Tax Compliance: Challenges to Corporate Tax Enforcement and Options to Improve Securities Basis Reporting
Published: 2006-06-13T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Corporate income taxes are expected to bring in about $277 billion in 2006 to help fund the activities of the federal government. Besides raising revenue, the tax alters investment decisions and raises concerns about competitiveness in an environment of increasing global interdependency. The complexity of the tax breeds tax avoidance, including an estimated $32 billion of noncompliance detected by the Internal Revenue Service (IRS). This testimony provides information on trends in corporate taxes and opportunities to improve corporate tax compliance. Congress also asked that GAO discuss recent work on the misreporting of capital gains income from securities sales and options to improve compliance. This statement is based largely on previously published GAO work.
section_title: What GAO Found
paragraphs: The corporate income tax is an important source of federal revenue and must be considered in dealing with the nation's long-term fiscal imbalance. Reexamining both federal spending and revenues, including corporate tax policy, corporate tax expenditures and corporate tax enforcement must be part of a multi-pronged approach to address the imbalance. The total amount of corporate tax avoidance, which includes the $32 billion in noncompliance estimated by IRS, is unknown. A complex tax code, complex business transactions, and often multinational corporate structures make determining corporate tax liabilities and the extent of corporate tax avoidance a challenge. Opportunities exist to improve corporate tax compliance and include simplifying the tax code, obtaining better data on noncompliance, continuing to oversee the effectiveness of IRS enforcement, leveraging technology, and sending sound compliance signals through increased collections of taxes owed. In a companion report issued today, GAO found that many taxpayers misreport capital gains or losses, sometimes inappropriately underpaying their taxes and sometimes overpaying them. IRS has efforts in place to help ensure proper reporting of capital gains and losses, but these efforts face several obstacles. GAO found that expanding third-party information reporting on the cost basis of capital assets could help mitigate this problem if related problems are addressed. GAO suggested that Congress consider requiring brokers to report adjusted basis to taxpayers and IRS and requiring IRS to work with the securities industry to develop cost-effective ways to mitigate reporting challenges. GAO also recommended that IRS clarify its guidance on reporting capital gains and losses.

section_title: Letter
paragraphs: I appreciate the opportunity to discuss the corporate income tax with you  as well as our work on options for improving taxpayers’ voluntary  compliance in reporting their capital gains or losses from the sales of  securities. As the Committee is well aware, the U.S. position in the  worldwide economy has fundamentally changed and the structure and  composition of our economy has shifted. U.S. workers and firms must now  succeed in a world of fast-paced technological change and constantly  evolving global competition. This raises two sets of questions about the  corporate income tax. The first is about reforming the overall U.S. tax  system and perhaps changing the role of corporate taxes. The second set  of questions is about how to administer and enforce the existing corporate  income tax in a changing world. As per your request, my statement focuses  principally on this question.
The complexity of the corporate income tax generates opportunities for  tax avoidance that can be categorized as clearly legal, clearly  noncompliant (illegal), or of uncertain legality. Corporate tax base is  reduced by statutory corporate tax expenditures, legal and illegal tax  avoidance, and deliberate underreporting of income. The overall amount  of tax base reduction is unknown but the Internal Revenue Service (IRS)  has estimated the amount of clear noncompliance to total $32 billion  for tax year 2001. Corporate tax avoidance in its various forms  reduces overall federal revenue or, for the government to take in the same  revenue, means that other taxpayers pay more.
My statement today makes the following points:    Although less of a revenue source than it once was, the corporate  income tax is one of the pillars of the federal tax system. The $277  billion in corporate tax revenues that the Office of Management and  Budget (OMB) estimates will be paid in fiscal year 2006 must be part of  overall considerations for dealing with the nation’s long-term fiscal  imbalance. More specifically, corporate tax policy, corporate tax  expenditures and corporate tax enforcement all must be part of a  multi-pronged approach that reexamines both federal spending and  revenues.
Determining corporate income tax liabilities and the extent of  corporate tax avoidance is a challenge because of the complex tax  code, complex business transactions and often multinational corporate  structures. Opportunities exist to improve corporate tax compliance,  such as simplifying the tax code, obtaining better data to the extent  feasible on noncompliance, continuing to oversee the effectiveness of  IRS’s efforts, continuing to leverage technology, and sending sound  compliance signals through such things as increased effectiveness in  collecting taxes owed.
Also, at your request, I have included a section in this statement that  discusses our findings in the area of capital gains basis reporting. In  summary, we found that many taxpayers misreport capital gains or losses,  sometimes inappropriately underpaying their taxes and sometimes  overpaying them. IRS has efforts in place to help ensure proper reporting  of capital gains and losses, but these efforts face several obstacles. Finally,  we found that expanding third-party information reporting on the cost  basis of capital assets could help mitigate this problem if related problems  are addressed.
My statement today is largely drawn from previous GAO reports and  testimonies, which were done in accordance with generally accepted  government auditing standards. We also relied on other published  information for the sections of this statement dealing with corporate  taxation. The latter part of this statement discusses capital gains basis  reporting and is drawn from the report on that subject we are releasing  today.
subsections: section_title: Background
paragraphs: The base of the federal corporate income tax includes net income from  business operations (receipts, minus the costs of purchased goods, labor,  interest, and other expenses). It also includes net income that  corporations earn in the form of interest, dividends, rent, royalties, and  realized capital gains. The statutory rate of tax on net corporate income  ranges from 15 to 35 percent, depending on the amount of income earned.
The United States taxes the worldwide income of domestic corporations,  regardless of where the income is earned, with a foreign tax credit for  certain taxes paid to other countries. However, the timing of the tax  liability depends on several factors, including whether the income is from  a U.S. or foreign source and, if it is from a foreign source, whether it is  earned through direct operations or through a subsidiary.
Statutory and effective tax rates are not necessarily the same. An effective  tax rate, which is often lower—even substantially lower—than the  statutory rate, measures the amount of tax that a corporation actually pays  on a dollar of its economic income, when all aspects of the tax  (deductions, credits, deferrals, etc.) are taken into account. Statutory and  effective rates may differ, for example, because depreciation allowances  for specific types of capital investments exceed (or fall short of) the true  (economic) depreciation. Other differences arise because income from  foreign subsidiaries is generally not taxed until it is repatriated to the  United States. Special incentives, such as the research tax credit, that are  designed to encourage certain behavior, also cause the effective rate of the  tax to differ from its statutory rate. A recent Congressional Budget Office  (CBO) study found that the United States’ statutory corporate tax rates are  high relative to Organization for Economic Cooperation and Development  (OECD) countries but comparable with the rates for what were then the G- 7 countries. Comparisons of effective rates depend on the type of  investment and the type of financing. According to CBO, U.S. effective  corporate tax rates in 2003 were the G-7 median for equity-financed  investments in machinery, second lowest for debt-financed investment in  machinery, and second highest for equity-financed investment in industrial  structures.
Differences in effective tax rates across types and sources of income are  pervasive, reflecting the complexity of the tax code. The corporate income  tax (1) reduces the after tax return on capital income and, therefore,  affects the incentive individuals have to save and invest; (2) taxes  corporations differently than partnerships and sole proprietorships; (3)  taxes U.S. corporations operating in foreign countries differently than  those operating domestically and differently than foreign governments tax  corporations; (4) taxes different types of corporate investments, such as  machinery or structures, unevenly; and (5) taxes debt-financed investment  at lower rates than equity-financed investment. These differences in  effective tax rates alter both investment decisions and the reporting of  corporate income as firms try to minimize their taxes. Such tax avoidance,  much of it legal but some illegal, reduces tax revenue. Guiding investments  to lightly taxed activities rather than those with high before tax  productivity may reduce economic growth, further reducing tax revenue  from what it otherwise would have been.
section_title: Corporate Income Taxes Are a Significant Source of Federal Revenue and Must Be Part of the Overall Considerations for Fiscal Reform
paragraphs: At about $277 billion, corporate income taxes are far smaller than the $841  billion in social insurance taxes and $998 billion in individual income taxes  that OMB estimates will be paid in fiscal year 2006 to fund the federal  government. Figure 1 shows the relative importance of federal taxes.
Figures 1 and 2 show the trend in corporate tax revenues since 1962. Tax  experts have written that corporate tax revenues fell from the 1960s to the  early 1980s for several reasons. For example, corporate income became a  smaller share of national income during these years, partly due to the fact  that corporate debt, and therefore deductible interest payments, increased  relative to corporate equity, reducing the tax base. In addition, tax  expenditures, such as more generous depreciation rules and corporate tax  rate reductions lowered corporate taxes. Since the early 1980s corporate  tax revenues have fluctuated in a narrower range, reflecting changes in  corporate profits, tax laws, and other factors.
Since the early 1980s the corporate tax has accounted for from about 6 to  13 percent of federal revenue, as shown in figure 2. Consequently,  although not the largest, it remains an important source of federal  revenue. Relative to the gross domestic product (GDP), the corporate tax  has ranged from a little over 1 percent to just under 2.5 percent during  those same years. CBO has recently projected that despite the recent  uptick, corporate tax revenue for the next 10 years as a percentage of GDP  is expected to stay within this same range.
Corporate tax revenues of the magnitude shown in figure 2 make them  relevant to considerations about how to address the nation’s long-term  fiscal imbalance. Over the long term, the United States faces a large and  growing structural budget deficit primarily caused by demographic trends  and rising health care costs as shown in figure 3, and exacerbated over  time by growing interest on the ever larger federal debt. Continuing on this  imprudent and unsustainable fiscal path will gradually erode, if not  suddenly damage, our economy, our standard of living, and ultimately our  national security.
We cannot grow our way out of this long-term fiscal challenge because the  imbalance between spending and revenue is so large. We will need to  make tough choices using a multipronged approach: (1) revise budget  processes and financial reporting requirements; (2) restructure entitlement  programs; (3) reexamine the base of discretionary spending and other  spending; and (4) review and revise tax policy, including tax expenditures,  and tax enforcement programs. Corporate tax policy, corporate tax  expenditures, and corporate tax enforcement need to be part of the overall  tax review because of the amount of revenue at stake.
Corporate tax expenditures reduce the revenue that would otherwise be  raised from the corporate income tax. As already noted, to reduce their  tax liabilities, corporations can take advantage of preferential provisions  in the tax code, such as exclusions, exemptions, deductions, credits,  preferential rates, and deferral of tax liability. Tax preferences—which are  legally known as tax expenditures—are often aimed at policy goals similar  to those of federal spending programs. For example, there are different tax  expenditures intended to encourage economic development in  disadvantaged areas and stimulate research and development, while there  are also federal spending programs that have similar purposes. Also, by  narrowing the tax base, corporate tax expenditures have the effect of  raising either corporate tax rates or the rates on other taxpayers in order  to generate a given amount of revenue.
The sum of estimated forgone revenue for the federal government because  of corporate tax expenditures was $80 billion for fiscal year 2005. In its  most recent report, the Department of the Treasury (Treasury) listed 27  tax expenditures for corporate taxpayers only and another 52 provisions  available to both corporations and other businesses. As of fiscal year 2005,  the two largest tax expenditures used by corporations were the  accelerated depreciation of machinery and equipment ($15.9 billion) and  the deferral of income of controlled foreign corporations ($10.5 billion);  these two accounted for a third of the sum of corporate revenue losses  estimated by Treasury.
We reported in September 2005 that the effectiveness of many tax  expenditures is not subject to a level of review similar to that of programs  that spend money directly. Although some corporate income tax  expenditures are reviewed by government agencies, academics, and  others, all should be reviewed periodically to ensure they have not  outlived their usefulness, are not redundant, or are not inefficient in  accomplishing their intended purpose. In that report, we recommended  that the OMB and Treasury take steps to ensure regular reexamination of  tax expenditures, including the corporate provisions. OMB disagreed with  the recommendations, citing methodological and conceptual issues. Our  report discusses in detail the issues that OMB raised and why we continue  to believe that our recommendations are valid. Also, as far back as 1994,  we have suggested that Congress should review these tax expenditures,  considering such things as how well the corporate tax expenditures are  achieving their purposes and whether they should remain, given the  potential benefits of a simpler corporate tax code, possibly with reduced  tax rates.
section_title: Opportunities Exist to Improve Corporate Tax Compliance
paragraphs: Ensuring corporate income tax compliance is challenging because much  corporate tax avoidance is legal and the true tax liability for large  corporations is difficult to determine. A wide variety of strategies will  undoubtedly be needed to address corporate tax compliance.  Opportunities to pursue include simplifying the tax code, obtaining better  data to the extent feasible on noncompliance, continuing to oversee the  effectiveness of IRS’s efforts, continuing to leverage technology, and  sending sound compliance signals through such things as increased  effectiveness in collecting taxes owed.
subsections: section_title: Corporate Tax Avoidance Is Bred in Part by Complexity
paragraphs: The amount of corporate tax avoidance is unknown. A complex tax code,  complicated business transactions, and often multinational corporate  structures make determining corporate tax liabilities and the extent of  corporate tax avoidance a challenge. Tax avoidance has become such a  concern that some tax experts say corporate tax departments have  become “profit centers” as corporations seek to take advantage of the tax  laws in order to maximize shareholder value. Some corporate tax  avoidance is clearly legal, some falls in gray areas of the tax code, and  some is clearly noncompliance or illegal. Tax code simplification has the  potential to reduce at least some of this avoidance.
Often corporate tax avoidance is legal. For example, multinational  corporations can locate active trade or business operations in jurisdictions  that have lower effective tax rates than does the United States and, unless  and until they repatriate the income, defer taxation in the United States on  that income, thus reducing their effective tax rate. Similarly, making  investments that qualify for accelerated depreciation can lower a  corporation’s current effective tax rate, although in the future its rate  would be higher.
Corporate tax planners may find legal ways to exploit tax code complexity  to play one provision of the code off another in ways that Congress never  intended. In response, Congress has sometimes acted to address what it  considered to be abusive tax shelters. For example, the American Jobs  Creation Act of 2004 limited the tax benefits of leasing transactions  involving tax-exempt entities, such as transit authorities. One type of  transaction the act limited was the sale-in/lease-out (SILO) arrangement,  which involved a taxable entity buying assets, such as railcars, from a tax- exempt entity, for example, a metropolitan transit system, and leasing  them back to the tax-exempt entity. The estimated revenue gain from the  2004 act’s provision covering leasing transactions with tax-indifferent  parties was about $26.6 billion for 2005 through 2014.
Complicating corporate tax compliance is the fact that in many cases the  law is unclear or subject to differing interpretations. In fact, some have  postulated that major corporations’ tax returns are actually just the  opening bid in an extended negotiation with IRS to determine a  corporation’s tax liability. An illustration is transfer pricing. Transfer  pricing involves setting the appropriate price for such things as goods,  services, or intangible property (such as patents, trademarks, copyrights,  technology, or “know-how”) that is transferred between the U.S.-based  operations of a multinational company and a foreign affiliate. If the price  paid by the affiliate to the U.S. operation is understated, the profits of the  U.S. operation are reduced and U.S. taxable income is inappropriately  reduced or eliminated. The standard for judging the correct price is the  price that would have been paid between independent enterprises acting  at “arm’s length.” However, it can be extremely difficult to establish what  an arm’s length price would be. Given the global economy and the number  of multinational firms with some U.S.-based operations, opportunities for  transfer pricing disputes are likely to grow.
Tax shelters are one example of how tax avoidance, including corporate  tax avoidance, can shade into the illegal. Some tax shelters are legal  though perhaps aggressive interpretations of the law, but others cross the  line. In a 2003 testimony, we reported that IRS had identified 27 kinds of  abusive shelter transactions—called listed transactions—promoted to  corporations and others. As of June 2006, IRS’s web site lists 31 such listed  transactions. IRS also had a number of other transactions that had to be  reported to IRS and may have had some characteristics of abusive shelters  but were not, and possibly never would be, listed.
Abusive shelters often are complex transactions that manipulate many  parts of the tax code or regulations and are typically buried among  legitimate transactions reported on tax returns. Because these  transactions are often composed of many pieces located in several parts of  a complex tax return, they are essentially hidden from plain sight, which  contributes to the difficulty of determining the scope of the abusive shelter  problem. Often lacking economic substance or a business purpose other  than generating tax benefits, abusive shelters have been promoted by  some tax professionals, often in confidence, for significant fees,  sometimes with the participation of tax-indifferent parties, such as foreign  or tax-exempt entities. These shelters may involve unnecessary steps and  flow-through entities, such as partnerships, which make detection of these  transactions more difficult.
For example, a company had a sizable gain from the sale of a subsidiary  and wanted to avoid or minimize paying tax on the gain. An investment  bank proposed forming an offshore partnership with a foreign corporation  (a tax-indifferent party) for the express purpose of sheltering the capital  gains of its corporate client. The partnership purchased and quickly resold  notes in a contingent installment sale transaction. The partnership earned  a large capital gain, most of which it allocated to the foreign corporate  partner. Later, related losses were allocated to the U.S. corporation,  generating approximately $100 million in capital loss for the investment  bank’s client. The corporation used this capital loss to shelter its U.S.- based capital gains. Both the Tax Court and the Third Circuit Court of  Appeals ruled that the transaction lacked economic substance. The Third  Circuit, in addition to requiring economic substance, held that a  transaction must have a subjective nontax business motive to be respected  for tax purposes. For this transaction, the investment bank was to earn a  fee of $2 million.
In part because tax shelters are intentionally hidden, IRS has not been able  to produce a reliable estimate of the revenues lost because of shelters. As  we reported in October 2003, one estimate, which had a number of  methodological limitations, suggested an average annual tax gap because  of tax shelters (both corporate and individual) that could have been from  about $11.6 billion to about $15.1 billion for the years 1993 through 1999.  Because the methodological limitations were serious, the true amount of  the revenue loss could be lower or higher than this range. Furthermore,  this estimate does not cover non-abusive tax shelters.
Establishing a presence in a low-tax country is another technique for  avoiding corporate income tax. Some low-tax countries are called tax  havens. The company’s presence in a tax haven in some cases may be  nominal, nothing more than a file in an office. Use of a tax haven can be  questionable when combined with abusive transfer pricing or techniques,  such as interest stripping, to artificially shift income to the tax haven. In  several reports since 2002, we reported on federal contractors’ use of tax  havens. We reported that 4 of the top 100 federal contractors that were  publicly traded corporations in 2001 were located in tax havens and that 3  of these were originally U.S.-headquartered corporations. Later, we  reported that large tax haven contractors in both 2000 and 2001 had a tax  cost advantage compared to large domestic contractors.
section_title: IRS’s Incomplete and Dated Estimates of Corporate Tax Noncompliance Can Be Improved
paragraphs: In large part because of the complexity and uncertainty in the application  of tax laws, the actual level of corporate income tax noncompliance  (illegal tax avoidance) is poorly understood. IRS estimates a corporate tax  gap in the tens of billions of dollars, but also acknowledges that this  estimate is not based on robust, recent, and reliable research.
As noted above, IRS’s published estimate of the corporate tax gap—the  difference between what corporations pay voluntarily and on time in taxes  and what they are required to pay under the law—is $32 billion for tax  year 2001. This is out of an overall gross tax gap of $345 billion for that  year. Underreporting of income was the largest component of the  corporate tax gap, contributing an estimated $30 billion. The IRS estimate  included both small corporations (those reporting assets of $10 million or  less) and large corporations (those reporting assets of over $10 million).  Underpayment of taxes due accounted for $2 billion of the corporate tax  gap for tax year 2001. IRS has no estimate for nonfiling of corporate  income tax returns for tax year 2001.
However, the available tax gap estimates are highly uncertain and  incomplete. IRS has not systematically measured the level of compliance  for large corporations, and the last measure of noncompliance for small  corporations was from the 1980s. IRS’s level of certainty with regard to the  accuracy of the corporate tax gap estimate is low for reasons such as use  of incomplete and old data, interpretation of complex laws, and resource  constraints. The 2001 estimate used data from the 1970s and 1980s to  estimate underreporting of corporate income taxes. For large corporate  income tax underreporting, IRS based its estimate on the amount of tax  recommended from operational examinations. As we reported in July  2005, according to IRS officials, IRS relies on the amount of tax  recommended because it is difficult to determine the true tax liability of  large corporations because of complex and ambiguous tax laws that  create opportunities for differing interpretations and that complicate the  determination. Because these examinations do not cover all firms and do  not test all items on a tax return, the estimate produced from the  examinations is incomplete. IRS officials also explained that because of  these complexities and the costs and burdens of collecting complete and  accurate data, IRS has not systematically measured large corporation tax  compliance through statistically valid studies.
As of June of this year, IRS did not have approved plans to update the  corporate tax gap estimate. Although measuring corporate tax compliance  can be challenging and costly, such compliance data aid in identifying new  or growing types of noncompliance, identifying changes in tax laws and  regulations that may improve compliance, more effectively targeting  examinations of tax returns, understanding the effectiveness of its  programs to promote and enforce compliance, and properly determining  its resource needs and allocations. In order to improve efforts to reduce  the tax gap, we have recommended that IRS develop plans to periodically  measure tax compliance for areas that have been measured, and study  ways to cost effectively measure compliance for other components of the  tax gap that have not been measured, such as excise taxes and corporate  taxes. IRS agreed with our recommendations.
section_title: IRS Has Strengthened Corporate Tax Compliance Efforts, but Continued Oversight Will Be Warranted
paragraphs: IRS has recently increased the number of corporate audits and  recommended tax assessments. These trends are promising. However,  given the lack of a reliable measure of the extent of corporate  noncompliance and other factors, continued oversight of these efforts will  be warranted to make informed judgments about their overall  effectiveness.
As shown in figure 4, the number of corporate income tax returns that IRS  examined rose from its recent low of 0.71 percent in fiscal year 2004 to  1.25 percent in fiscal year 2005. This number includes examinations of 20  percent of large corporations in fiscal year 2005 as well as audits of all  1,100 of the nation’s largest corporations with assets of more than $250  million.
Figure 5 shows that the amount of taxes that IRS recommended as a result  of examinations performed grew from its recent low of $13.5 billion in  fiscal year 2003 to $32 billion in fiscal year 2005.
According to IRS, about a third of the increase in recommended  assessments comes from tax shelter examinations, and nearly all of the  increase comes from examinations of the largest corporations. IRS notes,  not surprisingly, that a large portion of the recommended taxes were not  agreed to by the corporations. In the past, we found that under IRS’s  examination program of the nation’s largest corporations, the amount of  taxes IRS actually assessed has been about 20 percent of the amount  initially recommended during examinations. Further, the amounts  assessed often are not ultimately collected after cases are reviewed in  IRS’s Appeals function or in the courts. Because the various review and  appeal options can be time consuming, it may be a number of years before  actual collection occurs on some cases.
The shelter-related results come from IRS’s multiyear effort to attack tax  shelters. In 2003 we reported that IRS had shifted resources to create a  broad-based strategy to combat what it considered to be a high priority  challenge—abusive tax shelters. IRS had adopted a broad-based strategy  for addressing abusive shelters, including  targeting promoters to head off the proliferation of shelters;    making efforts to deter, detect, and resolve abuse;    offering inducements to businesses to disclose their use of  questionable tax practices; and    using performance indicators to measure outputs and some outcomes  and intending to go down the path it had started and develop long-term  performance goals and measures linked to those goals. We said that  without these latter elements, Congress would find gauging IRS’s  progress difficult.
In addition to examinations, IRS has undertaken a number of initiatives to  address corporate tax compliance. Some of these initiatives are intended  to resolve tax issues beyond the examination process. The Advance  Pricing Agreement (APA) program, the Fast Track Settlement program,  the Pre-Filing Agreement program, and the Industry Issue Resolution  program all work to some degree to resolve contentious tax issues outside  of the examination process. For example, the APA program is intended to  address transfer pricing issues up front so that they do not arise during  subsequent examinations.
IRS has also been revising the corporate tax examination process. For  instance, IRS reports that it has shortened the cycle time of examinations.  According to IRS, reducing cycle time allows IRS to examine additional  taxpayers and reduces administrative burdens on taxpayers. Similarly,  IRS’s Limited Issue Focused Examination process seeks to have IRS and  corporations reach a formal agreement to govern key aspects of the  examination.
Future success in following through on these initiatives will require  replenishment of IRS’s staff, which could be challenging given the  increasing numbers of key employees who are eligible for retirement or  who are otherwise leaving key occupations. The Large and Mid-Size  Business Division (LMSB), which is responsible for the compliance of the  largest corporations, reported in its fiscal year 2006 strategic assessment  that it will continue to lose substantial experience as revenue agents leave.  The Small Business and Self Employed Division, which covers the rest of  corporations, also has growing numbers of employees eligible for  retirement or leaving their enforcement positions. Although hiring to fill  positions is occurring, past experience suggests that training these new  employees and giving them on-the-job experience will take time and likely  adversely affect the divisions’ overall productivity to some extent. The  Treasury Inspector General for Tax Administration has designated  managing human capital a management and performance challenge for  IRS.
In part because IRS does not have a reliable measure of corporate tax  compliance, it will be challenged to demonstrate the effectiveness of the  increased audits and the various initiatives it has undertaken. The  effectiveness of IRS’s efforts will depend on the extent to which the taxes  recommended are actually collected given past data showing that a  relatively small portion of recommended assessments is ultimately  collected. For these reasons, as well as human capital management  challenges, IRS’s increased compliance efforts will warrant continued  oversight.
section_title: Continuing to Leverage Technology
paragraphs: Judicious use of technology has already helped IRS improve its  productivity, and continued, well-managed technology initiatives have the  potential to further improve the use of its resources. According to IRS,  electronic filing of individuals’ tax returns has enabled it to reduce the  amount of staffing devoted to processing paper tax returns and to transfer  staffing allocations to other endeavors, including compliance work.  Further, because of the software used in electronically preparing and filing  returns, these returns have fewer errors, thus saving IRS and taxpayers  needless time and effort to correct avoidable errors.
Starting in 2006, many larger corporations are now required to file their  tax returns electronically. This is no small undertaking, and some  transition issues are likely to occur. However, electronic returns offer the  potential to speed examinations—if for no other reason than often very  voluminous corporate tax returns can be moved to appropriate locations  for review immediately. IRS believes electronically filed returns will also  speed analysis of corporate tax returns and the identification of issues and  taxpayers most in need of examination or other resolution of potential  compliance issues. IRS plans to gradually expand the number of firms  required to electronically file. This and other opportunities to leverage  modern technology can serve to help IRS deal with the complex tax issues  in corporate tax returns.
section_title: Improving the Collection of Delinquent Taxes Would Send a Compliance Signal
paragraphs: When any taxpayer has been found to owe taxes and those amounts are no  longer in dispute, failure to collect the taxes sends an adverse compliance  signal. While not collecting these debts may send a message to  corporations that IRS is not serious about enforcing the tax law,  developing and exploiting opportunities to improve collections sends the  opposite signal and can contribute to reducing corporate noncompliance.  In February 2004, we reported that some Department of Defense (DOD)  contractors abuse the federal tax system with little consequence. We  reported that based on our analysis of a limited number of DOD  disbursement systems, more than 27,000 DOD contractors owed nearly $3  billion in unpaid federal taxes. In June 2005, we reported that many  contractors of civilian agencies throughout the federal government also  abuse the federal tax system. Our analysis showed that about 33,000  contractors that received substantial federal payments from civilian  agencies during fiscal year 2004 owed a total of more than $3 billion in  unpaid taxes. The unpaid taxes owed by DOD and civilian agency  contractors included corporate income, excise, unemployment, individual  income, and payroll taxes. We also found evidence of abusive and  potentially criminal activities on the part of both DOD and civilian agency  contractors.
In our reports on this issue, we made numerous recommendations  intended to improve the Federal Payment Levy Program by expanding the  amount and type of tax debt eligible for inclusion in the program,  expanding the volume of federal payments subject to levy, and correcting  process and control deficiencies that hindered the program’s ability to  maximize the amount levied from payments to contractors with unpaid  federal taxes. In our 2004 report, we also recommended that OMB develop  options for prohibiting federal contract awards to businesses and  individuals that abuse the federal tax system, including designating such  tax abuse as a cause for government wide debarment or suspension. The  agencies involved did not agree with all of our recommendations. We  discuss their views and our responses in detail in our reports, as well as  our continued belief that our recommendations are valid. Consistent with  our recommendation to OMB, I believe Congress should consider  suspending government business with contractors who are delinquent on  their taxes as of a specific and prospective effective date, with a provision  for limited waivers if necessary in unique circumstances.
section_title: Capital Gains Basis Reporting
paragraphs: Finally, you also asked us to testify on a report—done at your request— that we are issuing today on individual taxpayers’ compliance in reporting  capital gains’ income from the sale of securities. Misreporting such  income contributes to the annual tax gap, which is the gap between tax  amounts that taxpayers should pay under the law and do pay voluntarily  and on time. For tax year 2001, the IRS estimated a gross tax gap of $345  billion, of which at least $11 billion is attributed to individual taxpayers  who misreported their income from capital gains or losses. Taxpayers are  to determine their capital gains or losses by subtracting the “basis”  amount, which is generally the cost for an asset, from the gross proceeds  amount when selling the asset.
For tax year 2001, an estimated 36 percent (over 7 million) of  individual taxpayers who sold securities misreported capital gains or  losses. Using the wrong cost basis for the securities was a primary type  of noncompliance leading to this misreported income. About two-thirds  of the misreporting taxpayers understated gains or overstated losses,  while about one-third overstated gains or understated losses.  Additionally, a few taxpayers with securities sales misreported whether  their gains or losses were short-term or long-term.
IRS attempts to address misreported securities sales’ income through  enforcement and taxpayer service programs, which are to find  noncompliance or help taxpayers comply voluntarily. Various  challenges limit the impact of these programs, such as that IRS  enforcement programs contact relatively few taxpayers and the lack of  cost basis information impedes efficient use of IRS’s enforcement  resources. IRS also faces difficulties in ensuring that taxpayers  understand their obligations for determining and reporting their capital  gains and losses.
Expanding information reporting to taxpayers and IRS on securities  sales to include cost basis has potential to improve taxpayer voluntary  compliance and help IRS verify securities gains or losses. Basis  reporting would raise challenges, many of which can be mitigated to  some extent. For example, broker costs would increase but could be  constrained by limiting the scope of any reporting requirement and by  building on the basis reporting to taxpayers that many brokers already  do. For example, reporting basis for only future purchases would  mitigate challenges when brokers do not know the basis for securities  purchased in the past. 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. IRS’s broad authority to require information reporting for  securities sales may not be enough to require all the actions necessary  to implement cost basis reporting and mitigate the challenges.
Based on these results, our report includes matters that Congress may  want to consider, including requiring brokers to report to both taxpayers  and IRS the adjusted basis of sold securities and ensuring that IRS has  sufficient authority to implement the requirement. Congress could also  require brokers to report whether the securities sold were short- or long- term and IRS to work with brokers to develop rules that mitigate the  challenges. Further, we recommend that IRS modify the instructions for  the individual tax return to (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 basis. IRS agreed with our  recommendations.
Mr. Chairman, this concludes my prepared statement. I would be happy to  respond to any questions you or other Members of the Committee may  have at this time.
section_title: Contacts and Acknowledgments
paragraphs: For further information on this testimony, please contact Michael Brostek  at (202) 512-9110 or brostekm@gao.gov. David Lewis, Assistant Director;  Jeffrey Arkin; Kevin Daly; Amy Friedheim; Thomas Gilbert; Lawrence  Korb; Signora May; Edward Nannenhorn; Cheryl Peterson; Michael Rose;  Marylynn Sergent; Thomas Short; Michael Volpe; James White, Jennifer  Wong; and James Wozny made key contributions to this testimony.
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