Wednesday, April 15, 2009

Navigating a Tax Return Minefield

Earlier today posted a helpful article for anyone trying to beat the tax deadline and get his or her returns in on time. The reporter spoke with Taxpayer Advocate Nina E. Olson on how to avoid making a costly mistake in the mad rush. I’ve included a portion of the article below but you can read the full text at The Urge to Fudge on Form 1040.

With just a few more days to file your tax returns, you may be tempted — especially in this down economy — to shave a little income, maybe, or add a little more to your deductions.

After all, what are the odds of being audited? (For the record: Only about 1.4 million of the 135 million returns filed each year are audited and of those, only about 310,000 taxpayers are forced to look an I.R.S. agent in the eye and explain their numbers.)

You couldn’t help thinking of this when one after another of President Obama’s nominees was caught underpaying taxes after the nominee’s returns underwent a heavy-duty scrubbing. Most people don’t have to worry about paying taxes on free limousines and chauffeurs — as in the case of Tom Daschle, the former South Dakota senator who was Mr. Obama’s first choice as health and human services secretary. But many of us could easily be unable to come up with a receipt for a charitable donation, which is what tripped up Mr. Daschle’s replacement, Kathleen Sebelius. And how many people think it’s easier to simply pay the baby sitter in cash and, by coincidence, avoid the nanny tax?

All this raises the question: If most Americans’ tax returns were subject to the same scrutiny as those inside the Beltway, would we find that many of us pay less than we really owe? Or would we find that a lot of returns are, at the very least, riddled with errors?

As it turns out, the most recent Internal Revenue Service statistics estimate that about 86 percent of taxes owed are collected. And of the approximately $290 billion that goes uncollected by the I.R.S., a big piece can be attributed to inadvertent mistakes, given the complexity of the tax code. But when presented with the opportunity, a large swath of people still seem to forget to report a chunk of their undocumented income.

Not surprisingly, the I.R.S. has studied the issue. And what it found was that the biggest portion of uncollected tax revenue was from people who run cash-intensive businesses and don’t have receipts for all their earnings. Wage earners, whose employers report every last penny, don’t have much wiggle room. As a result, only 1 percent of income from wages, salaries and tips is estimated to be underreported, compared with 57 percent of income from businesses like plumbers or other sole proprietors, according to a 2006 report conducted by the IRS’s National Research Program.

Another report on the subject found that those who earn $500,000 to $1 million have the highest rate of misreported income. These people often have income from investments and other sources that are hard to track.

“They make a risk calculation,” said Nina E. Olson, the national taxpayer advocate, whose office helps taxpayers resolve their problems with the I.R.S. “If the risk of me being discovered is low, the penalty is modest and the benefit is great, then I am willing to accept that risk.”

But, she added, that logic cannot alone explain the fact that an overwhelming majority pay their fair share given the IRS’s limited resources. When asked, of course, the vast majority of Americans claim to be a righteous bunch: 89 percent said it was unacceptable to cheat on their income taxes, according to the I.R.S. Oversight Board’s 2008 Taxpayer Attitude Survey. And 81 percent of those polled said their personal integrity had a “great deal of influence” on whether they’re truthful about their taxes.

But, as Ms. Olson explained, there’s only so much more reporting that can be reasonably done. Busy families can’t be expected to file a 1099 every time they pay the landscaper, for instance, or the party caterer.

What might work, Ms. Olson said, is appealing to people’s consciences, or really examining why we pay taxes and what society receives in return.

The government tried this tack during World War II, when it co-opted Donald Duck for the job. In an animated short produced by Walt Disney, a radio announcer reminds a tax-averse Donald that it’s his patriotic duty to pay taxes. Donald, who in 1941 earned $2,501 (the equivalent of $36,101 in today’s dollars), is persuaded after being told he needs to pay “taxes to beat the Axis!”

But civic duty may be a harder sell today, especially when average taxpayers are constantly bombarded with news of new bailouts, corporate tax breaks, loopholes and offshore hiding spots exploited by wealthier Americans.

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