reductions 

in the net tax gap could yield substantial returns. 

One type of noncompliance that contributes to the tax gap occurs when 

individual taxpayers do not accurately report gains or losses from 

transactions involving capital assets, which generally refers to property 

owned for investment or personal purposes, on their tax returns. Taxpayers 

generally determine their capital gains or losses by subtracting the basis, 

which is generally the price they paid for an asset, from the gross amount 

of proceeds they received from its sale. IRS estimated that for 2001, 

individual taxpayers’ failure to accurately report their capital gains income

1

According to an IRS research official, in mid-2006, IRS plans to publish its final report on 

the 2001 tax gap that will include an updated tax gap estimate based on a refined 

methodology. It is possible that the updated tax gap figures could differ from the current 

estimates. 

2

Unless otherwise noted, references to the tax gap refer to the gross tax gap.
Page 2 GAO-06-603 Capital Gains Tax Gap

accounted for at least $11 billion of the gross tax gap for that year.3 This 

amount is due to taxpayers understating their capital gains or overstating 

their capital losses, both of which reduced the amount of taxable income 

they reported. Although IRS has not estimated the amount of the capital 

gains tax gap attributed to specific types of capital assets, it has estimated 

that in recent years, securities transactions have accounted for the majority 

of individuals’ capital gains and losses.4

 Securities transactions include the 

sale of securities—stocks, mutual funds, bonds, and options—and capital 

gain distributions from mutual funds.5

 Securities transactions may be 

executed through third parties, such as brokers. 

To address your long-standing concerns about the tax gap, and particular 

concern about the tax gap from individual capital gains tax noncompliance 

for securities, this report responds to your request for information on

(1) the extent of and primary types of noncompliance that cause individual 

taxpayers to misreport capital gains from securities, (2) actions IRS takes 

in attempting to reduce the individual capital gains tax gap for securities 

and any challenges that IRS faces with these actions, and (3) options with 

the potential to improve taxpayers’ voluntary compliance for reporting 

securities gains and losses and IRS’s ability to find noncompliance related 

to the individual capital gains tax gap for securities.

To provide information on the extent of and primary types of 

noncompliance that cause individual taxpayers to misreport capital gains 

from securities, we reviewed a probability sample of case files selected 

from the nearly 46,000 randomly selected individual tax returns from tax 

year 2001 that IRS reviewed or examined through the National Research 

Program (NRP), IRS’s most recent study of individual taxpayer compliance. 

We used the results of our case file review along with data from IRS’s 

3

The overall capital gains tax gap could be larger than $11 billion because IRS did not 

estimate the portion of the combined $48 billion tax gap attributable to capital gains for 

individual taxpayers who did not file tax returns or did not pay the taxes they reported on 

filed returns.

4

IRS's most recent published studies of capital asset transactions were for tax years 1997 

through 1999. See IRS Statistics of Income Bulletin, Sales of Capital Assets Reported on 

Individual Tax Returns, 1999, Summer 2003, Publication 1136 (Rev. 09-2003), and Sales of 

Capital Assets Reported on Individual Tax Returns, 1998 and 1997, Summer 2002, 

Publication 1136 (Rev. 08-2002).

5

Options are contracts giving the purchaser the right to buy or sell a security at a fixed price 

within a specific period of time. Mutual funds pay capital gain distributions from their net 

realized long-term capital gains.
Page 3 GAO-06-603 Capital Gains Tax Gap

examinations of the tax returns from NRP to make estimates for the entire 

population of individual taxpayers. We present information on the extent of 

noncompliance by estimating the percent of noncompliant taxpayers. We 

did not estimate the portion of the capital gains tax gap specific to 

securities. We could not provide a meaningful estimate of the tax gap for 

securities because (1) of the 1,017 cases in our sample, we only received 

849 complete cases by the time we completed our review, (2) the cases we 

received included too few taxpayers who misreported securities 

transactions (when selecting our sample, we could not determine which 

cases included misreported gains and losses from securities as compared 

to other types of capital assets), and (3) taxpayers misreported a wide 

range of dollar amounts from the transactions. Since our estimates are 

based on a sample, we express our confidence in our estimates as a 95 

percent confidence interval, plus or minus the margin of error indicated 

along with each estimate in the report, which is the interval that would 

contain the actual population value for 95 percent of the samples we could 

have selected. To address the question of what actions IRS takes in 

attempting to reduce the individual capital gains tax gap for securities and 

related challenges, we reviewed documents from IRS’s enforcement 

programs and IRS publications that address capital gains. We also 

interviewed IRS officials knowledgeable about the subject. To identify 

options with the potential to improve taxpayers’ voluntary compliance for 

reporting securities gains and losses and IRS’s ability to find 

noncompliance related to the individual capital gains tax gap for securities, 

we reviewed our prior reports, documents from IRS’s enforcement 

programs, IRS publications that address capital gains, and industry reports 

on securities holdings and information reporting.6

 We also spoke with IRS 

officials and representatives related to the securities industry. For further 

discussion of our scope and methodology, see appendix I. We conducted 

our review from June 2005 through May 2006 in accordance with generally 

accepted government auditing standards.

Results in Brief For tax year 2001, an estimated 38 percent of individual taxpayers who had 

securities transactions failed to accurately report their capital gains or 

losses from the transactions (8.4 million out of 21.9 million taxpayers), 

often because they misreported the securities’ cost basis. A greater 

6

Information reporting involves the filing of returns with IRS and taxpayers that contain 

information on certain transactions, such as information on gross proceeds that brokers 

report from securities sales.
Page 4 GAO-06-603 Capital Gains Tax Gap

percentage of taxpayers are estimated to have misreported gains or losses 

from their securities sales (36 percent) than misreported their capital gain 

distributions from mutual funds (13 percent). One reason for this 

difference could be because taxpayers must determine what portion of 

income from securities sales is taxable whereas taxpayers need only add 

up their capital gain distributions and enter the amounts on their tax 

returns. We were not able to determine the total amount of capital gains 

income from securities that taxpayers misreported or the securities tax gap 

because the cases we reviewed included too few misreported securities 

transactions and we did not receive other cases in time to include them in 

our review. However, we found that around half of taxpayers who did not 

accurately report their securities sales were estimated to have misreported 

at least $1,000 of capital gains or losses. Also, around half of the taxpayers 

who misreported their gains or losses from securities sales did so because 

they failed to accurately report the securities’ basis, sometimes because 

they did not know the securities’ basis or failed to take certain events into 

account that required them to adjust the basis of their securities. 

Additionally, around 9 percent of taxpayers with securities sales 

misreported whether their gains or losses were short-term or long-term.

IRS attempts to reduce the individual capital gains tax gap for securities 

through enforcement and taxpayer service programs; however, various 

challenges limit the impact these programs have on reducing this tax gap. 

IRS uses enforcement programs to contact selected taxpayers it believes 

may have inaccurately reported capital gains or losses. IRS’s automated 

enforcement programs largely rely on matching tax returns filed by 

taxpayers to information returns provided by brokers that report 

taxpayers’ gross proceeds from securities sales. IRS also examines tax 

returns by reviewing taxpayers’ records of their securities transactions. 

Additionally, IRS offers various taxpayer services intended to help 

taxpayers comply with capital gains tax obligations, such as publications 

describing how to determine tax liabilities from selling securities. The 

challenges that limit the impact these programs have on reducing the tax 

gap for securities include the relatively small portion of taxpayers with 

securities transactions that IRS contacts through its enforcement programs 

and the lack of information on the basis of securities sold, which IRS needs 

to verify most gains or losses, and the difficulty in communicating capital 

gains tax reporting requirements. Although IRS assesses additional taxes 

through its enforcement programs, neither IRS nor we know the extent to 

which these assessments reduced the 2001 capital gains tax gap for 

securities, in part because the gap itself is not known. 
Page 5 GAO-06-603 Capital Gains Tax Gap

Expanding information reporting on securities sales to include cost basis 

has potential to improve taxpayers’ voluntary compliance and help IRS find 

noncompliance related to the capital gains tax gap for securities. On one 

hand, some of this potential exists if IRS were to change its enforcement 

and taxpayer service programs, such as by examining more tax returns or 

enhancing guidance related to securities gains or losses. However, 

examinations can be costly, and taxpayers may not know about or use the 

guidance. On the other hand, basis reporting to taxpayers and IRS would 

help taxpayers to voluntarily comply and would reduce their burden in 

computing capital gains or losses. IRS research has repeatedly shown that 

taxpayers’ compliance is strongly related to the extent to which their 

income is subject to information reporting. Basis reporting also would 

provide information to help IRS verify securities gains or losses and target 

enforcement resources to noncompliant taxpayers. However, such basis 

reporting would raise challenges and trade-offs. Many of the challenges can 

be mitigated to some extent. For example, tracking and reporting basis 

would increase brokers’ costs, but decisions about the scope and details of 

the reporting could constrain the increase. Further, taxpayers’ costs would 

be reduced, and many brokers already provide some form of basis 

information to taxpayers. The challenges arising when brokers do not 

know the basis for securities purchased in the past could be mitigated by 

only reporting basis for future purchases, which would somewhat delay the 

full impact that basis reporting would have on reducing the capital gains 

tax gap. Although IRS has broad authority to require information reporting 

for securities sales, it may not have the authority to require all of the 

actions that would be needed to implement cost basis information 

reporting.

This report includes matters Congress may want to consider to reduce the 

capital gains tax gap for securities. Specifically, Congress could require 

brokers to report to both taxpayers and IRS the adjusted basis of securities 

that taxpayers sell and whether the gains or losses were short- or longterm, and direct IRS to work with brokers and related parties to develop 

rules that seek to cost effectively mitigate some of the challenges 

associated with requiring basis reporting. We are also making 

recommendations to IRS on clarifying guidance related to reporting capital 

gains and losses. In commenting on a draft of this report, the Commissioner 

of Internal Revenue agreed with our recommendations.

Background Individual taxpayers generally realize gains or losses when they sell capital 

assets, which are generally defined as properties owned for investment or 
Page 6 GAO-06-603 Capital Gains Tax Gap

personal purposes and outside the normal course of a taxpayer’s trade or 

business. In recent years, IRS studies show that the majority of capital 

asset transactions and capital gains and losses were for securities 

transactions, including sales of corporate stock, mutual funds, bonds, 

options,7

 and capital gain distributions from mutual funds.8 For example, in 

1999, the latest year for which IRS published data on capital assets sales, an 

estimated 91 percent of capital asset transactions, 62 percent of capital 

gains, and 79 percent of capital losses were from securities transactions.9

Also, over the past two decades, individual ownership of securities assets 

held outside of retirement accounts has increased.10 According to the 

Federal Reserve Board, the percentage of families that own stock, mutual 

funds, and bonds outside of retirement accounts increased from 25 percent 

in 1983 to a high of 42 percent in 2001, before falling to 38 percent in 2004.11

When taxpayers sell or otherwise receive income from securities, they 

must report the transactions on their federal income tax returns. For 

securities sales, taxpayers are to report the dates they acquired and sold 

the asset; sales price, or gross proceeds from the sale; cost or other basis of 

the sold asset; and resulting gains or losses on Schedule D to the individual 

7

Although by statute, futures contracts are not considered securities, we include them as 

securities for the purposes of this report because futures transactions are generally reported 

by brokers to IRS and we found 2 taxpayers through our file review who misreported such 

transactions. A futures contract is an agreement to buy or sell a specific quantity of a 

commodity or financial instrument at a specified price on a particular date in the future. 

8

Other types of capital assets include personal residences and other personal-use property; 

real property held for investment; collectibles, such as art, coins or precious metals; and 

interest in a partnership, S corporation, estate, or trust. Capital gains and losses for assets 

sold by partnerships, S corporations, estates, or trusts are generally taxed at the partner, 

shareholder, or beneficiary level. Non-business bad debts are treated as capital losses. All or 

part of the net gains from certain other transactions may be treated as capital gains, 

including involuntary conversions from destruction, theft, condemnation, or eminent 

domain; other depreciable real property or personal property used in a business; land used 

in a business, including farmland; timber; livestock; patents; and copyrights.

9

Includes futures transactions. 

10References to capital assets in this report refer to assets held outside of retirement 

accounts.

11The Federal Reserve Board surveys U.S. families' holdings of financial assets in its 

triennial Surveys of Consumer Finances. See Robert B. Avery, Glenn B. Canner, Gregory E. 

Elliehausen, and Thomas A. Gustafson, Survey of Consumer Finances, 1983, Federal 

Reserve Bulletin, vol. 70 (September 1984), and Brian K. Bucks, Arthur B. Kennickell, and 

Kevin B. Moore, Recent Changes in U.S. Family Finances: Evidence from the 2001 and 

2004 Survey of Consumer Finances, Federal Reserve Bulletin, vol. 92 (February 2006).
Page 7 GAO-06-603 Capital Gains Tax Gap

tax return—Form 1040. Taxpayers are to report this information separately 

for short-term transactions and long-term transactions. Taxpayers also are 

to report the total amount of their capital gain distributions from mutual 

funds, which are always considered to be long-term transactions. 

Taxpayers are to report their overall gains or losses from securities sales, 

capital gain distributions, and other capital gains on the Form 1040 tax 

return itself. 

Generally, a taxpayer’s gain or loss from a securities sale is simply the 

difference between the gross proceeds from the sale and the original 

purchase price, or original cost basis.12 However, before taxpayers can 

determine any gains or losses from securities sales, they must determine if 

and how the original cost basis of the securities must be adjusted to reflect 

certain events, such as stock splits, nontaxable dividends, or nondividend 

distributions. For example, figure 1 shows how a taxpayer would need to 

adjust the basis of a stock following a stock split to accurately determine 

the resulting capital gain or loss when the stock is sold. In this example, if 

the taxpayer fails to properly adjust the basis of the stock to account for 

the split, he or she will incorrectly report a capital loss from the sale.

12The original cost basis of a security can also include costs of purchase, such as sales 

commissions.
Page 8 GAO-06-603 Capital Gains Tax Gap

Figure 1: Example of How Failure to Adjust Basis Can Lead to Misreporting a Capital 

Gain or Loss from a Securities Transaction

Taxpayers who buy and sell the same stock or mutual fund shares at 

various times can determine basis in a number of ways. Taxpayers can 

specifically identify the groups of shares they want to sell. For example, if a 

taxpayer buys a group of 10 shares of stock in one year for $1 per share and 

another group of 10 shares of the same stock in the next year for $2 per 

share, and then sells 10 shares of the stock, the taxpayer can choose to sell 

the stocks with either the $1 or $2 cost basis.13 If taxpayers cannot identify 

which shares they sold among many they bought on varying occasions, 

13Taxpayers who specifically identify groups of shares sold among multiple groups held 

must inform their brokers which shares to sell, and brokers are to provide written 

confirmation of taxpayers’ decisions.

Per share cost basis = $10

Per share cost basis = $5

Correctly calculated 

Sale proceeds =

Cost basis =

$5

$5

$0

Incorrectly calculated

Sale proceeds =

Cost basis =

$5

$10

($5)

Taxpayer sells stock

original

cost basis

adjusted

cost basis

Gain (loss) Gain (loss)

Source: GAO.

$10

$5 $5

Taxpayer buys one share of Company A stock for $10

Company A splits its shares 2 to 1

($10 share now equivalent to two $5 shares)

Taxpayer sells 1 share of 

Company A stock 

(sale proceeds $5) 

and calculates gain or 

loss for tax purposes
Page 9 GAO-06-603 Capital Gains Tax Gap

they must report the basis of the securities they purchased first as the basis 

of the sold shares. Except for mutual fund shares, taxpayers cannot use the 

average cost of securities they purchased at various times to determine 

basis.

When taxpayers sell securities through a broker, that broker is required to 

file Form 1099-B with IRS and the taxpayers to report a description of the 

security, sales date, number of shares sold, and gross proceeds from the 

sale, along with other information.14 Brokers are not required to report the 

cost or other basis of the sold security or, with the exception of regulated 

futures contracts, the resulting gain or loss from a security sale. Capital 

gain distributions from mutual funds are to be reported on Form 1099-

DIV.15

The rate at which income from securities is taxed depends on how long 

taxpayers held a security before sale and taxpayers’ regular income tax 

rates. Securities assets sold after being held for 1 year or less are 

considered short-term and taxed at the taxpayers’ regular income tax rates. 

Assets sold after being held for more than 1 year are considered to be longterm and are generally taxed at maximum rates of 5 percent or 15 percent, 

depending on the taxpayer’s regular income tax rates.16 Capital gain 

distributions from mutual funds are always taxed as long-term gains. 

Taxpayers can deduct capital losses against their capital gains, and any 

excess losses can be deducted against ordinary income up to a limit of 

$3,000 ($1,500 for married taxpayers filing separately), beyond which the 

14Congress established the requirement that brokers report proceeds in the Tax Equity and 

Fiscal Responsibility Act of 1982—Pub. L. No. 97-248 (1982). Other information that can be 

reported on Form 1099-B includes the security’s Committee on Uniform Security 

Identification Procedures number; gross amounts received through bartering; federal 

income tax withheld; classes of stock exchanged, such as preferred or common stock; and 

profit or loss for regulated futures contracts. Brokers may send a substitute for Form 1099-B 

if it meets IRS requirements for substitutes.

15A number of other dividends and distributions are also reported on Form 1099-DIV.

16The Jobs and Growth Tax Relief Reconciliation Act of 2003—Pub. L. No. 108-27 (2003)—

established maximum tax rates for long-term gains at 5 percent for income otherwise taxed 

in the 10 percent and 15 percent marginal income tax brackets and 15 percent for income 

otherwise taxed at higher rates, effective for assets sold or exchanged on or after May 6, 

2003, and before January 1, 2009. These rates were extended for assets sold or exchanged 

before January 1, 2011 in the Tax Increase Prevention and Reconciliation Act of 2005—Pub. 

L. No. 109-222 (2006). 
Page 10 GAO-06-603 Capital Gains Tax Gap

losses can be carried over to offset capital gains or ordinary income in 

future tax years. 

Individual Taxpayers 

Frequently 

Misreported Their 

Capital Gains or Losses 

from Securities Sales, 

Often Because They 

Misreported the 

Securities’ Basis 

Thirty-eight percent of individual taxpayers who had securities 

transactions misreported their securities gains or losses for tax year 2001. 

A greater percentage of taxpayers misreported their securities sales (36 

percent) than misreported their capital gain distributions (13 percent), and 

most of the misreported securities transactions exceeded $1,000 of capital 

gain or loss. Taxpayers often misreported their capital gains or losses from 

securities sales because they failed to accurately report the securities’ 

basis. 

Individual Taxpayers 

Frequently Misreported 

Their Capital Gains or 

Losses from Securities Sales

For tax year 2001, individual taxpayers frequently misreported their capital 

gains or losses from the securities they sold. Overall, an estimated 8.4 

million of the estimated 21.9 million taxpayers with securities transactions 

misreported their gains or losses.17 Table 1 shows the estimated 

percentages of taxpayers who misreported their securities sales and capital 

gain distributions, overall and by the securities’ holding period. 

17We are 95 percent confident that from 7.3 million to 9.5 million taxpayers misreported 

securities transactions and from 20.3 million to 23.5 million taxpayers had securities 

transactions.
Page 11 GAO-06-603 Capital Gains Tax Gap

Table 1: Estimated Percentage of Individual Taxpayers with Securities Transactions Who Misreported the Gain or Loss from One 

or More Transaction, Tax Year 2001

Source: GAO analysis of IRS data and examination case files.

Note: Percentage estimates have sampling errors of (+/-) 7 percent or less.

a

For securities sales, “all transactions” includes those for which we could not determine whether the 

holding period was short-term or long-term.

b

Capital gain distributions are always considered long-term transactions.

c

“All securities” includes taxpayers who misreported both securities sales and capital gain distributions. 

Table 1 shows that a higher estimated percentage of taxpayers misreported 

a securities sale than a capital gains distribution. Overall, an estimated 7.3 

million out of an estimated 20.3 million taxpayers misreported their 

securities sales compared to the estimated 1.2 million out of an estimated 

9.1 million taxpayers who misreported their capital gain distributions.18

One reason taxpayers may misreport securities sales more frequently is 

that taxpayers must compute the portion of their sales proceeds that 

constitutes a gain or loss, whereas taxpayers need only add up their capital 

gain distributions from information returns they receive and enter the 

amounts on their tax returns. Table 1 also shows that individual taxpayers 

are estimated to have misreported their short-term securities sales about as 

often as their long-term sales. In addition, our analyses showed the 

following:

• Of those taxpayers who misreported securities sales, an estimated 97 

percent misreported gains or losses from the sales of stocks and mutual 

funds while an estimated 5 percent misreported bonds, options, or 

futures.19

Estimated percentage of taxpayers who misreported their transactions

Type of transaction Short-term transactions Long-term transactions All transactionsa

Securities sales 28 31 36

Capital gain distributions N/Ab 13 13

All securitiesc 28 32 38

18We are 95 percent confident that from 6.2 million to 8.3 million taxpayers misreported 

securities sales, from 18.7 million to 21.9 million taxpayers sold securities, from 0.66 million 

to 1.7 million taxpayers misreported capital gain distributions, and from 7.8 million to 10.4 

million taxpayers had capital gain distributions. 

19Some taxpayers misreported both stocks and mutual funds and bonds, options or futures. 

Estimates have sampling errors of (+/-) 5 percent or less. 
Page 12 GAO-06-603 Capital Gains Tax Gap

• Individual taxpayers misreported securities sales more frequently than 

other types of income, such as wages and salary, dividend income, and 

interest income. Respectively, an estimated 10 percent, 17 percent, and 

22 percent of taxpayers with these types of income misreported the 

income.20

We were not able to estimate the capital gains tax gap for securities 

because the cases we reviewed included too few misreported securities 

transactions and taxpayers misreported a wide range of dollar amounts 

from the transactions, among other reasons (see app. I). However, we were 

able to determine the direction of the misreporting. For securities sales, an 

estimated 64 percent of taxpayers underreported their income from 

securities (i.e., they understated gains or overstated losses) compared to an 

estimated 33 percent of taxpayers who overreported income (i.e., they 

overstated gains or understated losses).21 For both underreported and 

overreported income, some taxpayers misreported over $400,000 in gains 

or losses. Also, as shown in table 2, around half of taxpayers who did not 

accurately report their securities sales were estimated to have misreported 

at least $1,000 of capital gains or losses (that is, taxpayers not in the less 

than $1,000 categories).22

20Estimates have sampling errors of (+/-) 2 percent or less. 

21Figures do not sum to 100 percent because some taxpayers misreported securities sales in 

a way that had no effect on the amount of income from the sales, for example, in cases 

where taxpayers only misreported the securities’ holding periods. Estimates have sampling 

errors of (+/-) 9 percent or less.

22By comparison, from 49 percent to 96 percent of taxpayers that misreported their capital 

gain distributions were estimated to have misreported between $0 and $1,000 of income.
Page 13 GAO-06-603 Capital Gains Tax Gap

Table 2: Distribution of the Estimated Amount of Net Misreported Capital Gains 

Income From Securities Sales by Misreporting Taxpayers, Tax Year 2001

Source: GAO analysis of IRS data and examination case files.

Notes: Percentage figures do not sum to 100 because of rounding. Percentage estimates have 

sampling errors of (+/-) 8 percent or less.

a

Category includes taxpayers that misreported securities sales in a way that had no effect on the gain 

or loss from the sales. 

In terms of income levels, the distribution of taxpayers who misreported 

gains or losses from securities sales and capital gain distributions did not 

vary greatly from the income level for all individual taxpayers for tax year 

2001, as shown in table 3.

Table 3: Estimated Distribution of Individual Taxpayers Who Misreported Capital 

Gains or Losses from Securities Transactions and All Individual Taxpayers by 

Adjusted Gross Income, Tax Year 2001

Source: GAO analysis of IRS data and examination case files.

Notes: For misreporting taxpayers, estimates have sampling errors of (+/-) 8 percent or less. For all 

individual taxpayers, estimates have sampling errors of (+/-) 0.3 percent or less.

Net misreported amount Percentage of misreporting taxpayers

Overreporting taxpayers

Less than $1,000a 19

$1,000 to $9,999 15

$10,000 and greater 5

Underreporting taxpayers

Less than $1,000 27

$1,000 to $9,999 19

$10,000 and greater 14

Adjusted gross income

Percentage of misreporting 

taxpayers

Percentage of all individual 

taxpayers

Less than $25,000 51 46

$25,000 to $49,999 20 25

$50,000 to $99,999 20 20

$100,000 or greater 9 9
Page 14 GAO-06-603 Capital Gains Tax Gap

Misreported Basis Was a 

Primary Type of 

Noncompliance That 

Caused Taxpayers to 

Inaccurately Report Their 

Capital Gains or Losses 

from Securities Sales

Based on information in the files we reviewed, a primary type of 

noncompliance that caused taxpayers to inaccurately report their capital 

gains or losses from securities sales in tax year 2001 was misreporting the 

basis of the securities they sold. Table 4 shows the estimated frequency of 

the types of noncompliance that caused taxpayers to misreport capital 

gains or losses from their securities sales.23

Table 4: Estimated Frequency of Types of Noncompliance That Caused Individual 

Taxpayers to Misreport Capital Gains or Losses from Securities Sales, Tax Year 2001

Source: GAO analysis of IRS data and examination case files.

Notes: Estimates in this table do not include the results of our review for four cases where we could not 

determine the type of noncompliance that caused taxpayers to misreport securities sales. The “Other” 

category includes taxpayers who misclassified capital income as other types of income or vice versa or 

made mathematical errors. Some taxpayers misreported more than one security sale or misreported a 

sale because of more than one type of noncompliance. Percentage estimates have sampling errors of 

(+/-) 9 percent or less. 

For taxpayers who misreported basis, a greater percentage failed to 

accurately report basis for long-term securities holdings (35 percent of 

taxpayers who misreported securities sales) than for short-term holdings 

(21 percent).24 Taxpayers who failed to report securities sales altogether 

did not report short-term and long-term securities sales at a similar rate 

(20 percent and 22 percent, respectively, of taxpayers who misreported 

securities sales).25

Although we were able to determine the percentage of taxpayers who 

failed to accurately report their securities sales because they misreported 

23For taxpayers who misreported capital gains distributions, from 48 percent to 89 percent 

were estimated to have failed to report the distributions altogether.

Type of noncompliance Estimated percentage of misreporting taxpayers

Misreported basis of security sold 49

Failed to report sale 44

Misreported sale proceeds 12

Misclassified holding period 9

Other 9

24Estimates have sampling errors of (+/-) 8 percent or less.

25Estimates have sampling errors of (+/-) 8 percent or less.
Page 15 GAO-06-603 Capital Gains Tax Gap

basis (49 percent), we could not develop reliable estimates on the reasons 

for this type of misreporting because most of the NRP examination case 

files did not provide sufficiently descriptive information. However, of the 

133 taxpayers who misreported basis from the 849 case files we reviewed, 

we were able to determine that 32 taxpayers misreported basis for the 

following reasons:

• Taxpayers did not have records of their securities purchases (16 

taxpayers). Although during examinations, IRS was able to obtain basis 

records for some of these taxpayers from their brokers, for 9 taxpayers, 

basis records could not be obtained. For these taxpayers, IRS examiners 

considered basis to be zero and treated all gross proceeds amounts as 

capital gains. 

• Taxpayers used original cost basis instead of adjusted cost basis (6 

taxpayers). 

• Taxpayers did not understand how to determine basis (5 taxpayers). 

• Taxpayers reported basis information that was incorrectly determined 

by a tax return preparer (4 taxpayers).26

• One taxpayer reported inaccurate basis information provided by a 

broker.

Of taxpayers who failed to report their securities sales altogether, an 

estimated 28 percent were estimated to have failed to report capital 

losses.27 By not reporting losses, these taxpayers potentially failed to offset 

other capital gains or deduct their losses against other types of income they 

reported. Likewise, some of these taxpayers who failed to report capital 

losses exceeding $3,000 did not carry over these losses to offset capital 

gains or other income in future tax years. Although in most cases we could 

not determine why taxpayers did not report these losses, some taxpayers 

26Of all taxpayers who misreported a securities transaction, an estimated 52 percent used a 

tax return preparer with a sampling error of (+/-) 9 percent or less. Of all individual 

taxpayers, an estimated 56 percent used a tax return preparer for tax year 2001 with a 

sampling error of (+/-) 0.4 percent or less. We recently reported that some tax return 

preparers make serious errors when completing returns. See GAO, Paid Tax Return 

Preparers: In a Limited Study, Chain Preparers Made Serious Errors, GAO-06-563T

(Washington, D.C.: Apr. 4, 2006).

27Estimate has a sampling error of (+/-) 13 percent or less.
Page 16 GAO-06-603 Capital Gains Tax Gap

told IRS examiners that they did not know they had to report losses. In 

addition, IRS officials said some taxpayers might not report their capital 

losses because they worry that their returns will be examined if they 

overstate their losses. Also, the officials told us that taxpayers might want 

to avoid the burden of filing a Schedule D or the cost of paying someone to 

prepare their returns in cases where filing Schedule D would make the 

difference between self preparing and using a paid preparer. 

As also shown in table 4, taxpayers failed to accurately report their 

securities sales because they misreported the amount of their sale 

proceeds (12 percent) or misclassified the securities’ holding period (9 

percent). However, the case files did not contain enough information to 

explain why taxpayers made these errors. Also, the responsible officials we 

interviewed at IRS could not provide explanations for why taxpayers might 

have made these errors.

IRS Attempts to 

Reduce the Individual 

Capital Gains Tax Gap 

for Securities through 

Enforcement and 

Taxpayer Service 

Programs, but Various 

Challenges Limit Their 

Impact

IRS uses both enforcement and taxpayer service programs in attempting to 

reduce the individual capital gains tax gap for securities. IRS checks the 

accuracy of tax returns through its enforcement programs and contacts 

taxpayers who may have inaccurately reported their securities gains or 

losses. IRS also offers service programs to provide taxpayers with 

assistance in fulfilling their capital gains tax obligations. However, these 

programs face challenges that limit their impact on reducing the capital 

gains tax gap for securities. Although IRS assesses additional taxes for 

securities income through its enforcement efforts, neither IRS nor we 

know the extent to which these assessments reduced the 2001 capital gains 

tax gap for securities.

IRS Attempts to Reduce the 

Individual Capital Gains Tax 

Gap for Securities through 

Enforcement and Taxpayer 

Service Programs

Consistent with its overarching philosophy that a combination of 

enforcement and service efforts are essential to tax compliance, IRS 

attempts to reduce the individual capital gains tax gap for securities 

through its programs that enforce the tax laws and that seek to help 

taxpayers voluntarily comply with the laws. IRS uses its enforcement 

programs to check the accuracy of filed tax returns and contacts taxpayers 

who have potentially made errors or inaccurately reported capital gains
Page 17 GAO-06-603 Capital Gains Tax Gap

information on their returns.28 Aspects of IRS’s enforcement programs 

related to capital gains income for securities appear in table 5.29

Table 5: IRS Enforcement Programs and Types of Securities Capital Gains Tax 

Noncompliance They Can Detect

Source: IRS.

Math Error, AUR, and ASFR are automated enforcement programs. IRS 

uses the Math Error program to check filed tax returns for internal 

inconsistencies or mathematical errors, and contacts taxpayers, including 

when the errors result in a tax change. Through AUR, IRS computers match 

the amounts of capital gains proceeds that taxpayers report on their tax 

returns and that brokers report on information returns. If this matching 

indicates that taxpayers may have underreported their sale proceeds for 

securities and IRS cannot resolve the discrepancies based on available 

information, IRS may send notices asking taxpayers to explain the 

discrepancies or pay any taxes assessed. When IRS determines through 

ASFR that taxpayers for whom IRS received information returns on the 

sale proceeds for securities failed to file tax returns, it may create tax 

returns for the taxpayers and assess tax liabilities. 

During examinations, IRS uses information from third parties as well as 

from taxpayers to determine if taxpayers have accurately reported their

28Taxpayers can appeal additional taxes that IRS assesses. 

29For a more complete discussion of these programs, see GAO, Tax Administration: IRS 

Should Continue to Expand Reporting on Its Enforcement Efforts, GAO-03-378

(Washington, D.C.: Jan. 31, 2003).

IRS program Capable of detecting

Math Error Data reported inconsistently between Schedule D 

and Form 1040

Automated Underreporter (AUR) Inaccurately reported gross proceeds from securities 

sales and capital gain distributions

Automated Substitute for Return 

(ASFR)

Taxpayers who received proceeds from securities 

sales but did not file tax returns

Examination All forms of capital gains noncompliance for 

securities
Page 18 GAO-06-603 Capital Gains Tax Gap

capital gains or losses.30 Examiners also may use other resources, such as 

online services, to help them determine the basis of taxpayers’ securities. 

IRS assesses additional taxes if it determines that taxpayers have 

underreported their capital gains income from securities.

IRS’s taxpayer service programs provide taxpayers with information, 

support, and assistance to help them understand and fulfill their capital 

gains tax obligations for securities. For example, IRS produces 

publications that explain how to report capital gains or losses and provide 

examples of how to determine adjusted basis.31 IRS also provides Webbased information and telephone, written, or face-to-face assistance at 

Taxpayer Assistance Centers on how to accurately report capital gains and 

losses. 

Various Challenges Limit the 

Impact IRS Programs Have 

on Reducing the Individual 

Capital Gains Tax Gap for 

Securities

IRS’s enforcement and taxpayer service programs face limitations in 

reducing the individual capital gains tax gap for securities. In addition to 

resource constraints that limit how many cases of potential noncompliance 

are pursued, table 6 summarizes the main limitations each program faces.

30IRS performs some examinations through correspondence and others through face-to-face 

meetings with taxpayers.

31IRS publications related to capital gains or losses from securities include Publication 544, 

Sales and Other Dispositions of Assets, Publication 550, Investment Income and Expenses; 

Publication 551, Basis of Assets, and Publication 564, Mutual Fund Distributions. 
Page 19 GAO-06-603 Capital Gains Tax Gap

Table 6: IRS Enforcement and Taxpayer Service Programs and Their Principle 

Limitations on Reducing the Individual Capital Gains Tax Gap for Securities 

Source: IRS.

As table 6 shows, IRS cannot use its automated programs to fully verify the 

reported capital gains or losses from securities sales because it does not 

receive basis information from brokers. Also, according to IRS officials, a 

lack of basis information reduces productivity because IRS spends 

resources contacting taxpayers for whom it ultimately does not assess 

additional taxes. For example, for tax year 2002, the latest year for which 

IRS has complete data, IRS did not assess additional taxes for around 46 

percent of the taxpayers it contacted through AUR to address potentially 

misreported securities sales.32 By comparison, this “no tax change” 

percentage was around 20 percent for AUR contacts for all other types of 

income for 2002.33 For ASFR, IRS officials said that the lack of basis 

IRS program Principle limitations

Math Error Not intended to verify if taxpayers have accurately 

reported their capital gains tax liabilities for securities

AUR Lack of basis information from brokers prevents AUR 

from verifying the accuracy of reported capital gains 

or losses from securities sales

ASFR Lack of basis information from brokers prevents 

AFSR from accurately determining how much of 

taxpayers’ gross proceeds from securities sales is 

taxable

Examination Capital gains are too complex and time consuming to 

examine through correspondence

Face-to-face examinations are resource intensive 

and cover a small percentage of taxpayers with 

capital gains

Taxpayer services Taxpayers may not use the services

Taxpayers may not understand information IRS 

provides

32For some taxpayers, IRS did not assess additional taxes when it identified underreported 

income from securities sales because the changes to reported income only reduced 

taxpayers’ capital loss carryovers. 

33Through AUR, IRS contacted around 190,000 taxpayers who potentially misreported 

securities sales out of a total of over 2.3 million taxpayers it contacted for all types of 

misreported income for tax year 2002. IRS does not collect information on the number of 

taxpayers it contacts through Math Error and ASFR programs who potentially misreported 

capital gains.
Page 20 GAO-06-603 Capital Gains Tax Gap

information hampers IRS’s ability to determine which taxpayers with gross 

proceeds from securities sales should have filed tax returns and to 

productively pursue those taxpayers who did not file. 

Given that IRS does not receive basis information from brokers, it can only 

verify the accuracy of the basis and gains and losses that taxpayers report 

for their securities sales by examining these individuals’ tax returns. IRS 

does not examine these taxpayers’ returns through correspondence 

because it believes the returns are too difficult and would take too much 

time to examine. IRS can only verify the accuracy of the reported basis and 

gains and losses from securities sales through face-to-face examinations. 

However, these examinations are resource intensive and only cover a small 

percentage of individual taxpayers. For example, in fiscal year 2004, IRS 

conducted approximately 200,000 face-to-face examinations34 for the 130 

million individual taxpayers that filed tax returns in 2003, including the 

estimated 22.7 million taxpayers that filed a Schedule D with their tax 

returns.35 Even when IRS selects individual taxpayers to examine face-toface, IRS often places a greater focus on issues it believes are more 

productive than securities sales, such as business income or the sale of 

personal or business real property, according to an IRS official responsible 

for examination planning. 

In providing taxpayer services, IRS faces challenges in communicating 

information to taxpayers on complying with capital gains reporting 

requirements. Taxpayers may not use the services IRS offers or may not 

understand the information that IRS provides. For example, IRS recently 

changed the instructions for filing Schedule D to include language that 

specifies taxpayers must include the details of all their capital gains 

transactions when filing their tax returns. Although IRS included this 

language to clarify an existing reporting requirement, some taxpayers and 

tax practitioners perceived that the instructions required taxpayers to 

report each capital asset transaction on Schedule D itself and not on 

attached brokerage statements, as otherwise allowed. This misconception 

required IRS to clarify on its Web site that taxpayers could continue to 

34By comparison, IRS examined through correspondence approximately 800,000 individual 

tax returns in fiscal year 2004. Approximate examination figures are given because, 

according to IRS, in general, examination activity may be associated with returns filed in the 

previous calendar year. 

35We are 95 percent confident that the number of taxpayers who reported capital gains or 

losses was from 22.4 million to 22.9 million. 
Page 21 GAO-06-603 Capital Gains Tax Gap

report the details of their transactions on attached statements as long as all 

transactions were included and they reported aggregate information on 

Schedule D.

The Extent to Which IRS 

Enforcement Programs 

Have Reduced the 2001 

Capital Gains Tax Gap for 

Securities Is Not Known 

Through its enforcement programs, IRS assessed additional taxes for 

taxpayers who misreported their securities gains and losses for tax year 

2001; however, neither IRS nor we know the extent to which these 

assessments reduced the securities tax gap for that year. IRS has not 

estimated the portion of the capital gains tax gap attributed to securities for 

tax year 2001, and we were not able to estimate this portion of the tax gap 

from our review of NRP case files. Likewise, IRS does not have complete 

information on the amount of additional taxes it assessed for taxpayers 

who underreported their income from securities sales for 2001.

Through AUR for tax year 2001, IRS assessed around $190 million in 

additional taxes for securities sales and around another $5 million for 

capital gain distributions, and refunded over $8 million to taxpayers who 

overreported securities income.36 For tax year 2001 examinations, IRS does 

not have complete data for the amount of taxes it assessed for misreported 

capital gains or losses. IRS maintains a database that tracks examination 

results by the type of issue examined, such as capital gains or losses. 

However, prior to October 2004, the database only captured examination 

results for around 60 percent of individual examinations, according to IRS 

officials.37As such, the database does not include all capital gains 

noncompliance that IRS identified in tax year 2001 examinations. Even 

when it includes such noncompliance, the database does not distinguish 

between misreported capital gains income from securities versus other 

capital assets. Likewise, the database does not specify the portion of 

additional tax assessments that is attributable to misreported capital gains

36For tax year 2002, IRS increased the number of taxpayers contacted for potentially 

misreported securities sales to around 190,000, assessing over $550 million in additional 

taxes. 

37As previously reported, IRS had not been entering all examination cases into this database, 

and started implementing improvements in October 2004 to case processing and data 

capture. See GAO, Tax Compliance: Better Compliance Data and Long-term Goals Would 

Support a More Strategic IRS Approach to Reducing the Tax Gap, GAO-05-753

(Washington, D.C.: July 18, 2005). 
Page 22 GAO-06-603 Capital Gains Tax Gap

income versus other types of noncompliance.38 Finally, IRS does not 

maintain data on additional taxes assessed and collected because of capital 

gains noncompliance through the Math Error or ASFR programs. 

Reporting of Cost Basis 

Could Reduce the 

Individual Capital 

Gains Tax Gap for 

Securities, but 

Implementation 

Challenges Would 

Need to Be Addressed

Expanded reporting of cost basis information has the potential to reduce 

the individual capital gains tax gap for securities. Making administrative 

changes to IRS’s compliance programs that address capital gains also has 

some potential to reduce the tax gap, but enforcement programs can be 

resource intensive and taxpayers do not always use IRS’s taxpayer service 

programs. With such limitations, these changes likely would not 

significantly boost taxpayers’ voluntary compliance involving securities 

sales. Information reporting of adjusted cost basis to taxpayers and IRS 

would likely help reduce the tax gap from securities sales by improving 

taxpayers’ voluntary compliance and IRS’s ability to cost effectively 

address noncompliant taxpayers. Consistent reporting of basis information 

would involve challenges that would need to be, and to some extent can be, 

mitigated.

Increasing Examinations of 

Taxpayers with Securities 

Sales Could Reduce That 

Portion of the Tax Gap but 

at the Expense of Not 

Covering Other Areas of 

Noncompliance

IRS could seek to reduce the capital gains tax gap for securities by 

increasing examination coverage of taxpayers with gains or losses from 

securities, either by considering them when selecting taxpayers to examine 

through correspondence or by increasing face-to-face examinations of 

these taxpayers. Conducting more of each type of examination could 

increase the amount of taxes assessed for misreporting securities income. 

However, absent an increase in resources or access to basis information, 

which would help IRS better target its resources toward truly 

noncompliant taxpayers, focusing on taxpayers with securities gains or 

losses would divert IRS’s examination resources away from other 

productive areas of noncompliance, according to IRS officials. An 

increased focus on securities sales could reduce the capital gains tax gap, 

but a diversion of resources could result in greater noncompliance for 

other types of income. Moreover, although increasing examination 

coverage could induce taxpayers who are misreporting willfully to 

voluntarily comply, expanded coverage would not significantly affect 

voluntary compliance for taxpayers who make mistakes while trying to 

38If the data were complete, according to IRS it would be possible to estimate the portion of 

additional taxes IRS assessed that could be attributed to capital gains.
Page 23 GAO-06-603 Capital Gains Tax Gap

comply, such as taxpayers who made errors calculating basis, according to 

an IRS research official who has studied the impact of enforcement on 

taxpayer compliance.

Enhanced Taxpayer 

Services Might Improve 

Taxpayers’ Voluntary 

Compliance, but the Impact 

of Any Changes Would Be 

Hard to Gauge

Addressing capital gains tax noncompliance for securities sales by 

enhancing IRS’s taxpayer service efforts might improve taxpayers’ 

voluntary compliance by helping them to better understand and fulfill their 

capital gains tax obligations for securities. However, the effects of any 

additional guidance that IRS might develop, for example on reporting 

losses or on resources for determining basis, would be tempered by 

challenges similar to those previously discussed, such as taxpayers not 

using or understanding information IRS provides. Although IRS attempts to 

generally ensure tax compliance through its service efforts, IRS 

researchers have found it difficult to determine the extent to which 

taxpayer services improve compliance among taxpayers who want to 

comply. As such, it is hard to know if these improvements to IRS’s service 

efforts would have a substantial impact on taxpayer’s reporting compliance 

for securities sales. 

Regardless, IRS’s instructions for reporting capital gains and losses and 

related guidance do not contain some information related to the causes for 

taxpayers misreporting the basis of securities they sold or failing to report 

sales at all—the leading types of noncompliance when taxpayers erred in 

reporting capital gains and losses. In many cases, we could not determine 

and IRS did not know exactly why taxpayers made these errors. However, 

some taxpayers did not know they had to report gains or losses and others 

did not understand how to determine basis. One counterintuitive situation 

existed among the cases we reviewed, that is some taxpayers did not report 

losses, which generally help them by lowering their tax liabilities. IRS’s 

instructions for filing Schedule D direct taxpayers to report their capital 

gains or losses but the instructions do not clarify the appropriate use of 

capital losses to offset capital gains or other income. Further, although IRS 

provides guidance on how to calculate basis for a variety of securities 

transactions, the instructions to Schedule D do not contain guidance on 

resources available to taxpayers and tax practitioners to determine basis 

for securities. Some examples of resources taxpayers might use to 

determine the basis of their securities holdings include brokers, tax 

preparers, or Web sites for companies that issue stocks or other 

information. Providing taxpayers more information on the benefits of 

reporting losses and resources available to them on calculating basis would 

be consistent with IRS’s responsibility to ensure that taxpayers pay the 
Page 24 GAO-06-603 Capital Gains Tax Gap

right amount of tax. Further, compared to other steps such as enforcement 

actions, providing additional guidance to taxpayers would be a low cost 

option to potentially increase their capital gains reporting compliance. 

Finally, any improvement in taxpayers’ compliance due to better guidance 

would reduce IRS’s enforcement expenses related to capital gains. 

Information Reporting of 

Adjusted Basis Could 

Reduce the Capital Gains 

Tax Gap for Securities

According to IRS officials and some representatives related to the 

securities industry, taxpayers would likely report their gains or losses from 

securities sales more accurately and at a reduced burden if brokers 

consistently provided them with the adjusted basis of the securities they 

sold. Likewise, basis reporting would allow IRS to verify taxpayers’ 

securities gains and losses through its automated enforcement programs 

and take more efficient enforcement actions to address noncompliant 

taxpayers, according to IRS compliance officials. The likely increase in 

taxpayers’ voluntary compliance and in the productiveness of IRS 

enforcement actions resulting from basis reporting would likely 

substantially reduce the capital gains tax gap for securities.

Taxpayers would benefit from basis reporting because, in many cases, they 

would not have to track and compute the adjusted basis of the securities 

they sold. Therefore, basis reporting would likely reduce the chance that 

taxpayers who had not been tracking their adjusted basis would misreport 

it for securities they sold. Also, if taxpayers received basis information 

from their brokers for the securities they sold, they would enjoy a reduced 

burden in filing Schedule D with their tax returns because, in many cases, 

they would not need to make basis calculations on their own. 

For taxpayers, the greater accuracy and reduced burden of reporting basis 

that would result from basis reporting would likely improve their voluntary 

compliance. As shown in figure 2, taxpayers tend to accurately report 

income that third parties report on information returns because the income 

is transparent to taxpayers as well as to IRS. For example, individual 

taxpayers misreport nearly twice the percentage of their income from 

sources subject only to some information reporting, which is the case with 

income from securities sales now, compared to income subject to 

substantial information reporting, such as income from dividends and 

interest, and which would be close to the case for securities sales if basis 

were consistently reported, according to an IRS research official. Also, as 

discussed previously, based on our file review, taxpayers were much less 

likely to misreport capital gain distributions (13 percent), which are similar 

to dividends and are subject to substantial information reporting, 
Page 25 GAO-06-603 Capital Gains Tax Gap

compared to income from securities sales (36 percent), for which 

information reporting only covers gross proceeds but not cost basis. The 

smallest percentage of misreporting is for wage and salary income, for 

which substantial information reporting exists and taxes are withheld by 

taxpayers’ employers. 

Figure 2: Individual Net Income Misreporting Categorized by the Extent of Income 

Subject to Information Reporting, Tax Year 2001 

Cost basis reporting would also benefit IRS, to the extent the reporting was 

complete and accurate. IRS could use basis information to verify securities 

gains and losses through its automated enforcement programs and could 

more effectively allocate its enforcement resources to focus on the most 

noncompliant taxpayers. For AUR and ASFR, IRS officials told us that basis 

information would allow it to more precisely determine taxpayers’ income 

for securities sales and would allow it to identify which taxpayers who 

Percentage of net income misreported

Source: IRS.

0

10

20

30

40

50

60

Little 

or no

reporting

• Nonfarm proprietor 

 income

• Informal supplier 

 income

• Other income

• Rents and royalties

• Farm income

• Form 4947 income

• Adjustments

Some 

information

reporting

• Capital gains

• Deductions

• Partnership/S-Corp

 income

• Exemptions

• Alimony income

Substantial

information

reporting

• Pensions and annuities

• Dividend income

• Interest income

• Unemployment

 compensation

• Social Security benefits

Substantial

information reporting

and withholding

• Wages and salaries

1.2

53.9

8.6

4.5
Page 26 GAO-06-603 Capital Gains Tax Gap

misreported securities income have the greatest potential for additional tax 

assessments. IRS’s examination program could similarly benefit. 

Specifically, IRS officials told us that receiving cost basis information might 

enable IRS to examine noncompliant taxpayers through correspondence 

because it could productively select tax returns to examine. Also, having 

cost basis information could help IRS identify the best cases to examine 

face-to-face, making the examinations more productive while 

simultaneously reducing the burden imposed on compliant taxpayers who 

otherwise would be selected for examination. As a result of all these 

benefits, basis reporting would allow IRS to better allocate its resources 

that focus on securities misreporting across its enforcement programs.

IRS has endorsed the concept of matching information returns to tax 

returns for the purpose of identifying unreported income since the 1960s 

and Congress has created a number of statutes requiring information 

reporting for various types of income or taxpayer information.39 The 

related GAO products section at the end of this report provides references 

to selected GAO reports related to information reporting.

We previously discussed the notion of basis reporting to help reduce capital 

gains tax noncompliance in our May 1994 report on the tax gap.40 Also, 

based on discussions we had with officials from IRS’s Taxpayer Advocate 

Service when we initiated our review, the National Taxpayer Advocate 

recommended that brokers be required to track and report cost basis for 

stocks and mutual funds in her 2005 Annual Report to Congress.

41 In 

March 2006 a bill was introduced in the U.S. Senate and in April and May 

2006 bills were introduced in the House of Representatives that would 

require brokers to report taxpayers’ basis for their securities transactions.42

39For a list of major legislation affecting IRS’s information returns program, see GAO-03-378.

40GAO, Tax Gap: Many Actions Taken, But a Cohesive Compliance Strategy Needed, 

GAO/GGD-94-123 (Washington, D.C.: May 11, 1994).

41Internal Revenue Service, Taxpayer Advocate Service, National Taxpayer Advocate 2005 

Annual Report to Congress (Washington, D.C.: Dec. 31, 2005).

42S. 2414, 109th Cong. §2 (2006), H.R. 5176, 109th Cong. §206 (2006), and H.R. 5367, 109th Cong. 

§2 (2006).
Page 27 GAO-06-603 Capital Gains Tax Gap

Expanding Basis Reporting 

Involves Implementation 

Challenges That Would 

Need to Be Addressed

Expanding information reporting on securities sales to include basis 

information would involve challenges for brokers and IRS. There are 

various ways to mitigate each challenge. Tables 7 and 8 list some major 

challenges for brokers and IRS, respectively, as well as some ways to start 

mitigating the challenges. Discussion after the tables covers some issues to 

consider when evaluating these mitigation strategies. 

Table 7: Challenges to Brokers Associated with Basis Reporting and How the 

Challenges Could Be Mitigated 

Challenges to brokers Ways to mitigate challenges

Implementing systems to track 

and report basis involves 

monetary costs

• Although the following do not directly mitigate costs 

for all brokers,

• Many brokers and mutual funds already track and 

report basis to many taxpayers, which could help 

form a foundation for expanded basis reporting

• Brokers could leverage existing systems that track 

and report gross proceeds to taxpayers and IRS

• Congress or IRS could provide an appropriate 

effective date that would allow brokers that lack 

such systems to develop them

Brokers may not be able to 

determine basis for some 

securities transactions because of 

complex tax laws

• Brokers could report on those securities 

transactions not affected by complex tax laws

• Tax laws on selling securities could be simplifieda

• Absent tax law changes, IRS could develop 

consistent reporting rules in concert with those who 

report

Brokers may not know basis for 

securities purchased through 

another broker 

• Brokers could use an existing system that allows 

them to transfer basis information when taxpayers 

move their securities holdings from one broker to 

another

Brokers may not know basis for 

securities purchased through 

companies that directly issue 

stock (e.g., employee stock 

purchase plans)

• Companies that directly issue stock could track and 

report basis and use the basis transfer system 

Brokers may not know basis for 

older securities

• Brokers could track and report basis prospectively 

(i.e., only for securities purchased after a particular 

date) 

Brokers that do not know the basis 

may rely on taxpayers to provide 

basis without any verification (e.g., 

for stocks received as gifts)

• Prospective reporting would likely produce fewer 

cases in which the broker does not know the basis 

• Brokers could indicate on the information return if 

the basis information came from taxpayers
Page 28 GAO-06-603 Capital Gains Tax Gap

Source: GAO.

a

Tax code simplification is a method through which some believe tax compliance could be enhanced. 

See GAO, Understanding the Tax Reform Debate: Background, Criteria, & Questions, GAO-05-

1009SP (Washington, D.C.: September 2005).

Table 8: Challenges to IRS Associated with Basis Reporting and How the 

Challenges Could Be Mitigated 

Source: GAO.

Although not all inclusive, the strategies discussed above could help 

mitigate many of the challenges facing brokers and IRS if information 

reporting were expanded to include cost basis. However, the strategies also 

involve a number of trade-offs that would need to be considered in terms of 

the costs and burdens associated with basis reporting for taxpayers, IRS, 

Brokers cannot always obtain 

timely adjusted basis information 

from companies that issue stock 

and engage in corporate events 

(e.g., mergers, acquisitions) 

• These companies and the securities industry in 

concert with IRS could develop a system to timely 

make such information available on corporate 

events that affect basis 

Challenges to IRS Ways to mitigate challenges

Expanding IRS’s computer system 

capacity to store and use 

additional data on basis involves 

monetary costs

• Cost to implement system would be outweighed by 

increased tax revenue resulting from higher 

voluntary reporting compliance (although such 

funds would not be IRS’s to directly use)

• Funds could be budgeted to cover these costs

IRS systems may not be able to 

process and match basis for each 

securities sale reported on 

information returns and on 

Schedule D of the Form 1040 

(including any attachments on the 

securities sold) 

• Brokers could report aggregate adjusted basis for 

all securities sold for a taxpayer on the information 

return while reporting adjusted basis for all sales on 

annual statements provided to taxpayers

IRS may still encounter taxpayers 

that misclassify the holding period 

for their securities sales

• Brokers could report aggregate basis and gross 

proceeds for short-term and long-term transactions 

separately on the information return 

Taxpayers may improperly report 

basis when they sell portions of 

their holdings in a security that 

they purchased on multiple 

occasions 

• Allow taxpayers to use the average costs of their 

securities holdings to determine basis for securities 

beyond mutual funds

• Taxpayers could indicate the method they will use to 

determine basis when their security is sold and 

brokers then would report the method selected and 

the related basis amount on the information return

(Continued From Previous Page)

Challenges to brokers Ways to mitigate challenges
Page 29 GAO-06-603 Capital Gains Tax Gap

and brokers, and the impact on reducing the capital gains tax gap for 

securities. 

Representatives from the securities industry we interviewed said that 

brokers would incur additional costs to develop and maintain systems to 

track and report basis, although they did not provide precise costs. 

However, we were also told that almost all of the largest brokers directly 

provide basis information to a significant portion of their clients, and many 

smaller brokers provide basis to a significant portion of their clients 

through outsourcing. Also, representatives of the mutual fund industry 

estimated that 80 to 90 percent of mutual funds provide average cost basis 

information to their shareholders. Likewise, from a societal perspective, 

the cost that brokers would incur in reporting basis information would be 

offset to some extent by the reduced costs to taxpayers in researching, 

calculating, and reporting basis, or paying a return preparer to perform 

such services. However, some brokers may pass on the costs of reporting 

basis information to their customers. Further, decisions about the scope 

and details of basis reporting, as further discussed below, could constrain 

how much brokers’ costs would increase.43

Also, representatives from the securities industry told us that their ability 

to provide taxpayers and IRS with accurate basis information would be 

challenged when taxpayers move their securities holdings from one broker 

to another. Some brokers use a system to transfer basis among one another, 

but the system is not used by all brokers. In addition, brokers do not always 

track and transfer basis in a consistent manner; that is, some track original 

cost basis while others track adjusted cost basis. Without a system through 

which all brokers transfer standardized basis information, the effectiveness 

of basis reporting would be limited.

Additionally, brokers do not always know or may be challenged in 

determining the basis of taxpayers’ holdings. For example, some taxpayers 

may hold securities that they purchased long ago or received as a gift, for 

which neither they nor their brokers know the original purchase dates. In 

these cases, brokers cannot know the basis of the securities. However, this 

challenge could be mitigated to a large extent if brokers were to track and 

43Although IRS has not estimated the costs to taxpayers of filing Schedule D, taxpayers 

spend billions of dollars every year in complying with their tax obligations. See GAO, Tax 

Policy: Summary of Estimates of the Costs of the Federal Tax System, GAO-05-878

(Washington, D.C.: Aug. 26, 2005).
Page 30 GAO-06-603 Capital Gains Tax Gap

report basis prospectively, that is, only for securities purchased after a 

specified future date. The trade-off to prospective basis reporting, however, 

is that it would not help some taxpayers report basis for securities they 

owned before brokers began to report basis, which for a period of time 

would limit the impact basis reporting would have on reducing the tax gap. 

Also, prospective reporting would be complicated in cases where a 

taxpayer held a security prior to the specified date and then purchased 

additional shares of the same security after the specified date. Brokers 

would likely incur some additional costs to separately account for shares of 

stock purchased before and after the specified date for prospective 

reporting on information returns. 

Likewise, it is difficult for brokers to determine basis for some complicated 

securities transactions, according to representatives of the securities 

industry. For example, when taxpayers sell stock for a loss and then buy 

shares of the same stock within 30 days, they are prohibited from claiming 

a loss on the original sale. For these sales, known as wash sales, basis is 

difficult for the broker to determine because the taxpayer is required to add 

the disallowed loss from the wash sale to the basis of the subsequently 

purchased stock. The difficulty in determining basis for wash sales is 

compounded when taxpayers sell a stock at a loss through one broker and 

then buy the same stock within 30 days from another broker. In this case, 

the second broker would not know of the wash sale the taxpayer executed 

through the first broker and would not know to adjust the taxpayer’s basis 

accordingly. We only found two cases through our file review where 

taxpayers had misreported basis because of wash sales. Regardless, 

transactions such as wash sales may be too complex for brokers to feasibly 

report basis. Excluding these transactions from basis reporting, however, 

would further reduce the impact of basis reporting on closing the securities 

tax gap.

For IRS, having basis information, along with gross proceeds information, 

for each of a taxpayer’s securities sales would best enable the agency to 

check whether taxpayers properly reported their capital gains and losses. 

However, storing and making use of such information would be challenging 

because of the costs and difficulty involved in storing and computer 

matching the large volume of information that transactional reporting 

would entail. However, if brokers were to report only aggregate basis 

amounts to IRS for all of a taxpayer’s transactions, the costs and difficulties 

of storing and using the information for matching would be reduced. 

Aggregate reporting would also reduce the costs to brokers of reporting 
Page 31 GAO-06-603 Capital Gains Tax Gap

basis to IRS, although they could still report basis for all transactions to 

taxpayers.

Another complication for IRS and brokers is that taxpayers can choose 

among various methods for reporting basis in cases where they sell some of 

their shares of a security they purchased on multiple occasions. Taxpayers 

may choose to report basis in a different way than brokers would otherwise 

choose because taxpayers can (1) specifically identify which shares they 

sell among many they hold and report basis for those shares; (2) use the 

basis of the first shares they bought; or (3) in the case of mutual funds, use 

the average cost of the shares they own.44 Taxpayers could indicate the 

method they chose to determine basis when they sell their securities, and 

brokers then could report the method selected and the related basis 

amount on information returns. However, this additional layer of tracking 

would likely add to costs to taxpayers, brokers, and IRS. Although this 

challenge could be alleviated if taxpayers were required to report basis in a 

consistent manner, this requirement would end taxpayers’ ability to 

determine basis in the most advantageous manner for their particular tax 

situations.

Given the number of decisions that would need to be made in conjunction 

with basis reporting, IRS may not be able to require such reporting given its 

current authority. Although IRS has long had the authority to require 

information reporting related to securities, an official from IRS’s Office of 

Chief Counsel told us that IRS may not have the authority to require all of 

the actions that would be needed to implement cost basis information 

reporting, such as regulating a system through which brokers transfer 

standardized basis information. Therefore, it may be difficult for IRS to 

implement cost basis information reporting without further statutory 

authority. 

Representatives from the securities industry told us that in order to 

implement basis reporting, a set of rules would need to be developed to 

clearly establish, for example, what types of securities transactions would 

be covered by any requirement and how a system to transfer basis would 

44Taxpayers who own mutual funds face similar choices through reinvested dividends. 

However, tracking and computing cost basis for dividend reinvestments may not be as 

challenging to track because mutual funds shareholders can use the average costs of their 

holdings to determine basis, a method that cannot be used for stocks or other securities.
Page 32 GAO-06-603 Capital Gains Tax Gap

be standardized. These representatives thought their input could be helpful 

in designing any set of rules.

Conclusion Although neither IRS nor we know the size of the tax gap related to 

securities sales, tens of millions of taxpayers hold securities outside of 

their retirement accounts and, according to our analysis of IRS data, an 

estimated 36 percent of taxpayers who sold securities in 2001 erred in 

reporting their gains and losses (an estimated 7.3 million out of an 

estimated 20.3 million taxpayers). Of those erring, an estimated 64 percent 

underreported their income and 33 percent overreported income. Also, an 

estimated 9 percent of individual taxpayers who sold securities 

misclassified their holding periods, either reporting short-term holdings as 

long-term, or vice versa. Enhancing IRS’s current enforcement and service 

efforts is an option for addressing these compliance problems, but the most 

effective tool for improving taxpayers’ compliance levels has long been 

information reporting and tax withholding. Individual taxpayers misreport 

nearly twice the percentage of their income from sources subject only to 

some information reporting—which is the case for securities income 

now—compared to income subject to substantial information reporting. 

Also, given that the tax consequences associated with the holding period of 

securities are significant, broker reporting on this specific issue, whether 

as part of basis reporting or separately, would help taxpayers apply the 

proper tax rules to their gains or losses and help IRS in identifying 

compliance problems. 

Extending information reporting for securities sales to include basis 

information is not a simple and straightforward proposition. The manner in 

which basis reporting is designed would affect how the costs of basis 

reporting are distributed among taxpayers, brokers, and IRS, and the 

extent to which basis reporting would close the securities-related tax gap. 

In addition, although IRS has the general authority to require basis 

reporting, IRS officials were not certain the agency had sufficient authority 

to regulate how such reporting is implemented, such as regulating a system 

through which brokers transfer standardized basis information.

In the event that brokers were required to report basis for securities 

purchased as of a specific future date, some taxpayers may continue to 

misreport their gains and losses from the securities holdings they currently 

hold. For these taxpayers, additional guidance on reporting basis and gains 

or losses for securities sales could be a low cost way to help them 

voluntarily comply with their tax obligations. For example, an estimated 28 
Page 33 GAO-06-603 Capital Gains Tax Gap

percent of taxpayers who failed to report their securities sales had losses. 

Clarification of IRS’s instructions for Schedule D on the appropriate use of 

capital losses to offset capital gains or other income could be a means to 

help ensure that taxpayers do not disadvantage themselves when they 

experience losses from their investments. Also, given the complexity 

involved in determining some securities’ basis because of events such as 

stock splits, guidance on the resources available to taxpayers on 

determining basis, such as utilizing brokers, or services offered by 

companies that issue stocks or other information available on Web sites, 

could help improve taxpayers’ ability to determine their securities’ basis. 

Matters for 

Congressional 

Consideration

In order to reduce the capital gains tax gap for securities, Congress may 

want to consider requiring brokers to report to both taxpayers and IRS the 

adjusted basis of securities that taxpayers sell and ensuring that IRS has 

sufficient regulatory authority to implement the requirement. Either in 

connection with requiring basis reporting or separately, Congress could 

also require brokers to report to taxpayers and IRS whether the securities 

sold were short-term or long-term holdings. Additionally, Congress could 

direct IRS to work with brokers and related parties to develop rules that 

seek to mitigate some of the challenges associated with requiring basis 

reporting. 

Recommendations for 

Executive Action

To assist taxpayers in accurately reporting their capital gains and losses 

from securities, in the instructions to Schedule D the Commissioner of 

Internal Revenue should (1) clarify the appropriate use of capital losses to 

offset capital gains or other income and (2) provide guidance on resources 

available to taxpayers to determine their basis.

Agency Comments and 

Our Evaluation

In written comments on a draft of this report, which are reprinted in 

appendix II, the Commissioner of Internal Revenue agreed with our 

recommendations. He also concurred that for some securities, basis 

reporting involves unique challenges and noted that IRS is committed to 

working with industry stakeholders to develop cost effective methods to 

mitigate such reporting challenges. IRS also provided comments on several 

technical issues, which we incorporated in this report where appropriate.

As agreed with your offices, unless you publicly announce its contents 

earlier, we plan no further distribution of this report until 30 days from its 
Page 34 GAO-06-603 Capital Gains Tax Gap

issue date. At that time, we will send copies to the Chairman and Ranking 

Minority Member, House Committee on Ways and Means; the Secretary of 

the Treasury; the Commissioner of Internal Revenue; and other interested 

parties. Copies will be made available to others upon request. This report 

will also be available at no charge on GAO’s Web site at http://www.gao.gov.

If you or your staff have any questions, please contact me at (202) 512-9110 

or brostekm@gao.gov. Contact points for our Offices of Congressional 

Relations and Public Affairs may be found on the last page of this report. 

Key contributors to this report are listed in appendix III.

Michael Brostek

Director, Tax Issues

Strategic Issues Team
Page 35 GAO-06-603 Capital Gains Tax Gap

Appendix I

Scope and Methodology AAppenednxidexiIs

To provide information on the extent of and primary types of 

noncompliance that cause individual taxpayers to misreport capital gains 

from securities, we performed a number of activities that relied on data 

from IRS’s National Research Program (NRP). Through NRP, IRS selected 

and reviewed a stratified random sample of 45,925 individual income tax 

returns from tax year 2001. The NRP sample is divided across 30 strata by 

the type of individual tax return filed and income levels. IRS accepted as 

filed some of the NRP returns, accepted others with minor adjustments, 

and examined the remainder of returns either through correspondence or 

face-to-face meetings with taxpayers. If IRS examiners determined that 

taxpayers misreported income for any aspect of the selected tax returns, 

they adjusted the taxpayers’ income accordingly and assessed additional 

taxes.

IRS captured data from taxpayer returns and examination results in the 

NRP database, including capital gains income. However, the data on capital 

gains do not indicate the type of capital asset for which taxpayers reported 

gains or losses or for which examiners made income adjustments. 

Therefore, to obtain information on the extent and primary types of capital 

gains tax noncompliance specific to securities, we selected a statistical 

sample of NRP examination files to review.

The sample we selected contained 1,017 cases spread across 90 substrata, 

defined by replicating each of the 30 NRP strata across 3 GAO substrata. 

The first GAO substratum consisted of examination cases for which the 

adjustments to capital gain income the examiners made had the largest 

impact on the total amount of these adjustments for all taxpayers when 

weighted for the entire population of individual taxpayers. We focused on 

cases with the largest adjustments, in weighted terms, because including 

these cases would improve the level of confidence of any estimates of the 

total amount of capital gains income adjustments for securities. Because 

our sample is a subsample of the NRP sample and is subject to sampling 

error, we added cases, when applicable, to ensure that each of the 30 NRP 

strata in this GAO substratum contained a minimum of 5 cases. In total, we 

selected 290 cases for the first GAO substratum, and these cases accounted 

for around 75 percent of the total capital gains adjustments in NRP when 

weighted for the population of individual taxpayers.

The second substratum consisted of 187 cases for which IRS did not 

identify misreported capital gains income when it reviewed or examined 

the tax returns. We included these returns as part of our sample to verify 

that the NRP examinations had correctly recorded when taxpayers were 
Appendix I

Scope and Methodology

Page 36 GAO-06-603 Capital Gains Tax Gap

compliant with respect to reporting capital gains and losses. We selected 

these cases at random and in proportion to the NRP sample through an 

iterative process, ensuring that a minimum of 5 cases and a maximum of 15 

cases was included in each of the 30 NRP strata. 

The remaining 540 cases that constitute the third GAO substratum were 

selected from cases for which IRS examined taxpayers’ capital gain 

income. We selected these cases at random and in proportion to the 

number of NRP returns for which IRS examined capital gains income, 

ensuring that we selected a minimum of 5 cases for each NRP stratum. For 

one stratum, we only included 2 cases because they were the only cases in 

the corresponding NRP stratum.

Of the 1,017 cases we selected for our sample, we reviewed 849 cases. We 

did not review the remaining 168 cases because either IRS did not provide 

the files in time to include in our review (164 cases) or the files did not 

contain examination workpapers essential to determining if examiners 

made adjustments to taxpayers income from securities (4 cases).1

 Based on 

an analysis of the response rates by the 90 GAO substrata, we concluded 

that the missing cases did not bias our analyses. We requested the cases at 

two points, in late-December 2005 and late-January 2006, and periodically 

checked on the status of our requests with IRS. We were only able to 

review cases that arrived by April 21, 2006 in order to meet our agreed upon 

issue date for the report. 

We reviewed each selected case file to determine if the taxpayers reported 

securities transactions on their returns or if examiners discovered any 

misreported securities transactions. For returns where examiners 

discovered misreported income from securities transactions, we 

determined, when possible, the related security type, holding period, 

adjustment amount, and reason for the adjustment, along with other 

information. We recorded all determinations on a data collection 

instrument (DCI) that we developed. 

To ensure that our data collection efforts conformed to GAO’s data quality 

standards, each DCI that a GAO analyst completed was reviewed by 

another GAO analyst. The reviewers compared the data recorded on the 

DCI to the data in the corresponding case file to determine whether they 

1

IRS could not provide one of these cases that was not yet closed because it was with IRS’s 

Appeals function. 
Appendix I

Scope and Methodology

Page 37 GAO-06-603 Capital Gains Tax Gap

concurred with how the data were recorded. When the analysts differed on 

how the data were recorded, they met to reconcile any differences.

We input the data we recorded on the DCIs into a computer data collection 

program. To ensure the accuracy of the transcribed data, each electronic 

DCI entry was compared to its corresponding paper DCI by analysts other 

that those that electronically entered the data. If the reviewers found any 

errors, changes were made to the electronic entries, and the entries were 

reviewed again to ensure that all data were transcribed accurately. 

The estimates we included in this report were based on the NRP database 

and the data we collected through our file review and were generated using 

statistical software. All computer programming for the resulting statistical 

analyses were checked by a second, independent analyst. Our final sample 

size was large enough to generalize the results of our review or had margins 

of error small enough to produce meaningful estimates in terms of 

percentages of taxpayers who were noncompliant in reporting capital gains 

from securities transactions. However, we could not produce meaningful 

estimates of the total amount of net misreported capital gain income from 

securities or determine the securities tax gap, in part because (1) in 

selecting our sample, we could not distinguish which cases included 

misreported securities transactions as opposed to misreported 

transactions for other types of capital assets, (2) some cases with large 

amounts of misreported capital gains or losses were due to noncompliance 

for assets other than securities, (3) 53 of the cases we requested from IRS 

from our first substratum, which represented a large percentage of the total 

amounts of misreported capital gains or losses, were not provided in time 

to include in our review, and (4) taxpayers misreported a wide range of 

dollar amounts from the transactions.2

 We discussed our estimates with 

IRS officials to obtain their perspectives on the results of our analysis. 

Because we followed a probability procedure based on random selection, 

our sample is only one of a large number of samples that we might have 

selected. Since each sample could have resulted in different estimates, we 

express our confidence in the precision of our particular sample’s results as 

a 95 percent confidence interval, plus or minus the margin of error 

indicated along with each estimate in the report. This interval would 

2

IRS could not provide one of these cases that was not yet closed because it was with IRS’s 

Appeals function. 
Appendix I

Scope and Methodology

Page 38 GAO-06-603 Capital Gains Tax Gap

contain the actual population value for 95 percent of the samples we could 

have selected.

We assessed whether the examination results and data contained in the 

NRP database were sufficiently reliable for the purposes of our review. For 

this assessment, we interviewed IRS officials about the data, collected and 

reviewed documentation about the data and the system used to capture the 

data, and performed electronic testing of relevant data fields for obvious 

errors in accuracy and completeness. We compared the information we 

collected through our case file review to corresponding information in the 

NRP database to identify inconsistencies. Based on our assessment, we 

determined that the NRP database was sufficiently reliable for the 

purposes of our review.

We also used IRS’s Statistics of Income (SOI) file for individual taxpayers, 

which relies on a stratified probability sample of individual income tax 

returns, to develop estimates for categories of individual taxpayers on 

adjusted gross income, the percentage of individual taxpayers that used 

paid tax preparers, and the number of taxpayers that filed a Schedule D 

with their tax returns for tax year 2003. We compared our analyses against 

published IRS data to determine that the SOI database was sufficiently 

reliable for the purposes of our review.

To provide information on actions IRS takes in attempting to reduce the 

individual capital gains tax gap for securities and on challenges that IRS 

faces with these actions, we reviewed documents from IRS compliance 

programs as they related to capital gains and interviewed IRS officials 

knowledgeable about the subject. We reviewed documentation for IRS’s 

enforcement programs that address capital gains and reviewed IRS 

publications and other documents that provided information on how to 

accurately report capital gains and losses. To provide additional 

information on IRS’s compliance programs and identify challenges IRS 

faces in using these programs to reduce the individual capital gains tax gap 

for securities, we interviewed IRS officials from various areas of the 

agency, including the enforcement, taxpayer service, and research 

functions.

To identify options with the potential to improve taxpayers’ voluntary 

compliance for reporting securities gains and losses and IRS’s ability to find 

noncompliance related to the individual capital gains tax gap for securities, 

we reviewed prior GAO reports and other documents on capital gains 

reporting and compliance such as those from IRS compliance programs 
Appendix I

Scope and Methodology

Page 39 GAO-06-603 Capital Gains Tax Gap

and industry reports on securities holdings and information reporting. We 

also spoke with IRS officials and numerous representatives from, and 

related to, the securities industry. At IRS, we spoke with officials from 

various areas of the agency, including the enforcement, taxpayer service, 

and research functions. Additionally, we spoke with officials from the 

Taxpayer Advocate Service and members of IRS’s Information Return 

Program Advisory Committee (IRPAC).3

 We also spoke with 

representatives of the Securities Industry Association; Investment 

Company Institute, which represents the mutual fund industry; Bond 

Market Association; American Banking Association Securities Association; 

American Institute of Certified Public Accountants; and the American Bar 

Association to get their perspectives on capital gains tax noncompliance, 

ways to reduce noncompliance, and any challenges related to reducing 

noncompliance and how those challenges could be mitigated.

3

IRPAC advises IRS on information reporting issues of mutual concern to the private sector 

and federal government. It is composed of 17 members who represent various private and 

public sector organizations with an interest in, or responsibility for, information reporting.
Page 40 GAO-06-603 Capital Gains Tax Gap

Appendix II

Comments from the Internal Revenue Service ApendxiI
Appendix II

Comments from the Internal Revenue Service

Page 41 GAO-06-603 Capital Gains Tax Gap
Appendix II

Comments from the Internal Revenue Service

Page 42 GAO-06-603 Capital Gains Tax Gap
Page 43 GAO-06-603 Capital Gains Tax Gap

Appendix III

GAO Contact and Staff Acknowledgments ApendxiI

GAO Contact Michael Brostek, (202) 512-9110 or brostekm@gao.gov

Acknowledgments In addition to the contact named above, Wes Phillips and Tom Short, 

Assistant Directors; Jeff Arkin; Susan Baker; Candace Carpenter; Keira 

Dembowski; Fred Jimenez; Matthew Keeler; Donna Miller; John Mingus; 

Franklin Ng; Karen O’Conor; Cheryl Peterson; Sam Scrutchins; Jay Smale; 

and Jennifer Li Wong made key contributions to this report.
Page 44 GAO-06-603 Capital Gains Tax Gap

Related GAO Products

Tax Gap: Making Significant Progress in Improving Tax Compliance 

Rests on Enhancing Current IRS Techniques and Adopting New 

Legislative Actions. GAO-06-453T. Washington, D.C.: February 15, 2006.

Tax Gap: Multiple Strategies, Better Compliance Data, and Long-term 

Goals Are Needed to Improve Taxpayer Compliance. GAO-06-208T. 

Washington, D.C.: October 26, 2005. 

Tax Compliance: Better Compliance Data and Long-term Goals Would 

Support a More Strategic IRS Approach to Reducing the Tax Gap. GAO-05-

753. Washington, D.C.: July 18, 2005. 

Tax Compliance: Reducing the Tax Gap Can Contribute to Fiscal 

Sustainability but Will Require a Variety of Strategies. GAO-05-527T. 

Washington, D.C.: April 14, 2005. 

Tax Administration: More Can Be Done to Ensure Federal Agencies File 

Accurate Information Returns. GAO-04-74. Washington, D.C.: December 5, 

2003.

Tax Administration: IRS Should Continue to Expand Reporting on Its 

Enforcement Efforts. GAO-03-378. Washington, D.C.: January 31, 2003. 

Tax Administration: IRS Can Improve Information Reporting for 

Original Issue Discount Bonds. GAO/GGD-96-70. Washington, D.C.: March 

15, 1996. 

Reducing the Tax Gap: Results of a GAO-Sponsored Symposium. 

GAO/GGD-95-157. Washington, D.C.: June 2, 1995. 

Options Reporting to IRS. GAO/GGD-95-145R. Washington, D.C.: May 5, 

1995. 

Tax Gap: Many Actions Taken, But a Cohesive Compliance Strategy 

Needed. GAO/GGD-94-123. Washington, D.C.: May 11, 1994. 

Tax Administration: Computer Matching Could Identify Overstated 

Business Deductions. GAO/GGD-93-133. Washington, D.C.: August 13, 

1993. 

Information Reporting. GAO/GGD-93-55R. Washington, D.C.: July 22, 1993.
Related GAO Products

Page 45 GAO-06-603 Capital Gains Tax Gap

Tax Administration: Information Returns Can Improve Reporting of 

Forgiven Debts. GAO/GGD-93-42. Washington, D.C.: February 17, 1993. 

Tax Administration: Overstated Real Estate Tax Deductions Need to Be 

Reduced. GAO/GGD-93-43. Washington, D.C.: January 19, 1993. 

Tax Administration: Federal Agencies Should Report Service Payments 

Made to Corporations. GAO/GGD-92-130. Washington, D.C.: September 22, 

1992. 

Tax Administration: Approaches for Improving Independent Contractor 

Compliance. GAO/GGD-92-108. Washington, D.C.: July 23, 1992. 

Tax Administration: Benefits of a Corporate Document Matching 

Program Exceed the Costs. GAO/GGD-91-118. Washington, D.C.: September 

27, 1991. 

IRS Needs to Implement a Corporate Document Matching Program. 

GAO/T-GGD-91-40. Washington, D.C.: June 10, 1991. 

Tax Administration IRS Can Improve Its Program to Find Taxpayers 

Who Underreport Their Income. GAO/GGD-91-49. Washington, D.C.: March 

13, 1991. 

Tax Administration: Expanded Reporting on Seller-financed Mortgages 

Can Spur Tax Compliance. GAO/GGD-91-38. Washington, D.C.: March 29, 

1991.

IRS’ Compliance Programs to Reduce the Tax Gap. GAO/T-GGD-91-11. 

Washington, D.C.: March 13, 1991. 

IRS Can Use Tax Gap Data to Improve Its Programs for Reducing 

Noncompliance. GAO/T-GGD-90-32. Washington, D.C.: April 19, 1990. 

Tax Administration: Information Returns Can Be Used to Identify 

Employers Who Misclassify Workers. GAO/GGD-89-107. Washington, D.C.: 

September 25, 1989. 

Tax Administration: Missing Independent Contractors’ Information 

Returns Not Always Detected. GAO/GGD-89-110. Washington, D.C.: 

September 8, 1989. 
Related GAO Products

Page 46 GAO-06-603 Capital Gains Tax Gap

Tax Administration: IRS’ Efforts to Establish a Business Information 

Returns Program. GAO/GGD-88-102. Washington, D.C.: July 22, 1988. 

The Merits of Establishing a Business Information Returns Program.

GAO/T-GGD-87-4. Washington, D.C.: March 17, 1987.

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Automated answering system: (800) 424-5454 or (202) 512-7470

Congressional 

Relations

Gloria Jarmon, Managing Director, JarmonG@gao.gov (202) 512-4400

U.S. Government Accountability Office, 441 G Street NW, Room 7125 

Washington, D.C. 20548

Public Affairs Paul Anderson, Managing Director, AndersonP1@gao.gov (202) 512-4800

U.S. Government Accountability Office, 441 G Street NW, Room 7149 

Washington, D.C. 20548