TREASURY INSPECTOR GENERAL
FOR TAX ADMINISTRATION
Significant Tax Revenue May Be Lost Due to Inaccurate Reporting of Taxpayer Identification Numbers for Independent Contractors
Reference No. 2001-30-132
For Tax Years (TY) 1995 through 1998, the Internal Revenue Service (IRS) received about 9.6 million Statements for Recipients of Miscellaneous Income (Forms 1099-MISC), reporting approximately $204 billion in non-employee compensation, that did not contain a Taxpayer Identification Number (TIN) for the payee or match the IRSí records of assigned TINs. Consequently, the IRS could not use these information documents in its computer-matching programs to determine whether the recipients of this compensation filed a tax return and/or reported all of the income.
Under the Internal Revenue Code (I.R.C.), payers are required to immediately begin backup withholding of taxes, at a rate of 31 percent, from non-employee compensation payments if the recipients fail to furnish a TIN. Payers are also required to begin backup withholding if the payees fail to timely resolve an incorrect TIN condition after the IRS has notified them. Treasury Regulation ß 301.6721-1 also permits the IRS to impose a $50 civil penalty upon payers for each information return that fails to include all required information or includes incorrect information.
Combating important areas of noncompliance is one of the IRSí strategies for achieving its goal of providing service to all taxpayers through the fair and uniform application of the law. The objective of this audit was to determine whether opportunities exist for the IRS to increase payer compliance with the reporting requirements for non-employee compensation by more effectively administering the existing tax laws and regulations.
The IRSí ability to encourage the filing of accurate information returns for non-employee compensation, through its administration of the existing backup withholding and penalty provisions, is extremely limited and largely ineffective. Between TYs 1995 and 1998, the number of Forms 1099-MISC reporting non-employee compensation received by the IRS with missing or incorrect TINs increased by 36 percent. Because the IRS was unable to match these documents with tax returns, tax revenue was potentially lost each year. The amount of the potentially lost revenue may be significant since the IRSí data suggests that independent contractors who receive non-employee compensation are far less compliant than wage earners in reporting their income.
This report discusses these issues and presents two divergent approaches the IRS could pursue for achieving more accurate information reporting and for protecting the significant tax revenue that may be lost due to the inaccurate reporting of TINs for independent contractors.
A Tax Law Change to Require Withholding on Non-Employee Compensation Would Encourage Independent Contractors to Furnish Correct Taxpayer Identification Numbers
Each year, the IRS receives an average of 2.4 million Forms 1099-MISC reporting non-employee compensation payments totaling $51 billion, which contain a missing or incorrect TIN. We believe the root cause of this problem is that when a business classifies a worker as an independent contractor, the law does not require the business to withhold taxes from their compensation. Thus, by not furnishing a correct TIN, or any TIN at all, to the businesses for which they work, independent contractors can conceivably avoid paying taxes on their earnings, since the IRS will be unable to verify their compliance in reporting the income.
The fundamental solution to more accurate information reporting lies in changing the law to require mandatory income tax withholding on non-employee compensation payments. Mandatory withholding on non-employee compensation would encourage independent contractors to provide payers with an accurate TIN and provide an incentive for them to report the income on their tax returns. It would also enable the IRS to more fairly administer its tax compliance programs among both employees and independent contractors, and reduce the need for the IRS to burden businesses with backup withholding notices and penalties that have proven to be largely ineffective.
In the past, the General Accounting Office (GAO) and the Joint Committee on Taxation have both concluded that the noncompliance among independent contractors is serious enough to warrant some form of tax withholding. In a 1992 audit report, for example, the GAO cited an IRS estimate that the annual tax gap caused by self-employed individuals (including independent contractors) who did not report all of their income was $20.3 billion. In testimony before the Congress in 1996, the GAO cited an estimate from a 1979 IRS study that 47 percent of the independent contractors reported none of their business income.
Backup Withholding Laws and Penalty Provisions Need Strengthening to Improve Compliance with Information Reporting Requirements
The IRS has no effective means to ensure that payers immediately initiate backup withholding, as required by law, when independent contractors fail to provide them with a TIN. For TY 1998, the IRS received nearly 417,000 Forms 1099-MISC reporting more than $7.2 billion in non-employee compensation, which did not include the payeeís TIN. None of the 192,000 payers who submitted these information documents to the IRS had implemented backup withholding as required by law. As a result, approximately $2.2 billion in taxes was not withheld and remitted to the IRS. It is not known how much in taxes the IRS eventually collected on this income.
In addition, almost half of all payers that submit Forms 1099-MISC with invalid TINs do not receive backup withholding notices because of the IRSí administrative criteria for issuing the notices. Because of the length of time it takes the IRS to process the information returns and identify those which contain an invalid TIN, the remaining payers who meet the IRSí backup withholding notice criteria receive the notices far too late to enable them to effectively correct most invalid TIN problems.
Penalties are also having a negligible impact on encouraging the accurate reporting of TINs on information returns. The IRSí administrative criteria for proposing penalties exclude most of the payers who submit information returns with missing or invalid TINs. For TYs 1996 and 1997, penalties were assessed against only 3,356 (0.2 percent) of the 1,643,000 payers who submitted Forms 1099-MISC with missing or invalid TINs.
Summary of Recommendations
Legislation to require mandatory tax withholding on all non-employee compensation payments is needed to encourage accurate information reporting and to protect the Treasury from the potential loss of significant tax revenue. As an alternative, the IRS needs to seek changes that will enable it to more aggressively impose backup withholding requirements and civil penalties on payers who submit Forms 1099-MISC with missing or invalid TINs. A prerequisite for improving compliance with the information reporting laws is the availability of a system that payers can use to confirm the accuracy of a TIN at the beginning of their relationship with a new worker. The IRS is currently developing an Internet-based TIN confirmation program as part of its overall business systems modernization efforts. With some changes to the tax laws and IRS procedures, we believe that the availability of a TIN verification system can also provide an opportunity to expedite and strengthen the backup withholding notification process and protect the government from the loss of tax revenue. The penalty criteria should be revised to enable the IRS to assess payers for the amount of any backup withholding they fail to collect when required by law.
Managementís Response: The Commissioner, Small Business/Self-Employed (SB/SE) Division, responded that the IRS has previously submitted proposals for legislative changes to Treasury that would require mandatory withholding of income taxes on non-employee compensation payments. In the past, Treasury has chosen not to forward these proposals to the Congress. He will work with the Legislative Affairs Office to consider whether it is feasible for the IRS to submit additional proposed legislative changes.
The Commissioner, SB/SE Division, also responded that he will consider supplementing the Internet-based TIN confirmation program with an automated telephone-based TIN confirmation process. However, he did not agree with proposing legislation to make it mandatory for payers to verify the accuracy of TINs at the beginning of their relationship with a payee. He also did not agree with changing the IRSí administrative guidelines so that, when the results of any submission to the TIN verification program indicate that a TIN is invalid, it constitutes the IRSí official notice to the payer to begin imposing backup withholding if the recipient does not provide a correct TIN. The Commissioner, SB/SE Division, will, however, consider proposing legislation to change the criteria for asserting the Incorrect Information Penalty.
Office of Audit Comment: We are encouraged that the IRS plans to consider some of our recommendations. However, we are disappointed that the IRSí response does not reflect a stronger overall commitment for addressing a significant tax compliance problem involving a rapidly growing segment of taxpayers. We are particularly concerned that the IRS does not plan to enforce accurate TIN reporting once a TIN verification program is made available to payers. If the IRS does not require accurate TIN information from payers, compliance is not likely to improve.
We have included both the IRSí response and our comments concerning the response in the main body of this report. The full text of managementís response to the draft report is included as Appendix V.