Who’s cheating Uncle Sam the most these days? Earlier this year, a pair of IRS researchers joined with economists from Carnegie Mellon, the London School of Economics, and the University of California at Berkeley to explore that question.
Americans up and down the income ladder, these analysts found, fail to report all their income. But the level of non-reporting varies enormously. Among Americans in the nation’s poorest 50%, just 7% of income goes unreported. In the top 1%, it’s nearly 20%.
What’s going on here? Or is it just deeply but unintentionally flawed?
It’s a complicated question. But as a tax attorney, I believe firmly that the flaws are intentional. Let’s examine the evidence.
Most of us don’t have the option of leaving income off our tax returns. Our employers report all our wages and salaries on W-2 forms. Our financial institutions report the interest on our savings and the dividends from our stocks on 1099s.
But the sort of income that flows to many at the top of our income ladder—business income of partnerships and other special categories of business enterprises—typically doesn’t show up on any form that has to be filed with the IRS.
In other words, we have a tax system with a built-in information reporting gap. That certainly counts as a major flaw.
An intentional flaw? Maybe, but it’s debatable. So let’s look at the recent and dramatic decline in IRS audit rates on the nation’s wealthiest.
Audits on incomes over $1 million have dropped an astounding 71% since 2010, the Center on Budget and Policy Priorities points out. This decline reflects some fairly substantial cuts in the IRS budget—a whack of 19% since 2010—and what could be more intentional than budget cuts?
Some might argue that the audit decline on high-income earners might just reflect the unavoidable complexity of their returns, which can include all kinds of business entities and trusts.
But if you keep digging, there’s still irrefutable evidence our tax system is rigged: tax code Section 6707A. No provision in our tax code smacks more of rigging by design.
Section 6707A of the tax code imposes a penalty for failing to disclose a “listed transaction,” basically any transaction the IRS identifies as an abusive move to avoid taxes.
The penalty for violating Section 6707A? A sum equal to 75% of the tax a taxpayer sought to avoid through the transaction, even if the transaction itself is determined to be legitimate. The failure to disclose also gives the IRS an unlimited amount of time to audit returns for listed transactions, not just the ordinary three years.
Sounds like a squeeze for shady filers, right? Those who engage in listed transactions can disclose their abusive transactions on their tax return, a move that will almost certainly trigger an audit. Or they can omit the disclosure and risk a whopping penalty.
But there’s a catch. Section 6707A comes with a maximum penalty. No individual who fails to disclose a listed transaction can be fined more than $100,000.
Think about that for a moment. For a person who engages in a listed transaction to avoid several million dollars of income tax, Section 6707A’s penalty limit essentially imposes no disincentive to tax cheating at all.
If you’re trying to avoid $50,000 in tax, the threat of a $37,500 penalty over and above the tax due will be daunting. But if you’re trying to avoid $3,000,000 in tax, that $100,000 penalty threat is trivial. Without the possibility of a stiff penalty, even the indefinite audit risk becomes far less threatening.
The bottom line: Section 6707A unquestionably rigs our tax system in favor of the ultra-rich. What possible good policy could be served by intentionally limiting the penalty exposure of very rich taxpayers and nobody else? I can’t think of one.
Could the intentional rigging of the tax code in favor of the rich be limited to this one obscure penalty provision? Do you wanna buy a bridge?
Bob Lord is a tax lawyer and an associate fellow at the Institute for Policy Studies.