Significant Tax Revenue May Be Lost Due to Inaccurate Reporting of Taxpayer Identification Numbers for Independent Contractors
August 2001
Reference Number: 2001-30-132
This report has cleared the Treasury Inspector General for Tax Administration disclosure review process and information determined to be restricted from public release has been redacted from this document.
August 24, 2001
MEMORANDUM FOR COMMISSIONER, SMALL BUSINESS/SELF-
EMPLOYED DIVISION
FROM: Pamela J. Gardiner /s/ Pamela J. Gardiner
Deputy Inspector General for Audit
SUBJECT: Final Audit Report – Significant Tax Revenue May Be Lost Due to Inaccurate Reporting of Taxpayer Identification Numbers for Independent Contractors
This report presents the results of our review of the Internal Revenue Service’s (IRS) ability to encourage the filing of accurate information returns for non-employee compensation through its administration of the existing backup withholding and penalty provisions. We performed this review because combating important areas of noncompliance is one of the IRS’ strategies for achieving its goal of providing service to all taxpayers through the fair and uniform application of the law.
In summary, from Tax Years (TY) 1995 through 1998, the IRS received about 9.6 million information documents, reporting approximately $204 billion in non-employee compensation, that did not contain a Taxpayer Identification Number (TIN) or match the IRS’ records of assigned TINs. Consequently, the IRS could not use these documents to verify that the taxpayers had filed tax returns and reported this income. The current tax laws and regulations enable the IRS to impose backup withholding requirements and assert civil penalties on payers, when applicable, to encourage the submission of accurate information returns. However, these tools have been used sparingly and have been largely ineffective as evidenced by a 36 percent increase in the number of information documents received with missing or invalid TINs between 1995 and 1998. Tax law changes are needed to effect significant improvement in information reporting and to protect the substantial tax revenues that are potentially being lost each year.
Management’s Response: In response to our recommendations, IRS management agreed to consider the feasibility of proposing new legislation to require mandatory withholding of income taxes on non-employee compensation payments, supplementing the Internet-based TIN confirmation program with an automated telephone-based system, and proposing legislation to change the criteria for asserting the Incorrect Information Penalty.
However, IRS management 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. They also did not agree with changing the IRS’ administrative guidelines so that when the results of any submission to the TIN verification program indicate that a TIN is invalid, it constitutes the IRS’ official notice to the payer to begin imposing backup withholding if the recipient does not provide a correct TIN.
Office of Audit Comment: We are encouraged that the IRS plans to consider some of our recommendations. However, we are disappointed that the IRS’ response does not reflect a stronger overall commitment for seeking legislation that would help to address 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. While we still believe our recommendations are worthwhile, we do not intend to elevate the disagreement concerning them to the Department of the Treasury for resolution.
We have included both the IRS’ response and our comments concerning the response in the main body of this report. The full text of management’s response to the draft report is included as Appendix V.
Copies of this report are also being sent to the IRS managers who are affected by the report recommendations. Please contact me at (202) 622-6510 if you have questions or Gordon C. Milbourn III, Assistant Inspector General for Audit (Small Business and Corporate Programs), at (202) 622-3837.
Appendix I – Detailed Objective, Scope, and Methodology
Appendix II – Major Contributors to This Report
Appendix III – Report Distribution List
Appendix IV – Outcome Measures
Appendix V – Management’s Response to the Draft Report
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 IRS’ 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 § 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 IRS’ 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.
Results
The IRS’ 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 IRS’ 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 payee’s 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 IRS’ 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 IRS’ 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 IRS’ 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.
Management’s 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 IRS’ administrative guidelines so that, when the results of any submission to the TIN verification program indicate that a TIN is invalid, it constitutes the IRS’ 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 IRS’ 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 IRS’ response and our comments concerning the response in the main body of this report. The full text of management’s response to the draft report is included as Appendix V.
Our overall objective was to determine whether opportunities exist for the Internal Revenue Service (IRS) to increase payer compliance with the information return filing/reporting requirements for non-employee compensation by more effectively applying the existing tax laws and regulations. Our purpose in conducting the review was to assist the IRS in its strategy to combat important areas of noncompliance to achieve its goal of providing service to all taxpayers through the fair and uniform application of the law.
To accomplish this objective, we determined whether the IRS effectively monitored and enforced payer compliance with the Internal Revenue Code (I.R.C.) backup withholding provisions for income recipients who fail to furnish a correct Taxpayer Identification Number (TIN). We also evaluated whether the IRS’ application of civil penalties against payers who submitted information documents with missing or incorrect TINs was consistent with its Penalty Policy Statement.
We focused our analysis on the invalid TIN data received by the IRS on Statement for Recipients of Miscellaneous Income (Form 1099-MISC) reporting non-employee compensation. To accomplish our objective, we extensively relied on computer-processed data extracted from the IRS’ Information Returns Masterfile (IRMF). We did not establish the reliability of this data because the majority of the input to this file originated from magnetic media sources outside of the IRS. This report reflects the actual number of deficiencies identified rather than sampled results. We also reviewed program requirements for the Backup Withholding-Incorrect TIN and the Incorrect Information Penalty programs.
Except for validating the accuracy and completeness of the IRMF data, this review was conducted in accordance with Government Auditing Standards. Our fieldwork was performed between June 2000 and February 2001 in the IRS’ Headquarters Office.
Details of our objective, scope, and methodology are presented in Appendix I. A listing of major contributors to this report is shown in Appendix II.
Federal tax laws require all entities engaged in a trade or business to file an accurate statement of payments made for services performed by each recipient. The IRS has prescribed the use of Form 1099-MISC for reporting payments of $600 or more on a calendar-year basis to persons who are not employees (e.g., independent contractors).
The IRS uses these information documents in its computer-matching program to determine whether the income recipients filed a return and/or reported all of their income. First, however, the IRS must validate the accuracy of the payee’s name and TIN. The validation program compares the information return data to the IRS’ and the Social Security Administration’s (SSA) records of valid TINs and associated taxpayer names. For individuals, the TIN is generally the Social Security Number (SSN) assigned by the SSA, while for businesses, the TIN is generally the Employer Identification Number (EIN) assigned by the IRS. For sole proprietors, the TIN may be an SSN or EIN.
The tax laws and regulations currently provide the IRS with two tools to encourage the filing of information returns with accurate TINs. For example, the law requires payers to immediately begin the backup withholding of taxes, at a rate of 31 percent, from certain reportable payments (including non-employee compensation) if the recipient fails to furnish a TIN. Payers are also required to commence backup withholding if the payees fail to timely resolve an incorrect TIN condition after the IRS has notified them that the TIN is incorrect. Treasury Regulation § 301.6721-1 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.
The IRS’ 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 Tax Years (TY) 1995 and 1998, the number of Forms 1099-MISC submitted to the IRS with missing or incorrect TINs increased by 36 percent. As a result, there was a potential loss of significant tax revenues, since the IRS was unable to verify that more than $200 billion in non-employee compensation was reported on tax returns filed for these years.
This report explores these issues and presents two different approaches that the IRS could take to achieve more accurate information reporting for non-employee compensation. Both approaches would require changes to the existing tax laws. The first would require businesses to withhold taxes from payments made to independent contractors. The second would use the IRS’ planned Internet application for payers to verify TINs as a means to expedite the backup withholding notification process and, when applicable, to permit the IRS to assess the businesses for the amount of any backup withholding that they failed to collect.
A Tax Law Change to Require Withholding on Non-Employee Compensation Would Encourage Independent Contractors to Furnish Correct Taxpayer Identification Numbers
For each tax year from 1995 to 1998, the IRS received an average of 2.4 million Forms 1099-MISC, reporting non-employee compensation payments totaling $51 billion, that did not contain valid TINs for the payees. Consequently, the IRS could not use these information documents in its computer-matching program to determine whether the income recipients filed a return and/or reported all of their income. 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 eventual payment and/or collection of taxes on this income is at risk because, historically, tax compliance among independent contractors who earn non-employee compensation has been significantly lower than wage earners whose taxes are withheld by their employers.
When a business classifies a worker as an employee, the business must withhold income taxes and Social Security/Medicare contributions from the worker’s pay and send the withheld taxes to the IRS. Withholding is a fundamental premise of the voluntary compliance system for individual employees in that it provides for a gradual and systematic method to pay taxes and, assuming that they provide a correct TIN, it ensures that the employees receive credit for Social Security coverage. For example, an audit report by the General Accounting Office (GAO) cited a 1988 study by the IRS that showed employees subject to withholding had voluntarily reported 99.5 percent of their 1987 wage income.
We believe that the root cause of the significant information reporting problems for non-employee compensation is that when a business classifies workers as independent contractors, the business is not required to withhold taxes, as it would be if these workers were classified as employees. Instead, self-employed taxpayers, such as independent contractors, are required to make estimated tax payments in quarterly installments. In addition to income taxes, these estimated payments include contributions to the Social Security trust fund.
To reduce costs, businesses are increasingly outsourcing work because they do not have to pay payroll taxes on payments to independent contractors and include independent contractors in their retirement plans and other fringe benefits. A recent financial magazine article stated that the number of self-employed taxpayers rose 26 percent between 1988 and 1999, while the number of taxpayers reporting wage income grew by only 14 percent.
Not withholding income tax on independent contractors has a significant effect on voluntary compliance. For example, the IRS’ Statistics of Income (SOI) data for individual income tax returns filed during 1997 showed that 2.3 million (26 percent) of the 8.8 million unpaid balance due returns involved taxpayers who had no withholding.
As early as 1979, the GAO concluded that the noncompliance among independent contractors was serious enough to warrant some form of tax withholding on payments made to them. Since then, at least two GAO reports and congressional testimonies have suggested withholding taxes from payments to independent contractors.
To support this position, the GAO has cited various IRS studies and data that show a significantly lower level of compliance among independent contractors as compared to employees.
In addition, a 1992 report by the Joint Committee on Taxation acknowledged the revenue loss associated with the lower compliance rates of independent contractors and made suggestions to improve compliance and enforcement. One suggestion was to require businesses to withhold income and employment taxes from payments to independent contractors, just as such taxes are withheld from wages paid to employees.
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.
Recommendation
The Director, Compliance, Small Business/Self-Employed (SB/SE) Division, is responsible for the overall management of programs that address post-filing compliance issues involving non-employee compensation. To reduce the number of information documents received each year with missing or invalid name/TIN data and to promote increased tax compliance by independent contractors, the Director, Compliance, needs to:
Management’s Response: The Commissioner, 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 the likelihood of Treasury’s acceptance of a resubmitted proposed legislative change and, by December 31, 2001, decide whether it is feasible for the IRS to submit it.
Office of Audit Comment: While we are encouraged that the IRS plans to consider our recommendation, we are disappointed that the IRS’ response does not reflect a stronger overall commitment for seeking legislation that would help to address a significant tax compliance problem involving a rapidly growing segment of taxpayers.
Backup Withholding Laws and Penalty Provisions Need Strengthening to Improve Compliance with Information Reporting Requirements
For a variety of reasons, the IRS has not been able to effectively use backup withholding and civil penalties as tools to encourage compliance with information reporting requirements for non-employee compensation. Consequently, as previously stated, between TYs 1995 and 1998, the number of Forms 1099-MISC submitted to the IRS with missing or incorrect TINs increased by 36 percent.
The current backup withholding laws are not effectively promoting compliance with information reporting requirements for independent contractors
I.R.C. § 3406 requires payers to immediately begin backup withholding at a rate of 31 percent from certain reportable payments (including non-employee compensation) if the recipient fails to furnish a TIN. The Senate Finance Report supporting the legislation that first imposed backup withholding on payments to independent contractors stated:
The absence of a correct TIN on an information return often makes it difficult and expensive for the Internal Revenue Service to match and verify the proper reporting of income on the tax return of the taxpayer concerned. The committee believes that if a taxpayer fails to supply his correct TIN to another person withholding should be imposed to assure that taxpayers comply with the income tax laws.
The IRS received nearly 417,000 Forms 1099-MISC for TY 1998 that did not include the payee’s TIN. These documents reported more than $7.2 billion in non-employee compensation. However, none of the 192,000 payers who filed these information returns had imposed backup withholding as required by law. As a result, the IRS did not receive approximately $2.2 billion in withheld income taxes. It is not known how much in taxes the IRS eventually collected on this income. However, the IRS’ past compliance studies suggest that a significant amount of the taxes due on the $7.2 billion in non-employee compensation may never be paid.
I.R.C. § 3406 also requires payers to begin backup withholding if the payees fail to timely resolve an incorrect TIN condition after the IRS has notified them that the TIN is incorrect. However, the IRS’ administrative criteria for issuing backup withholding notices excludes almost half of the businesses that file information returns with missing or invalid TINs.
Of the nearly 862,000 payers that submitted approximately 2.7 million TY 1998 Forms 1099-MISC with missing or invalid TINs, 842,177 had a distinct payer TIN and paid at least $600 to a worker. However, 386,499 (46 percent) of these payers did not meet the IRS’ backup withholding notification criteria.
In addition, the remaining payers who did meet the IRS’ backup withholding notification criteria received the notices too late to enable them to effectively correct most invalid TIN problems. Although payers are required to file information returns with the IRS by February 28 of the year following the end of the tax year, the IRS does not generate the initial backup withholding notices until October (e.g., October 1999 for TY 1998 information returns). This interval reflects the time it takes the IRS to process the information returns and validate the name and TIN data against its own records. The IRS makes a second execution of the backup withholding notice program in March of the subsequent tax year (e.g., March 2000 for TY 1998 information returns) to include those payers who filed their information returns late.
Therefore, by the time that the IRS issues backup withholding notices, the relationship between most payers and the recipients of the non-employee compensation has terminated. Of the 801,263 payers who submitted Forms 1099-MISC for TY 1996 with invalid TINs, 441,399 potentially met the IRS’ criteria for issuing backup withholding notices. However, only 113,815 (26 percent) of these payers had retained some of the same workers in 1997. By 1998, just 51,257 (12 percent) of these payers had retained some of the same workers.
The future availability of a TIN verification system provides an opportunity to expedite and strengthen the backup withholding notification process
If legislation is not enacted to require the mandatory withholding of taxes on non-employee compensation (as recommended on page 8 of this report), then other changes to the backup withholding laws and penalty provisions are needed. These changes are needed to minimize the potential loss of tax revenue and enable the IRS to more effectively encourage compliance with the information reporting requirements.
A prerequisite to improving payer compliance with information reporting requirements is the availability of a system that payers can use to verify the accuracy of a TIN at the beginning of their relationship with an independent contractor. The SSA already offers an Enumeration Verification Service (EVS) for employers that wish to ensure that the SSNs of their employees are correct when completing Wage and Tax Statements (Forms W-2).
At one time, the IRS had a TIN verification system in place on a pilot basis, but the equipment supporting the system was destroyed by fire and was never replaced. As part of its overall business systems modernization efforts, however, the IRS plans to develop an Internet-based application by October 2002. Once it is developed, payers required to file information returns will have an opportunity to determine whether the income recipient’s name and TIN match the SSA (for SSNs) and IRS (for EINs) records prior to filing the information return. However, the IRS has no current plans to provide a complementary way, such as by telephone, of accessing the TIN verification system for those taxpayers who do not have access to the Internet.
In addition to improving the accuracy of information returns reporting non-employee compensation, we believe that the IRS’ development of a TIN verification system also represents a major opportunity to expedite and strengthen the backup withholding notification process and protect the government from the loss of tax revenue. By changing the law to require businesses to use the TIN verification system at the time they hire an independent contractor, the interactive response from the TIN verification system that a submitted TIN was invalid could provide the IRS’ official notification for the business to begin the backup withholding process. This would eliminate the significant lag time that currently exists with the IRS’ backup withholding notification process.
Civil penalties are not effectively promoting compliance with information reporting requirements for independent contractors
As previously stated, Treasury Regulation § 301.6721-1 permits the IRS to impose a $50 civil penalty upon payers for each information return that fails to include all required information or that includes incorrect information. Civil penalties exist to encourage voluntary compliance by supporting the standards of taxpayer behavior required by law, and are effective when they educate taxpayers and enhance their future compliance.
The IRS has established an administrative threshold that causes the Incorrect Information Penalty to be rarely proposed or assessed. As a result, the penalty appears to have a negligible impact on encouraging the accurate reporting of TINs on Forms 1099-MISC.
For example, the IRS’ data showed that:
Thus, the IRS’ administration of the penalty excludes the vast majority of payers whose submissions of Forms 1099-MISC show obvious failures to make good-faith efforts to comply with the backup withholding requirements. For TYs 1996 through 1998, for example, nearly 619,000 payers submitted more than 1,320,000 Forms 1099-MISC with missing TINs or with obviously incorrect TINs. Since none of these payers had implemented backup withholding, it suggests that most payers can fail to comply with the information reporting and backup withholding requirements without any financial consequences.
Recommendations
To promote accurate information reporting for non-employee compensation, strengthen the backup withholding and penalty program, and protect against the potential loss of tax revenue, the Director, Compliance, SB/SE Division, should:
Management’s Response: The Commissioner, SB/SE Division, responded that he will consider the feasibility of supplementing the Internet-based TIN confirmation program with an automated telephone-based TIN confirmation process. However, he did not agree that the IRS should propose legislation making it mandatory for payers to verify the accuracy of TINs at the beginning of their relationship with a payee. He stated he did not agree that such legislation would be effective or that the IRS could administer such a mandate. He also stated that, if such a system were created, it would be cost prohibitive to administer.
The Commissioner, SB/SE Division, did not agree with changing the IRS’ administrative guidelines so that, when the results of any submission to the TIN verification program indicates that a TIN is invalid, it constitutes the official notice to the payer to begin imposing backup withholding if the recipient does not provide a correct TIN. He stated that it is cost prohibitive at this time to implement a system to track those payers who are not imposing backup withholding on missing TINs.
The Commissioner, SB/SE Division, will consider proposing legislation to change the criteria for asserting the Incorrect Information Penalty, as well as the amount of penalty that should be applicable for noncompliance. However, he advised that resources have not been identified to fund the design and implementation of a tracking system for those accounts that should have been in backup withholding status.
Office of Audit Comments: Again, we are encouraged that the IRS plans to consider some of our recommendations. However, we are disappointed that the IRS’ response does not reflect a stronger overall commitment, or propose alternative solutions, to address a significant tax compliance problem involving a rapidly increasing segment of taxpayers.
We are particularly concerned that the IRS does not plan to enforce accurate TIN reporting once an electronic web-based TIN verification program is made available to payers. Without enforcement, payers could put in any nine digits for a TIN to avoid imposing backup with-holding and the IRS would have no more compliance than it does now.
The IRS’ limited attempts to apply backup withholding requirements and impose civil penalties after payers have submitted their annual information returns are not effectively promoting compliance by independent contractors or reducing the number of documents received each year with missing or invalid name/TIN data. Significant tax revenues may be lost by the IRS’ inability to match information documents with missing or invalid TINs with tax return data.
A tax law change to require payers to withhold taxes from payments to independent contractors offers the best solution for increasing the accuracy of TIN information on Forms 1099-MISC reporting non-employee compensation. Expanding withholding to nonwage earners would also protect the Treasury from the potential loss in revenue resulting from unreported income and unpaid taxes.
A second approach would necessitate changing the law to require payers to verify the accuracy of a TIN at the beginning of their relationship with a new worker. The IRS’ planned Internet-based application could be used to make the backup withholding notification process instantaneous when a payee furnishes the payer an incorrect TIN. Stronger penalties are needed for payers who do not impose backup withholding when required by law.
Appendix I
Detailed Objective, Scope, and Methodology
Our overall objective was to determine whether opportunities exist for the Internal Revenue Service (IRS) to increase payer compliance with the information return filing/reporting requirements for non-employee compensation through using the existing laws and regulations. To accomplish this objective, we:
I. Determined whether the IRS effectively monitored and enforced payer compliance with the Internal Revenue Code (I.R.C.) provisions enacting backup withholding requirements for income recipients who fail to furnish a correct Taxpayer Identification Number (TIN).
Appendix II
Major Contributors to This Report
Gordon C. Milbourn III, Assistant Inspector General for Audit (Small Business and Corporate Programs)
Philip Shropshire, Director
William E. Stewart, Audit Manager
Rosa E. Cantu, Senior Auditor
Una K. Smith, Auditor
James Adkisson, Computer Programmer Specialist
James M. Allen, Computer Programmer Specialist
Kevin O’Gallagher, Computer Programmer Specialist
Appendix III
Commissioner N:C
Deputy Commissioner, Small Business/Self-Employed Division S
Director, Compliance, Small Business/Self-Employed Division S:C
Director of Communications, Small Business/Self-Employed Division S:COM
Acting Director, Internal/External Stakeholders, Small Business/Self-Employed Division,Compliance Policy S:C:CP:I
Director, Legislative Affairs CL:LA
Director, Office of Program Evaluation and Risk Analysis N:ADC:R:O
Chief Counsel CC
National Taxpayer Advocate TA
Office of Management Controls N:CFO:F:M
Audit Liaison: Commissioner, Small Business/Self-Employed Division S
Appendix IV
Type and Value of Outcome Measure:
Methodology Used to Measure the Reported Benefit:
The potential $2.2 billion in increased revenue/revenue protected per year was calculated by applying the 31 percent backup withholding rate to the total $7.2 billion in non-employee compensation payments reported to the Internal Revenue Service on Tax Year 1998 Forms 1099-MISC that did not contain a TIN. These funds represent the tax dollars that approximately 192,000 payers were required by law to withhold from nearly 417,000 independent contractors who did not furnish a TIN.
Appendix V
Management’s Response to the Draft Report
The response was removed due to its size. To see the complete response, please go to the Adobe PDF version of the report on the TIGTA Public Web Page.