Tax Compliance: Thousands of Federal Contractors Abuse the Federal Tax System
Published: 2007-04-19T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Since 1990, GAO has periodically reported on high-risk federal programs that are vulnerable to fraud, waste, and abuse. Two such high-risk areas are managing federal contracts more effectively and assessing the efficiency and effectiveness of federal tax administration. Weaknesses in the tax area continue to expose the federal government to significant losses of tax revenue and increase the burden on compliant taxpayers to fund government activities. Over the last several years, the Senate Permanent Subcommittee on Investigations requested GAO to investigate Department of Defense (DOD), civilian agency, and General Services Administration (GSA) contractors that abused the federal tax system. Based on that work GAO made recommendations to executive agencies including to improve the controls over levying payments to contractors with tax debt--many of which have been implemented--and referred 122 contractors to IRS for further investigation and prosecution. As requested, this testimony will highlight the key findings from prior testimonies and related reports. This testimony will (1) describe the magnitude of tax debt owed by federal contractors, (2) provide examples of federal contractors involved in abusive and potentially criminal activity related to the federal tax system, and (3) describe current law and proposed federal regulations for screening contractors with tax debts prior to the award of a contract.
section_title: What GAO Found
paragraphs: In our previous audits and related investigations, we reported that thousands of federal contractors had substantial amounts of unpaid federal taxes. Specifically, about 27,000 DOD contractors, 33,000 civilian agency contractors, and 3,800 GSA contractors owed about $3 billion, $3.3 billion, and $1.3 billion in unpaid taxes, respectively. These estimates were understated because they excluded federal contractors that understated their income or did not file their tax returns; however, some contractors may be counted in more than one of these groups. As part of this work, we conducted more in-depth investigations of 122 federal contractors and in all cases found abusive and potentially criminal activity related to the federal tax system. Many of these 122 contractors were small, closely held companies that provided a variety of goods and services, including landscaping, consulting, catering, and parts or support for weapons and other sensitive programs for many federal agencies including the departments of Defense, Justice, and Homeland Security. These contractors had not forwarded payroll taxes withheld from their employees and other taxes to IRS. Willful failure to remit payroll taxes is a felony under U.S. law. Furthermore, some company owners diverted payroll taxes for personal gain or to fund their businesses. A number of owners or officers of the 122 federal contractors owned significant personal assets, including a sports team, multimillion dollar houses, a high-performance airplane, and luxury vehicles. Several owners gambled hundreds of thousands of dollars at the same time they were not paying the taxes that their businesses owed. Federal law, as implemented by the Federal Acquisition Regulation (FAR), does not now require contractors to disclose tax debts or contracting officers consider tax debts in making contracting decisions. Federal contractors that do not pay tax debts could have an unfair competitive advantage in costs because they have lower costs than tax compliant contractors on government contracts. GAO's investigation identified instances in which contractors with tax debts won awards based on price differential over tax compliant contractors.

section_title: Letter
paragraphs: Thank you for the opportunity to discuss our past work on government  contractors that have failed to pay their federal taxes. Our remarks today  are based on work that we have performed over the last several years for  the Senate Permanent Subcommittee on Investigations, Committee on  Homeland Security and Governmental Affairs. In hearings held before that  Subcommittee over the last several years, we testified that federal  contractors at the Department of Defense (DOD), selected civilian  agencies, and the General Services Administration (GSA) abused the  federal tax system with little consequence. As requested, this testimony  highlights the key findings from those testimonies and related reports.  Specifically, this testimony will (1) describe the magnitude of tax debts  that were owed by federal contractors at the time of our previous  testimonies and related reports, (2) provide examples of federal  contractors involved in abusive and potentially criminal activity related to  the federal tax system, and (3) discuss current law and proposed changes  to the Federal Acquisition Regulation (FAR) concerning contractor tax  debt.
To address our objectives, we reviewed prior findings from GAO audits of  federal contractors that have abused the federal tax system. Our audit  work was performed in accordance with U.S. generally accepted  government auditing standards. We performed our investigative work in  accordance with standards prescribed by the President’s Council on  Integrity and Efficiency.
subsections: section_title: Federal Contractors Owe Billions of Dollars in Unpaid Federal Taxes
paragraphs: In each of our audits and related investigations, we found thousands of  federal contractors that owed billions of dollars of federal taxes.  Specifically,  In February 2004, we testified that DOD and IRS records showed that  about 27,000 DOD contractors owed nearly $3 billion in federal taxes.  About 42 percent of this $3 billion represented unpaid payroll taxes.  In June 2005, we testified that about 33,000 civilian agency federal  contractors owed over $3.3 billion in federal taxes. Over a third of the  $3.3 billion represented unpaid payroll taxes.  In March 2006, we testified that over 3,800 GSA contractors owed  about $1.4 billion in federal taxes. About one-fifth of the $1.4 billion  represented unpaid payroll taxes.
Because federal contractors may do business with more than one federal  agency, some federal contractors that owe tax debts may be included in  more than one analysis concerning DOD, GSA, and civilian federal  contractors that abuse the federal tax system.
In each of our audits, we found that government contractors owed a  substantial amount of unpaid payroll taxes. Employers are subject to civil  and criminal penalties if they do not remit payroll taxes to the federal  government. When an employer withholds taxes from an employee’s  wages, the employer is deemed to have a fiduciary responsibility to hold  these funds “in trust” for the federal government until the employer makes  a federal tax deposit in that amount. To the extent these withheld amounts  are not forwarded to the federal government, the employer is liable for  these amounts, as well as the employer’s matching Federal Insurance  Contribution Act contributions for Social Security and Medicare.  Individuals employed by the contractor (e.g., owners or officers) may be  held personally liable for the withheld amounts not forwarded and  assessed a civil monetary penalty known as a trust fund recovery penalty.  Willful failure to remit payroll taxes can also be a criminal felony offense  punishable by imprisonment of up to 5 years, while the failure to properly  segregate payroll tax funds can be a criminal misdemeanor offense  punishable by imprisonment of up to a year.  The law imposes no  penalties upon an employee for the employer’s failure to remit payroll  taxes since the employer is responsible for submitting the amounts  withheld. The Social Security and Medicare trust funds are subsidized or  made whole for unpaid payroll taxes by the federal government’s general  fund. Thus, personal income taxes, corporate income taxes, and other  government revenues are used to pay for these shortfalls to the Social  Security and Medicare trust funds.
Although each of our estimates for taxes owed by federal contractors was  a significant amount, it understates the full extent of unpaid taxes owed by  these contractors. The IRS tax database reflected only the amount of  unpaid federal taxes either reported on a tax return or assessed by IRS  through its various enforcement programs. The IRS database did not  reflect amounts owed by businesses and individuals that have not filed tax  returns and for which IRS has not assessed tax amounts due. Our analysis  did not attempt to account for businesses or individuals that did not file  required payroll or other tax returns or that purposely underreported  income and were not specifically identified by IRS as owing the additional  federal taxes. According to IRS, underreporting of income accounted for  more than 80 percent of the estimated $345 billion annual gross tax gap.
As result of the work we performed for the Senate Permanent  Subcommittee on Investigations, Committee on Homeland Security and  Governmental Affairs we made numerous recommendations to DOD and  civilian agencies to improve their controls over levying payments to  contractors with tax debt.  Many of those recommendations have been  implemented and have resulted in additional collections of unpaid tax  debt.  We also referred 122 contractors to IRS for further investigation and  prosecution.
section_title: Examples of Federal Contractors Involved in Abusive and Potentially Criminal Activity Related to the Federal Tax System
paragraphs: In our previous testimonies, we discussed the results of our in-depth  audits and related investigations of 122 federal contractors with  outstanding tax debt. For each of these 122 federal contractors, we found  instances of abusive or potentially criminal activity related to the federal  tax system. Many of our case study contractors were small, closely held  companies that operated in wage-based industries, such as security,  weapon components, space and aircraft parts, building maintenance,  computer services, and personnel services. These 122 federal contractors  provided goods and services to a number of federal agencies including  DOD, GSA, the National Aeronautics and Space Administration, and the  Departments of Homeland Security, Justice, and Veterans Affairs. The  types of contracts that were awarded to these contractors also included  products or services related to variety of government functions including  law enforcement, disaster relief, and national security.
Most of the contractors in our case studies owed payroll taxes, with some  federal tax debts dating back nearly 20 years. However, rather than  fulfilling their role as “trustees” and forwarding these funds to IRS, many  of these federal contractors used the funds for personal gain or to fund  their contractor operations.
Our investigations also revealed that some owners or officers of our case  study federal contractors with unpaid taxes were associated with other  businesses that had unpaid federal taxes. For example, we reported that  one of our case study contractors had a 20-year history of opening a  business, failing to remit taxes withheld from employees to IRS, and then  closing the business, only to start the cycle all over again and incur more  tax debts almost immediately through a new business. We also found that  a number of owners or officers of our case study contractors had  significant personal assets, including a sports team, commercial  properties, multimillion dollar houses, and luxury vehicles. Several owners  also gambled hundreds of thousands of dollars at the same time they were  not paying the taxes that their businesses owed. Despite owning  substantial assets and gambling significant amounts of money, the owners  or officers did not ensure the payment of the delinquent taxes of their  businesses, and sometimes did not pay their own individual income taxes.  Table 1 provides summary information on 10 of our 122 case study  contractors that we discussed in our previous testimonies and related  reports.
The following provides additional detailed information from our previous  testimonies on case numbers 1, 4, and 8 summarized in table 1:  Case # 1: In February 2004, we testified on a business that had nearly $10  million in unpaid federal taxes, and was contracted by DOD to provide  services such as trash removal, building cleaning, and security at U.S.  military bases. The contractor reported that it paid the owner a six figure  income and that the owner had borrowed nearly $1 million from the  business. The owner bought a boat, several cars, and a home outside the  country. This contractor went out of business in 2003 after state tax  authorities seized its bank account for failure to pay state taxes. The  contractor subsequently transferred its employees to a relative’s business,  which also had unpaid federal taxes, and continued submitting invoices  and receiving payments from DOD on the previous contract.
Case # 4: In June 2005, we testified on a case that involved many related  companies that provided health care services to the Department of  Veterans Affairs (VA). During fiscal year 2004, these related companies  received over $300,000 in federal contract payments. The related  companies had different names, operated in a number of different  locations, and used several different Taxpayer Identification Numbers  (TIN). However, they shared a common owner and contact address. At  the time they were paid by VA, the businesses collectively owed more than  $18 million in unpaid federal taxes—of which nearly $17 million was  unpaid federal payroll taxes dating back to the mid-1990s. During the early  2000s, at the time when the owner’s business and related companies were  still incurring payroll tax debts, the owner purchased a number of  multimillion dollar properties, an unrelated business, and a number of  luxury vehicles. Our investigation also determined that real estate holdings  registered to the owner totaled more than $30 million.
Case # 8: In March 2006, we testified on a GSA contractor that provided  security services for a civilian agency. Our investigative work indicated  that an owner of the company made multiple cash withdrawals, totaling  close to $1 million, while owing payroll taxes. In addition, the company’s  owner also diverted the cash withdrawals to fund an unrelated business  and purchased a men’s gold bracelet worth over $25,000. The company’s  owner has been investigated for embezzlement and fraud.
section_title: Contractors with Unpaid Taxes Are Not Prohibited from Receiving Contracts from the Federal Government
paragraphs: Federal law and regulations, as reflected in the FAR, do not prohibit  contractors with unpaid federal taxes from receiving contracts from the  federal government. Although the FAR provides that federal agencies are  restricted to doing business with responsible contractors, it does not  require federal agencies to deny the award of contracts to contractors that  abuse the federal tax system, unless the contractor was specifically  debarred or suspended by a debarring official for specific actions, such as  conviction for tax evasion.
The FAR specifies that unless compelling reasons exist, agencies are  prohibited from soliciting offers from, or awarding contracts to,  contractors who are debarred, suspended, or proposed for debarment for  various reasons, including tax evasion. Conviction for tax evasion is cited  as one of the causes for debarment and indictment for tax evasion is cited  as a cause for suspension. The deliberate failure to remit taxes, in  particular payroll taxes, is a felony offense, and could result in a company  being debarred or suspended if the debarring official determines it affects  the present responsibility of the government contractor. Most of the  contractors in our case studies owed payroll taxes, for which willful  failure to remit payroll taxes, a criminal felony offense, or failure to  properly segregate payroll taxes, a criminal misdemeanor offense, may  apply. At the time of our review, none of the 122 federal contractors  described in our previous case study work were debarred from  government contracts, despite conducting abusive and potentially criminal  activities related to the tax system.
As part of the contractor responsibility determination for prospective  contractors, the FAR also requires contracting officers to determine  whether a prospective contractor meets several specified standards,  including determination as to whether a contractor has adequate financial  resources and a satisfactory record of integrity and business ethics.  However, the FAR does not require contracting officers to consider tax  debt in making this determination.
section_title: Restrictions on IRS Tax Disclosure and Failure to Use Available Tools Hamper Consideration of Tax Debts in Contractor Qualification Determinations
paragraphs: Because of statutory restrictions on the disclosure of taxpayer  information, even if contracting officers were required to consider tax  debts in contractor qualification determinations, contracting officers do  not currently have access to tax debt information unless reported by  prospective contractors themselves or disclosed in public records.  Consequently, unless a prospective contractor consents, contracting  officers do not have ready access to information on unpaid tax debts to  assist in making contractor qualification determinations with respect to  financial capability, ethics, and integrity.
Further, contracting officers do not routinely obtain and use publicly  available information on contractor federal tax debt in making contractor  qualification determinations. Federal law generally does not permit IRS to  disclose taxpayer information, including tax debts. Thus, unless the  taxpayer provides consent, certain tax debt information generally can  only be discovered from public records when IRS files a federal tax lien  against the property of a tax debtor. However, contracting officers are  not required to obtain credit reports. In the instances where they are  obtained, contracting officers generally focus on the contractor’s credit  score rather than any liens or other public information showing federal tax  debts. However, while the information is available, IRS does not file tax  liens on all tax debtors nor does IRS have a central repository of tax liens  to which contracting officers have access. Further, the available  information on tax liens may be of questionable reliability because of  deficiencies in IRS’s internal controls that have resulted in IRS not always  releasing tax liens from property when the tax debt has been satisfied.
section_title: Contractors with Tax Debts Have Unfair Advantage in Contract Competition
paragraphs: Federal contractors who owe tax debts have an unfair competitive  advantage over contractors who pay their fair share. This is particularly  true for federal contractors in wage-based industries, such as security and  moving services. By not paying the employee taxes, these contractors keep  their payroll tax, which is typically over 15 percent of each employee’s  wages, thereby reducing the contractor’s costs. In this way, contractors  who do not pay their taxes do not bear the same costs that tax compliant  contractors have when competing on contracts. As a result, tax delinquent  contractors can set prices for their goods and services lower than their tax  compliant competitors.
In March 2006, we testified that we found some GSA contractors who did  not fully pay their payroll taxes who were awarded contracts based on  price over competing contractors that did not have any unpaid federal  taxes. Federal contractors’ tax debts were not considered in contract  award decisions. For example, a GSA Schedule contractor was awarded  two contracts for services related to moving office and equipment  furniture. On both contracts, the contractor’s offer for services was  significantly less than three competing bids on the first contract and two  competing bids on the second contract. The contractor owed about  $700,000 in taxes (mostly payroll taxes) while its competitors did not owe  any federal taxes.
section_title: Proposed FAR Rule Would Require Prospective Contractors to Provide Tax-Related Certifications
paragraphs: The Civilian Agency Acquisition Council and the Defense Acquisition  Regulations Council (councils) have proposed to amend the FAR to  require prospective contractors to certify whether or not they have, within  a 3-year period preceding the offer, been convicted of or had a civil  judgment rendered against them for violating any tax law or failing to pay  any tax, or been notified of any delinquent taxes for which they still owe  the tax. In addition, the prospective contractor will be required to certify  whether or not they have received a notice of a tax lien filed against them  for which the liability remains unsatisfied or the lien has not been  released. The proposed rule also adds the following as additional causes  for suspension or debarment: delinquent taxes, unresolved tax liens, and a  conviction of or civil judgment for violating tax laws or failing to pay  taxes.
By issuing the proposed rule on tax delinquency, the councils have  acknowledged the importance of delinquent tax debts in the consideration  of contract awards. The proposed rule requires offerors to certify whether  they have or have not, within a 3-year period preceding the offer, been  notified of any unresolved or unsatisfied tax debt or liens. Contracting  officers generally cannot verify whether prospective contractors certifying  that they have not received notice of unresolved or unsatisfied tax debts  actually owe delinquent federal taxes, unless that information is disclosed  in public records or unless the offeror provides consent for IRS to disclose  its tax records. In March 2006, we testified that in one contractor file we  reviewed, a GSA official did ask the prospective contractor about a federal  tax lien. The prospective contractor provided documentation to GSA  demonstrating the satisfaction of the tax liability covered by that lien.  However, because the GSA official could not obtain information from the  IRS on tax debts, this official was not aware that the contractor had other  unresolved tax debts unrelated to this particular tax lien.
section_title: Concluding Comments
paragraphs: Over the past several years, we have testified that thousands of federal  contractors failed in their responsibility to pay billions of dollars of federal  taxes yet continued to get federal contracts. This practice is inconsistent  with the fundamental concept that those doing business with the federal  government should be required to pay their federal taxes. With the serious  fiscal challenges facing our nation, the status quo is no longer an option.  Enhanced contractor requirements to pay their taxes would likely increase  contractor tax compliance and federal revenues. Federal law seeking to  achieve these objectives should provide flexibility to agencies, such as  exceptions for contractors critical to national security. Due process and  other safeguards should be built into the system to ensure that contractors  that pay their federal taxes are not inadvertently denied federal contracts.  We look forward to working with the Subcommittee on this important  matter.
Mr. Chairman and Members of the Subcommittee, this concludes our  statement. We would be pleased to answer any questions you may have.
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