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Unpaid taxes tough to recover

The tax gap -- the difference between what Americans owe the federal government and what they actually pay -- is an estimated $345 billion. Congress is looking for ways to close the gap.
/ Source: a href="" linktype="External" resizable="true" status="true" scrollbars="true">The Washington Post</a

Judging from his tax returns, Dinh Kim Huynh wasn't getting rich in the manicure business. In 2000, Huynh and his wife claimed taxable income of just $7,578 from their two nail salons in Southern Maryland -- so little that they qualified for a tax credit for the working poor. Their tax bill was $195.

But like millions of American business owners who trade primarily in cash, Huynh was not altogether honest with the Internal Revenue Service. When IRS agents poked around, they discovered four cars in Huynh's name, including a $77,000 Mercedes; receipts for diamonds and Rolexes in a closet at his Waldorf home; and a videotape of Huynh flashing a five-carat ring during the purchase of yet another vehicle at a local Honda dealership, court records show.

Huynh, 57, appears to be an especially bold contributor to the tax gap, the difference between what Americans owe the federal government and what they actually pay. By the most recent estimate, the tax gap is $345 billion. Unreported business income accounts for nearly a third of that amount. According to IRS data, U.S. shopkeepers, mechanics, farmers and landlords will pay less than half the taxes they owe on the returns that must be filed by midnight Tuesday.

The tax gap is becoming a popular target in Washington, where the White House and the Democrats who control Congress are eager to find new sources of cash without raising tax rates. But narrowing the gap would require potentially invasive new reporting requirements and ramped-up IRS audits that would inconvenience honest taxpayers and businesses even as they detect cheaters.

Some ideas under discussion: Force credit card companies to report the flow of funds to individual businesses, from the corner dry cleaner to online auctioneers who use eBay. Require stock brokers to report the purchase price when people sell stock. And create tax-withholding arrangements in industries that use independent contractors, such as hair salons, travel agencies and construction sites.

The U.S. Chamber of Commerce and other business groups say many of the proposals would burden law-abiding citizens while doing little to tackle the most significant component of the tax gap: small operators who deal directly with the public and are paid primarily in cash .

Nina E. Olson, the IRS's national taxpayer advocate, acknowledges that reducing the gap would be painful for the innocent as well as the guilty.

‘Going to take discipline’
"It's going to take discipline," she said. "Congress has said, 'collect the tax gap, collect the tax gap.' But can you stomach the complaints when people actually have to pay what they haven't paid before?"

"It's going to cause a lot of screaming," said economist Mark Zandi of Moody's

For the past four decades, voluntary compliance with U.S. tax laws has held relatively steady, varying from 81 to 84 percent, according to the Government Accountability Office. But the gap's size in dollars has grown with the economy, jumping from about $95 billion 15 years ago to nearly four times that today.

To some lawmakers, that looks like easy money. But the gap is notoriously stubborn. Former IRS executives identified just one big success: In 1985, taxpayers were told to name dependents on whom they wanted to claim deductions and list their Social Security numbers. "Lo and behold, we lost five million-plus children who never existed," said Donald C. Alexander, IRS commissioner at the time.

What were 5 million children worth to the IRS? About $5 billion -- peanuts compared with the overall tax gap. Reformers face the same problem now. Ideas offered by the White House in February, including the credit card measure, would collect only about $30 billion over the next decade.

Some Democrats, eager to find ways to pay for favorite government programs while offering middle-class tax breaks, say the IRS can squeeze as much as $100 billion a year out of tax cheats. Olson and others agree it could probably be done. "But not quickly and not easily," said former IRS commissioner Charles Rossotti. "And not without doing things people may not be willing to accept."

The IRS, of course, has a history of doing things people are not happy to accept. For years, the agency's chief tool for assessing the tax gap was a vast system of random examinations derided as "audits from hell." The surveys, last conducted in 1988, were discontinued in the mid-1990s after grass-roots anger flared over taxes and aggressive IRS enforcement. The 1988 survey remains the most recent source of detailed information about the tax-paying behavior of corporations.

In 2001, the IRS introduced a new compliance tool called the National Research Program. The first round focused on 46,000 individual taxpayers, including 21,000 sole proprietors with business income. Those results, combined with a re-estimate of the 1988 corporate data, make up the government's current understanding of the tax gap.

According to the IRS, taxpayers paid about $1.8 trillion on time in 2001, leaving an estimated $345 billion outstanding. (The IRS estimates that it will collect $55 billion through routine enforcement.) Those who didn't file returns or under paid accounted for $60 billion. But the biggest loss came from underreported income: $30 billion from corporations, $54 billion from employers and $197 billion from individuals.

For individuals, more than half the loss -- $109 billion -- was the result of unreported business income, the IRS found.

Agency officials say some underreporting is unintentional, though no one knows how much. Another portion may be caused by unscrupulous tax preparers, an emerging focus of concern.

Earlier this month, the Justice Department moved to shut down 125 offices of Jackson Hewitt, the nation's second-largest tax preparer, after discovering evidence of "massive" fraud. In Chicago, according to one complaint, Jackson Hewitt employees received kickbacks for accepting phony W-2 forms and generating fraudulent refunds.

The company has declined to comment on the action but noted in a statement that it is "limited to one franchisee, whose entities . . . represent about 2 percent" of the company's total revenue. "Jackson Hewitt remains committed to providing accurate, quality tax preparation," the statement said.

Volunteers who assist low-income taxpayers say they are routinely victimized by preparers who plump up their refunds and persuade them to take out refund-anticipation loans at high interest rates. Some preparers set up shop in car dealerships or rental furniture outlets where the loans can be put to immediate use.

Tax gap hearing
The IRS has resisted efforts to regulate tax preparers, but Olson said lawmakers are considering the idea. A Senate committee plans a hearing on the tax gap later this week.

Of course, some cheating tax preparers act at the behest of cheating taxpayers. The IRS has consistently found that cheating is concentrated where there is opportunity, meaning no paper trail. Wage earners, whose taxes are withheld and whose income appears on W-2 statements, tend to understate their tax bill by 1.2 percent. But sole proprietors, farmers, renters and "informal suppliers" such as sidewalk vendors and housekeepers pay just 46 percent of the taxes they owe, according to IRS research.

The courts are rife with examples of unreported business income. Just this year, prosecutors say:

  • Konstantinos "Gus" Stamoulis and three of his children pleaded guilty to skimming hundreds of thousands of dollars off daily receipts at a restaurant four blocks from the White House. Stamoulis was sentenced this month to two years probation.
  • Mike Hogan Jr., was indicted on charges of concealing income from a mattress shop, a restaurant and two other West Texas establishments, in part by depositing nearly $400,000 in bank accounts he allegedly opened in the names of his sister-in-law and ex-wife.
  • Joseph Francis, creator of the "Girls Gone Wild" videos, was indicted last week on charges that his companies claimed more than $20 million in phony business expenses, using offshore bank accounts to conceal income.

Then there is Huynh (pronounced HWIN), the nail salon owner. Prosecutors say Huyhn's taxable income in 2000 was $273,000 -- 36 times what he reported. The IRS won't say how it caught him. His attorney suspects a snitch, but IRS officials say that is rare. Cases like Huynh's typically start with a red flag during a routine tax review.

Prosecuting a tax cheat can be hugely labor intensive. IRS agents dug through Huynh's garbage and monitored his house and salons for days, logging license plate numbers and identifying associates, according to court records. A 2003 search warrant finally turned up critical documents.

Last year, Huynh pleaded guilty and began serving 18 months in prison. His wife is to be sentenced later this month. So far, they have been ordered to pay $365,000 in back taxes.

More money for enforcement
The IRS audited 1.3 million taxpayers last year, just under 1 percent of returns filed. The White House has requested more money for enforcement and Congress is inclined to grant it. But audits alone can't close the tax gap.

"We'd have to have every other person [in America] working for Internal Revenue," said Steve Burgess, a director of IRS examinations. "Nobody wants that."

Still, experts say closer scrutiny of American life will be necessary if the government wants to make serious inroads.

"Unless we want to do something much more drastic than we've done in the past, you're really talking about . . . incremental increases in compliance," said former IRS commissioner Lawrence Gibbs. "There is no low-hanging fruit in this area."