on June 4, 2007.
Over the past two decades, credit card companies have made a fortune using customer data to develop new products and fee structures. Now the federal government wants to enlist a small slice of the industry's vast information resources to attack Treasury's largest and most vexing compliance problem — underreporting of income by small businesses. Over 40 percent of the estimated $345 billion annual tax gap is attributable to underreporting of net business income by individuals.
The proposal first surfaced in President Bush's February 2006 budget release. It would require financial institutions that process credit and debit card payments for businesses to report each business's annual total card receipts to the IRS. Treasury and the Joint Committee on Taxation both estimated the proposal would help the IRS collect no more than $100 million in any year, and the Republican Congress ignored it. But when the administration proposed it again in February 2007, it was a whole new ballgame.
First, unlike Republicans who are generally fond of weak IRS enforcement, Democrats are now in control of Congress, and they are fixated on raising revenue by closing the tax gap. Second, it seems as though somebody riled up the revenue estimators at both Treasury and the JCT because they now estimate the proposal would raise a whopping $10.3 billion of revenue over 10 years. That makes it the largest of all the 16 compliance proposals offered by the administration in the fiscal 2008 budget.
The conventional wisdom among tax experts is that it is neither desirable nor possible for the IRS to audit its way out of the tax gap. The more promising approach to improving tax compliance is increased information reporting. IRS research summarized in Figure 1 (on the next page) shows why.
Underreporting by individuals can be divided into four categories:
1. When there is withholding and information reporting, the rate of underreporting of income is only 1.2 percent;
2. When there is substantial information reporting, the underreporting rate is 4.5 percent;
3. When there is some information reporting, the underreporting rate is 8.6 percent; or
4. When there is no information reporting, income is underreported by 53.9 percent.
The proposal would move small-business income from category 4 to category 3.
Clouds on the Horizon?
The problem with mandating additional information reporting is the burden it places on businesses. Given the high compliance costs already placed on small businesses and their clout on Capitol Hill, the resistance of those businesses is a substantial political hurdle for lawmakers pushing proposals to close the tax gap.
The payment card proposal has two features that help keep opposition to a minimum. First, the third-party source being tapped to supply information is already savvy in handling similar data. The belief among proponents, like Treasury Assistant Secretary for Tax Policy Eric Solomon, is that the "existing paper trail would make it relatively easy to generate information reports to the IRS."
Second, whatever the extra burden, none of it would fall directly on small businesses. All the newly required information would flow from credit card companies to the IRS. That's probably why former IRS Commissioner Mark Everson told the House Ways and Means Committee on March 20 that this was his favorite compliance proposal of the 16 the administration was proposing.
But still, the proposal is no shoo-in. A vigorous lobbying effort against it has begun. Most prominent of the opponents is the newly formed Coalition for Fairness in Tax Compliance. Backing the group are the National Federation of Independent Business (NFIB), the U.S. Chamber of Commerce, the Small Business Legislative Council, and a dozen other interested parties. In addition to their political power, opponents are providing Congress with a lot of reasons to kill the idea. Here's what they are saying:
It is unclear if there is an accurate and efficient system in place to report merchant payment card reimbursements to the IRS. Figure 2 (on p. 892) illustrates the flow of information of a typical credit card transaction. There are four steps: (1) the merchant provides the identity of the purchaser and the amount of the purchase to its credit card processor (also known as the "merchant acquiring bank"); (2) the acquiring bank sends the same information to the network processor (usually Visa or MasterCard); (3) the network processor sends the information to the customer's credit card issuer; and (4) the transaction amount is posted to the customer's account. The general idea behind the proposal is that the acquiring bank, which typically sends monthly statements to merchants, including the aggregate dollar value of card purchases, will also send an annual statement to the IRS.
Figure 1. Individual Income Tax Underreporting Gap
Source: IRS, "IRS Updates Tax Gap Estimates," Feb. 14, 2006
In reality, however, there can be more layers than shown in the simple figure. Sometimes the acquiring bank sends statements to a chain, but the individual franchisees are the parties of interest to the IRS. Sometimes an individual taxpayer will have multiple statements, each corresponding to individual locations. Sometimes the acquiring bank works with a larger bank that actually performs the merchant bank card services. In each of those cases, it is not exactly clear who should do the sending or what information should be sent. Opponents of the proposal fear that as a result of the confusion, errors will arise, costs will escalate, and there will be needless duplication of reporting.
Also, opponents of the proposal argue that if more reporting is required and it imposes additional costs on the merchant processor, those costs may ultimately be passed down to small businesses. While this is not a direct burden on small businesses, they may ultimately pay for it with increased fees to run the payment card reimbursement system.
It is unclear how the IRS will be able to match and use the information reported by the merchant processor. Ideally, credit card companies will report payment card reimbursements that correspond to gross receipts reported on a merchant's tax return. However, the IRS does not require businesses to separate their cash and credit income on their tax returns. Consequently, because payment card companies would only report credit transactions, and businesses would report income from both credit and cash transactions (combined, not separately) on their tax returns, the IRS will not be in a position to reconcile this information efficiently and accurately.
Also, payment card receipts may or may not include adjustments for disputed purchases known as charge-backs. Sometimes customers using debit cards get cash back in addition to making a purchase. In this case, reported volume may include dollar amounts not part of gross receipts. And while card activity corresponds to cash flow, it may not accurately reflect the gross income of an accrual basis taxpayer. For example, the sale of a gift card may be included in payment card totals but income is not booked until a purchase is made with the card.
The costs of programming and reporting are large and will result in higher fees. In general, the merchant acquiring bank does not retain its customers' taxpayer identification numbers or (in the case of sole proprietors) Social Security numbers. For security purposes, the banks will use their own internally generated merchant identification number. Under the proposal, the merchant acquiring banks would have to compute annual volume and keep the merchant numbers linked to TINs or SSNs. Programming and maintenance costs of this new database could be large. Another concern is that with increased use, there is increased risk that confidentiality of SSNs could be jeopardized.
Unfair auditing of honest small businesses will result. When the reported data do not correspond to IRS expectations simply because businesses have a low volume of cash transactions or because of other discrepancies described above, honest taxpayers will be subjected unfairly to audit through no fault of their own. "The IRS would have no real way to match the new data with a small business's tax return because there would be too many discrepancies between the reported data and a tax return," Chris Walters of the NFIB told Tax Analysts. "Any proposal that has the unintended consequence to set up the honest taxpayer for an audit is a serious concern to the small-business industry," he added.
Figure 2. In a Matter of Seconds -
Typical Credit Card Transaction
Cynics might say that some small businesses don't like the proposal because it would force them to cut back on one of their favorite pastimes — hiding income from the tax collector. And some of us might say that credit card companies don't like the proposal because once it is in place, businesses would redouble their efforts to get customers to use cash rather than credit, and that is a threat to financial institutions' profit. But don't mention such ideas in polite company or on Capitol Hill.
Actions Speak Louder Than Words
Senate Finance Committee Chair Max Baucus, D-Mont., has complained loudly and repeatedly that Treasury's current proposals for closing the tax gap are inadequate. Frustrated by what he perceives as a lack of action, he demanded on April 18, with Treasury Secretary Henry Paulson sitting right before him, that Treasury deliver by July 18 a plan to increase the rate of voluntary compliance from its current level of 85.3 percent to 90 percent by 2017. A 90 percent compliance rate would mean an extra $150 billion a year. "Mr. Secretary, you've not heard the last from me on this," Baucus said. "See you in three months."
On May 25 Baucus and Finance Committee ranking minority member Chuck Grassley, R-Iowa, released their agreed-on version of the president's proposal to require information reporting by brokers on customer basis in securities transactions (see p. 887). The president's proposal was estimated to raise $6.7 billion over 10 years. That is a major step forward for compliance efforts.
Baucus, however, will lose all rights to lead the crusade against tax cheating — and to demand further action from Treasury — if he cannot get the bulk of the proposals already proposed by the president through the Senate. So we await an announcement on credit card reporting — similar to the May 25 announcement on basis reporting — from the Finance Committee. Then it will be clear the committee is willing to go beyond talk and take the political heat that goes with closing the tax gap.