Montclair State University School of Business Professors Joe LiPari and Leonard Lauricella, provided a recommendation for solving the issue of cash only businesses not paying their fair share of taxes. The article was published in the May 8th issue of the Asbury Park Press.
IRS' biggest problem is that audit process is time intensive
By Joseph LiPari
Most people who work receive various forms that report their income to the government for tax purposes. Employees generally receive a Form W-2 from their employers at the end of the year. Self-employed workers who earn more than $600 each year from a business are issued a Form 1099 from the business.
Anyone who receives investment income, interest, dividends or capital gains is supposed to receive a Form 1099 detailing the amount received either from the actual source of the income (for example, a dividend from General Electric) or from a financial institution such as a bank or brokerage house that is holding the investment as a custodian for the investor.
In each of these cases, the income information on the forms is reported to the Internal Revenue Service. It is then relatively simple for the IRS to match these income reports with the income declared by taxpayers on their tax returns.
But if income is received from someone who is not in business, the person making the payment is not required to report that payment to the government. An example would be receipt of service income for repair to someone's personal residence or landscaping their property or repairing their automobile. This, however, does not relieve the service provider from having to report and pay tax on the income. When the payment is in cash, it may be difficult for the IRS to know whether or not the recipient has reported that income.
The Earned Income Credit (EIC), a refundable tax credit available to certain low-income individuals, poses a similar problem. In order to claim the credit, a taxpayer's Adjusted Gross Income, or AGI, must fall below a certain level.
Taxpayers whose business receipts consist primarily of cash are often "creative" when filing their taxes and report just enough income to be eligible for the maximum credit of more than $6,000 in 2014. In theory, it is possible for a taxpayer in this situation to pay no income taxes -- yet receive this "gift" from the government.
Well aware of these potential problems, the IRS on its website has posted a handbook that IRS agents should follow when auditing a taxpayer in a cash business. It gives the agents specific, detailed instructions on everything from how to construct a taxpayer interview to what taxpayer records to review — including bank records and loan applications. It even offers guidance for reviewing taxpayers' lifestyles, such as the cars they own and their living accommodations.
The real problem for the IRS is that this process is highly labor-intensive. It can take a long time to audit each taxpayer. The handbook suggests that an IRS agent schedule at least two hours for the interview alone. Reviewing and analyzing the taxpayer's records may take several hours more. In light of recent budget cuts, it is impossible for the IRS to audit more than a small percentage of all businesses — let alone cash-intensive ones.
Clearly the solution does not lie in requiring everyone who is not involved in a trade or business to report the payments they make to gardeners, dry cleaners, plumbers and the like. Even if it might solve the problem, the solution would be worse than the cure.
While the IRS has a whistleblower program that pays informers for information leading to the successful prosecution of tax evaders, this is a complicated procedure that usually subjects the informer to an audit — a frequent deterrent for would-be whistleblowers.
A larger potential problem looms in the future. As the use of digital cash grows, it will become increasingly difficult to trace income. The IRS includes a section on the audit of digital cash in their handbook, but if cash is used to purchase the digital cash it may become almost impossible to trace.
Ultimately, the only workable solution may be to budget more money for enforcement. It's not necessary — or practical — to audit everyone, but if word gets out that the IRS has stepped up its enforcement efforts, taxpayers with cash businesses may be more likely to report their income accurately.
Joseph LiPari is an assistant professor in the School of Business at Montclair State University. Leonard Lauricella, an associate professor in the business school at Montclair State, contributed to this essay.