Despite warnings, IRS lax in tracking nonwage income

Cheating on increase among the affluent


The government looks for tax cheating by wage earners far more carefully than it looks for cheating by people whose money comes from their businesses, investments, partnerships and trusts. This is true despite many warnings by federal tax officials that cheating is becoming far more common among the latter group.

Even as Congress finances a crackdown on tax cheating by the working poor, it is appropriating little money to detect abuses by people, usually among the wealthiest Americans, who do not rely entirely on wages for their income.

Executives at the Internal Revenue Service have mentioned this discrepancy in several reports to Congress. They have not focused attention on how little they can do about it. But an examination by The New York Times of IRS statistics including audit rates and staff deployment figures, as well as interviews with current and former IRS officials, shows that the agency can identify at best only a tiny percentage of the cheats and pursue even fewer of them.

That the IRS audits the working poor at a much higher rate than wealthy people has been disclosed before. What has not been discussed is that the agency does not track nonwage income as closely as wage income - and in some cases does not verify it at all, even as the IRS says that cheating on nonwage income is rising.

The greater scrutiny of wage earners begins with their employers, who must report wages in detail to the Internal Revenue Service on W-2 and 1099 forms. Banks report interest earned on accounts and paid on home mortgages. A Social Security number is required to take a child as an exemption.

IRS computers then compare each of these 1.4 billion independent reports to the entries on each individual income tax return.

Congress requires even more of the 19 million Americans who apply for the Earned Income Tax Credit, a payment from the government of as much as $4,008 for a low-income working family. Many of them are required to produce marriage licenses, school report cards to prove the existence of a child and other evidence.

But a much smaller group of Americans - almost all of them among the wealthiest 5 percent - are subjected to less rigorous standards. Among them are people who own businesses, collect rents from tenants and reap gains on their stocks and other investments, including partnerships.

The government trusts these people to report every dollar of income or profit. Business owners and landlords can report whatever they want, with no institution to contradict them.

Investors can also fudge their numbers. That is because brokerage firms are required to report to the IRS only the total amount received when stock or other securities are sold, leaving it to the investor to determine and report how much was taxable profit.

Even when a third party independently reports a person's income to the IRS - like income from partnerships, limited liability companies and trusts - the IRS has never matched these reports to individual income tax returns, said Dale Hart, an IRS deputy commissioner.

The reason, she said, is that historically the IRS saw little evidence of cheating by taxpayers with partnership and trust income. That is no longer true, she said.

Cheating on partnership income illustrates weaknesses in stopping abusive tax avoidance among the affluent. Three-fourths of partnership income goes to 2 percent of taxpayers, those making more than $200,000 annually.

As much as $1 in $5 from partnerships is not reported on individual tax returns, said Charles O. Rossotti, the former computer industry executive who has been commissioner of internal revenue for nearly five years.

After analyzing federal and state tax data at the request of The Times, Jerry Curnutt, a retired IRS expert on partnerships, estimated that by spending $9 million the IRS could recover $1.8 billion in taxes on partnership income alone, before counting interest and penalties. And perhaps $160 billion is lost in the underground economy, in which people are paid cash and report little or no income, based on IRS estimates.

But the focus of congressional action on tax cheats since 1995 has been on those among the working poor who actually file tax returns.

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